What opportunities lie between equities, bonds and cash?

Holding too much cash today creates reinvestment risks in the future and increases the opportunity cost of forgone returns in either the equity or the bond market.

The rise in bond yields to multi-decade highs has put fixed income back on the agenda for many investors. For an extended period of time, bonds presented little income and little diversification benefit, given their high price (low yield). This was at a time when ample liquidity was propelling equities higher, with investors broadly adopting the TINA (there is no alternative) trade.

In the past year, while equities and bonds went through a significant repricing, fixed income has adjusted more, given the sharp increase in cash rates. In the year to date ending in October, the yield on the 10-Year UST rose 100 bps to 4.88%, while the forward P/E ratio on the S&P 500 rose marginally from 16.7x to 17.2x. This has resulted in the highest bond yields in many years, while equity valuations remain above their long-run averages. It’s little wonder that bonds are looking relatively attractive compared to other asset classes such as equities.

However, complicating the investment picture is cash. The drag on portfolio returns from holding too much cash is well known, but when cash or cash-like instruments yield the same as part of the credit market, the hurdle to move out of cash is higher.

We can simply assess the relative attractiveness of the three main asset classes—cash, bonds and equities—by comparing the earnings yield on the S&P 500 (the inverse of the P/E ratio) with the yield on U.S. investment-grade bonds (to match the corporate risk in the S&P 500) and the three-month UST (a proxy for cash). There is little differentiation across the three, complicating the choice for investors.

Exhibit 9:

Source: Bloomberg, FactSet, J.P. Morgan Asset Management.
*Cash proxied by U.S. short-term treasuries.
Data reflects most recently available as of 31/10/23.

 

Our view is that cash rates and the yield on short-dated bond maturities are likely to be lower in 12 months’ time given the risks to the economic outlook and fading inflationary pressures across the developed world. This means that holding too much cash today creates reinvestment risks in the future and increases the opportunity cost of forgone returns in either the equity or the bond market.

The fact that the U.S. may be able to avoid a recession suggests that corporates may be able to maintain profits if they can generate enough top-line growth to offset higher financing and input costs. While this would support overall index returns, the rotation within sectors and styles given the dispersion of valuations may be more meaningful for investors. Return prospects may be higher in equity markets outside the U.S. given lower relative valuations and potential for earnings upgrades.

Heading into 2024, the starting point presents plenty of opportunities across asset classes beyond cash. With the economic outlook appearing somewhat sluggish, investors will once again be able to count on bonds to add ballast to portfolios while adding equity exposure.