Key takeaways
- Overweighting cash has been costly for long-term investors who underweighted stocks in 2023.
- The Fed’s extended pause on rate policy puts us on the lookout for falling cash yields.
- Right-size your cash allocation to align with your market outlook and portfolio goals.
An overweight to cash isn’t right for everyone
Too many plays of your favorite song can get annoying and too much candy can give you a stomachache, but too much cash in your portfolio can really cost you.
In 2023, investors have indulged in the generous, nearly risk-free yields on cash. For income-seekers who chose to overweight cash and ultra-short fixed income versus bonds, the indulgence was rewarding. As of November 15, floating rate Treasuries have outperformed the Bloomberg U.S. Aggregate Bond Index by about 4% this year.
But longer-term, growth-oriented investors who favored cash over stocks felt the stomachache as the S&P 500 soared past floating rate Treasuries by more than 10%.
Cash beat bonds, but stocks delivered the strongest returns
Total Return (%) of major asset classes year to date as of 11/15/23
Source: Bloomberg as of 11/15/2023. Cash equivalents defined as the Bloomberg US Treasury Floating Rate Bond Index TR Index Value Unhedged, Bonds as Bloomberg US Agg Bond Index, Stocks as the S&P 500, and 60/40 as 60% S&P 500 and 40% Bloomberg US Agg Bond Index.
Are you holding the right amount of cash?
With the Fed’s rate policy on an extended pause and many believing that the Fed may now really be done hiking, many are wondering what they should do about their cash allocation.
So how much cash should you hold? That depends on three key factors:
1. Your liquidity needs
The sooner you will need access to your money, the closer your investments should be to cash. There’s no reason to take any risk with money you plan to use within the next 6 to 12 months, especially while cash is yielding around 5%.
2. Your investment horizon
The longer you need to stay invested – or the farther out your growth goals are – the more it matters that the interest rate on cash is likely to go down from here. The opportunity cost of being over-invested in cash increases with your time horizon.
3. How often you revisit your portfolio allocation
A strategic allocation to cash within your bond portfolio can help lower your risk over time. But a tactical allocation funded from stocks or bonds on the belief that cash will outperform requires frequent attention. Many tactical portfolio managers earned their fee this year by overweighting cash at the right time. If you revisit your portfolio at least monthly, an overweight to cash could be a sensible tactical allocation. If you don’t, being invested in risk assets may be a better option to avoid missing out on potential market upside.
Does a cash overweight still make sense?
If you hold a tactical position in cash, consider how long you expect cash to continue outperforming bonds. Markets are starting to price in Fed cuts next year, giving rise to reinvestment risk. While floating rate Treasuries may deliver 5.5% in yield today, that could drop to 4.1% by the end of next year.
Cash yields are expected to fall over the next year
Market-implied pricing of federal funds rate (%)2
Source: Bloomberg as of 11/15/2023.
We expect the Fed to keep interest rates high through mid-2024, but bond yields have historically fallen prior to the Fed cutting rates, so investors who choose cash over bonds may lose the ability to lock in today’s high bond yields sooner than they think.
Bond yields typically fall before the Fed’s first cut
Average change in yield between the last hike and first cut, 1990 – 2023
Source: Bloomberg as of 10/31/23. Bps defined as basis points. Data represents four Fed rate cycles.
The good news is that today’s high yields make it hard to lose money in bonds and there are still opportunities to lock them in.
Ready to reallocate?
Global Allocation portfolio manager Russ Koesterich notes that investors should be wary of a longer-term cash tilt: “At some point in 2024 the Fed is likely to start cutting rates as the economy slows. This suggests that investors may want to start shifting into some bond exposure to lock in yields.”
The Global Allocation team has tactically reduced its cash position from a peak of 27% in May 2022 to 4% at the end of October 2023, re-allocating into quality stocks and bonds. If you’re ready to do the same, consider stepping into the belly of the curve (terms of 2 to 7 years), where we see the greatest opportunity to benefit from falling interest rates given today’s inverted yield curve. In equities, we prefer high quality stocks that can weather today’s high interest rates and a potentially slowing economy.
This year has been a case study in the sheer difficulty of timing markets. Stocks outperformed bonds when consensus was for bonds to outperform, and growth stocks outperformed everything when consensus was for another tough year for tech. But that’s the beauty of the diversified portfolio: even if you get a market call wrong, odds are that something you hold still does well.
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