New regime, new opportunities

Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.

 Historically, cash has often been seen as a temporary parking place for funds or as a means to bridge the gap between investment opportunities. However, with higher interest rates in effect and global economic uncertainties looming, cash has emerged as an asset class that demands another look. So how might investors consider cash as an asset class right now?

I'm pleased to welcome Beccy Milchem, Head of International Cash Management at BlackRock. Becky will join us to talk about the role of central banks and their recent rate announcements, how technology might impact the future of the asset class, and the top three things investors should consider when it comes to cash in uncertain market conditions.

 Becky, thank you so much for joining us on The Bid.

Beccy Milchem: Thank you for having me, Oscar.

Oscar Pulido: So, Becky, today we're talking about cash, which I have to imagine is a topic that is of interest to a lot of people. but when I think about cash, I think about currency and bills in my hand. But when you think about it from the context of an investor's portfolio, I think it means more than that. So maybe you can help elaborate on that a bit.

Beccy Milchem: Yeah, and I think it's a really good point. The term cash can mean different things to different investors. From readily available overnight cash, which could be held in a bank deposit or an overnight money market fund to cash and cash equivalents, which could encompass things that term out a little bit more, typically out to three months. Or even anything out as far as 12 months to two years and physical, money market securities that are held within a portfolio.

Oscar Pulido: And I think of the. phrase cash is king that seems to be something that gets said once in a while, but actually for many years, over the last 10 or so, with interest rates so low, it was quite punitive, I think, to have cash- you weren't earning much of a rate of interest. Now we're going through a cycle where central banks have been hiking interest rates quite aggressively, so how does that impact now the way in which investors are thinking about their cash allocation and their portfolios?

Beccy Milchem: Yeah, and I've always preferred the term Cash Is Queen! I think we went through a long period of time where people really didn't focus on it. As the world went into lockdowns, central banks were responding quickly to help economies, and many reacted by taking interest rates down to near zero or maintaining negative rates. These lower base rates were intended to feed through to lower borrowing costs for businesses and households so that lending didn't grind to halt and that people were able to keep spending.

As an investor of cash through our money market funds, we really had to be focused on client needs through those initial lockdown periods, and the reactions to problems that we all faced and what that meant for clients’ liquidity needs. In times of market volatility, we know that liquidity is a priority for all types of clients, and we will typically hold much higher levels of overnight and weekly liquidity in the money market funds that, that we manage. The aftereffects of the pandemic though and how central banks are reacting now is also having a very direct effect on cash investors. Global shutdowns meant that we have experienced a huge global supply shock with certain parts and goods very limited in availability, which has had a knock-on effect on prices increasing as demand has outweighed supply, and the war in the Ukraine has further compounded this issue but also not helped investor confidence levels. While some of those higher cash balances that people had through the peak of the pandemic are being spent down as a necessity.

What we're finding is investors are still really cautious about dipping a toe back in and taking more risks, so actually there are a lot of people still holding higher levels of cash.

From late 2021, we saw the Bank of England make the step to increase interest rates, and they have been followed by the Fed in March 2022 and the ECB, which moved its deposit rate back to zero in July last year, having maintained a negative deposit rate since 2014. Each central bank is attempting to combat rising prices by slowing demand, and we have seen a steady pace of increases up to this point.

From a cash perspective, we've gone from an environment where the opportunity costs of returns, to your point around different cash investment options was really low, and thus cash probably became a bit of an afterthought within portfolios. And what we've seen in the last few months is that with interest rates constantly moving higher, a more proactive approach to managing cash is definitely warranted.

One of the reasons that many investors have turned to money market funds is to help them proactively manage duration, risk, and effectively outsource this to a team of portfolio managers whose job is dedicated to the cash investment options available through money markets. Typically, money market funds will position themselves extremely short in duration ahead of expected central bank hikes that the fund has dry powder to deploy post the rate increase and will quickly reflect a prevailing market rate.

Oscar Pulido: I think we're used to seeing sort of volatility in the stock markets, and for that matter, we've seen a lot of volatility in the bond markets, but you've also highlighted that there's just a lot going on in the cash markets with changes in interest rates across the world. Now this also reminds me, I've heard you say that not all liquidity is created equal. So, what do you mean exactly by that?

Beccy Milchem: So, one thing that I think tends to be common amongst cash investors is that when you have a need for cash, you want to make sure you have access to it and a reasonable amount of certainty as to what you have to hand.

Now, for us and for many investors, the ultimate liquidity is that overnight cash bucket, because you know you've got it there when you need it. And as I touched on earlier, one observation I would make about the last year is that coming out of near zero or negative interest rates into an extremely dynamic interest rate environment has meant that it has been very challenging to make the right call if you are terming out your cash investments beyond overnight.

When you've been at zero and suddenly there is something on the table, it's quite easy to have that bit of a magpie moment of something bright and shiny that's not zero and jump straight in. And what we've seen is a lot of investors locking up money for a few months or even a year, which might have looked really attractive at first, but when you consider how far central banks have moved, The Bank of England, has moved, 12 times in between that December 2021 and May this year. So many of the term exposures that clients may have invested in might not have paid off through the duration of that investment. We often hear of term deposits with banks being self-liquidating, which is true if you don't need the cash until maturity, but it's definitely not the case if you need it before. Term bank deposits are typically unbreakable, meaning that you have to pay a penalty if cash is accessed early. And similarly, if you need to raise cash by selling direct investments in money market securities, there will be a price to pay if that instrument is not offering the prevailing rate.

Now, the case in point here has really been the short-term US T-Mobile market. In the run up to the debt ceiling debate, so highly rated short-term government bills typically offer significant liquidity in that they are easy to sell if you need to raise cash. But spreads on these exposures have been more volatile as investors have been avoiding holding positions with maturities close to the X-date, which is the date that would potentially mark the treasury running out of funds.

And to give you a live example, the yield on a US T-bill maturing on the 1st of June has at times been trading 200 basis points higher than a bill maturing at the end of May. That's a huge difference if you are a forced seller in this market, which is why we think that money market funds or liquidity funds make so much sense for investors.

They give you access to a sizeable pool of readily available cash, as well as portfolios of very high-quality holdings that evolve as the circumstances change. Now, we love T-bills for the liquidity that they would typically offer but what we typically do in this kind of scenario is rotate portfolios proactively in a way that as an investor, if you're not focused on the cash markets, you might not be able to do readily yourself.

Oscar Pulido: And you highlighted an example about investors who, as interest rates were going up, started to allocate to instruments that offered them a higher interest rate, but also locked them in at that interest rate and therefore they missed out as central banks continued to hike interest rates. And so therefore, as much as that is cash, it wasn't as liquid as they wanted it to be.

Beccy Milchem: Exactly, it's still cash and if you know you can hold that investment for the duration, it's fine. You're going to get your cash when you need it,

but sometimes those unforeseen expenditures can come and hit us at a personal level or even at the institutional level, and so that's where liquidity and it not all being equal comes into it.

Oscar Pulido: You've touched on central banks, you've mentioned the Bank of England, the Fed, the ECB, all have embarked on one of the fastest rate hiking cycles that we've seen in a few decades. As we're appearing to reach the cycle where maybe those rate hikes are going to slow or potentially even pause, what does that mean for some of those cash markets that you've been talking about?

Beccy Milchem: Yeah, central banks have a really difficult battle on their hands. They're continuing to grapple with bringing inflation down when economic growth is also perceived to be in a very delicate balance.

The recent May meeting saw a further 25 basis points increase from the three majors you mentioned, but it's definitely slowing the paces as we look forward, and we're probably close to the peak, but with a huge amount of uncertainty around inflation, numbers still running so high, and the added overlay of politics in each domestic market and at the global level, I think there's still a bit of an uncertain path ahead. Central banks themselves are now much more data dependent than they were a few months back with a growing awareness that the lag of transmission of previous hikes still has to catch up with within consumers. Now markets themselves are predicting that many central banks will go too far increasing rates and thus need to bring them back down a bit within the next sort of six to 12 months depending on which currency you are looking at.

This means investors are facing a yield curve that includes market pricing of those rate cuts, and in some cases has become inverted in that timeframe. So as a cash investor, you may plan your strategy based around when you have a known cash need and have different buckets for everyday use. A big expenditure for you and I might hopefully be something like a holiday, a car, or a house purchase, for institutional investors, that might be like a known acquisition or a transaction from a portfolio positioning taking place, in a few months. But from a practical perspective, an inverted yield curve in short term markets means you're probably not going to get compensated appropriately for the risk of locking up your cash for say, six months or a year. There is also still a lot of risk in turning out your cash if markets have got it wrong and rates stay where they are or perhaps even move higher still.

So, the way our portfolio managers are thinking about this is that throughout most of this hiking cycle, the market has underpriced the level at which rates will be moved to by central banks. So, unless you're looking at the markets all day, every day, that's a really difficult thing to keep on top of.

And at the end of the day, an investment strategy comes down to tolerance and appetite for risk. But if you are a cash investor with daily or short-term need for cash, there are not too many downsides to staying short at the moment. So, options that give you daily or next day access to your cash will allow you to be nimble, but you do still need to make sure those options are reflective of where interest rates are, as with inflation running where it is right now every basis point earned on cash is also critical.

Oscar Pulido: So, Becky, one of the underlying themes that you've touched on is, being nimble, and being active and flexible with your cash portfolio, which is again, I think an area of the market that many people don't realize you need to be as nimble in. You've also touched on a number of things that have clients concerned, and perhaps one of the reasons why they continue to maintain a higher cash allocation. It's things like inflation, you touched on the war in Ukraine, you touched on the debt ceiling. What are some of the other concerns that clients are raising?

Beccy Milchem: The cash investors, are typically concerned about whether they're going to be able to get access to their cash when they need it. And the mantra that most cash investors live by including ourselves, comes under a three-pillar approach.

So, the first being safety or capital preservation, knowing what you're going to get back, the second being liquidity and knowing you've got access to it when you need it. And the third being yield. And when it comes to concerns or things being raised by clients at the moment, they've typically fallen under one of those pillars.

 Firstly, the vulnerabilities in the banking sector this year have highlighted concerns of having all of your eggs in one basket, both from a capital preservation perspective, but also about always having that timely access to cash. As we talked about earlier, investors might be more defensively positioned than usual, given broader market sentiments. The level of cash they have may be much more than they are used to holding. Now in the past this may not have warranted too much thought, but now they may be thinking they need to practically diversify their exposures. Individual investors may have some level of government protection on bank deposit products, but investors with much larger cash balance, particularly on the institutional side, will need to think about how they prudently diversify their risk to individual counterparties and monitor their exposures.

Again, outsourcing the diversification and credit monitoring to dedicated products such as money market funds with their dedicated resources looking at this on a daily basis might be the most efficient way to manage those risks. Secondly, and as I've already mentioned, most investors are concerned about having access to their cash when they need it, and their liquidity and the debate around the US debt ceiling has prompted investors to be cautious around exposures in US T bills that may have some risk of delayed payments.

Now, I would hope by the time this recording goes out that we may have a resolution on the debt ceiling. But having been here before, this feels like a world trodden path for dedicated money market portfolio managers who will typically naturally rotate out of maturities in that X date window. And where investment guidelines allow, they'll rotate into overnight repurchase agreements.

They're collateralized by US government debt to give that portfolio the resiliency it needs. Now. Finally, my third pillar was yield, and the return on cash investments has also been much more in focus, in part spurred on by media coverage, prompting investors to review what their cash is earning. But cash has really gone from being the afterthought thought to being the asset class that many conversations are focused on as investors survey the options available.

Oscar Pulido: Beccy if we can switch gears a little bit and talk about technology. We hear a lot about artificial intelligence and how it's affecting virtually every industry, including asset management. How do you see the role of technology impacting the cash industry?

Beccy Milchem: So, in response to the US Regional Bank challenges, it's been widely reported that cash moved much more quickly in 2023 than it did during the global financial crisis.

Now, I think that is partly down to how quickly digital media spread the news of troubles in regional banks, but it is also down to the fact that physically moving cash can be a lot easier via technology today. We see a lot more of our investors accessing our money market funds through some kind of platform which can offer trading efficiencies and straight through processing, all enabled through the technology that exists today that didn't in 2008.

Similarly, a lot of the technology that helps companies look at things like cash flow forecasting means that a lot of institutional investors simply have a better line of sight on what cash they have available to invest today. Now we are seeing a lot of asset managers and banks investing in cash investment technology, and we're starting to see some of the functionality that we are used to in our personal lives through banking and investment applications on our smartphones be rolled out on institutional cash trading platforms.

I'm not quite sure it's in the realms of AI, but a big thing for investors is the level of automation that can be driven and across certain institutional investors, we see a lot of demand for sweep technology whereby the investment platform can simply take the level of excess cash determined by an underlying client and efficiently sweep this into their chosen investment products such as a money market fund.

And I think the other area that's really moved along is that technology can really help with all of the important reporting elements. And so, we look at the ways that clients interact with the technology, and they're looking at things like simplifying and automating things such as positions reporting, or what aggregate exposure is across a number of credits across their overall portfolio, even down to the cash.

Oscar Pulido: So maybe just looking ahead, you've touched on a lot of different aspects around the market environment right now, but what are two or three things investors should be thinking about with respect to their cash allocation as they look forward?

Beccy Milchem: So hopefully it's come through today, but I think cash is most definitely an asset class you need to think proactively about, and I think it comes back to that mantra that we live by capital preservation, liquidity, and yield, but maybe put slightly differently, know where your cash is, know how quickly you can access it and what it is earning.

Most of us don't have time or dedicated people in our teams to look at this all day, every day, so think about the tools you can use to more efficiently help you manage your cash and whether it's right to outsource it. And similarly in these uncertain times, which I don't think are going away, navigating terming out cash investments will continue to be challenging, but there are dedicated products that will continue to help proactively manage these risks. And my advice would be really to talk to an asset manager who has a specialty in this space.

Oscar Pulido: Well, Beccy, thank you so much for shining a spotlight on an area of the market that, maybe doesn't always get the attention that it needs. And thank you for joining us on The Bid.

Beccy Milchem: Thank you so much for having me.

Oscar Pulido: Thanks for listening to this episode of the Bid. Next week on The Bid, Mark Wiedman talks to Mark Schneider, CEO of Nestle, on the role of food in the transition to a low carbon economy. Subscribe to the bid wherever you get your podcasts.