Vinyl single records have two sides: The A-side is always the well-known hit song by the musician, and the other, called the “B-side,” is often a lesser-known (or unknown) work. When it comes to cash management, the hit song on the A-side—“Capital Preservation Is King”—has been played over and over since the financial crisis. As monetary stimulus in the US winds down, however, global investors need to consider turning the record over to the B-side and listening to the new tune for cash management: “Purchasing Power Preservation.”
Until now, traditional cash management strategies—investing via money market funds, directly buying US Treasury bills, or placing monies on deposit with banks—have mostly succeeded in preserving capital. However, regulatory and market forces are changing the landscape, and these traditional strategies have become less appealing or simply less available. In addition, many have failed to preserve purchasing power: Their near-zero returns have trailed even recent modest levels of inflation.
Time for a different tune in cash investing
Of the three traditional strategies, regulated money market funds have been the vehicle of choice for investors looking to manage liquidity while preserving capital. Over the past few years, investors have even forgone attractive returns, with money market funds yielding a mere 0.01% at the end of June, according to Crane’s Money Fund Index. With bond yields low overall and inflation expectations benign, the opportunity cost of this strategy has been small over the past five years.
But things are changing.
First, all three traditional methods of seeking to preserve capital are becoming increasingly curtailed. In general, banks are not encouraging deposits as these are no longer shareholder friendly, T-bill supplies have diminished as the fiscal outlook has improved, and money market reform in 2016 will likely bring floating net asset value (FNAV) share classes and the potential for withdrawal gates and redemption fees. Tools for cost-effective, immediate liquidity management and assured “par” capital preservation—in both nominal and inflation-adjusted real terms—are quickly becoming phenomena of the past, in our view.
In addition, investors waiting for rates to rise so that yields in traditional strategies become more attractive may be disappointed, especially holders of money market fund shares. During previous rate hike cycles, yields on money market funds have generally increased commensurate with the prescribed rate hikes. However, this cycle is likely to be different. A variety of factors, including lack of supply of investable assets for money market funds amid growing demand, will likely leave net yields on many short-term instruments significantly lagging: As the Federal Reserve moves 25, then 50 and even 100 basis points higher, the disconnect between the rate the Fed is targeting and the actual rates on short-term assets will likely continue to grow.
Investors will be phoning their brokers demanding to know why the standard liquidity management tools are still producing paltry returns even though rates have moved higher—not an easy question to answer.
Rising inflation: Flip to the B-side
We suggest investors begin to listen closely to capital preservation’s “B-side.”
By now, investors have experienced the increase in market volatility across all asset classes over the past few years. There are a variety of reasons for these episodes but all reflect a changing investment paradigm. The evolution of US monetary policy from accommodative to less accommodative, tighter conditions is one source of this volatility.
The prospect of the Federal Reserve raising interest rates should not necessarily be feared; in fact, it is a harbinger of positive economic data and growth. But with increased growth comes an increase in inflationary pressure, however modest it may be. While inflation is a significant consideration for all investors, during the upcoming tightening cycle, any increase in inflationary expectations will be more poignantly felt by those seeking capital preservation.
Investors have typically accepted modest nominal returns in the past in an effort to preserve capital, but even modest inflation will make money market fund returns look inadequate. The real cost of such strategies will be seen in negative real returns after inflation—even as rates begin to rise.
Consider active short-term strategies
Ahead of the Fed’s rate actions and the implementation of the Securities and Exchange Commission money market fund reform in 2016, we believe now is the time for investors to consider active approaches for capital preservation and look beyond money market funds. Alternatives, including low volatility short-term strategies for cash management, may offer more yield and the potential for higher total returns in exchange for a minimal increase in risk.
Learn more about PIMCO’s long-term thinking for short-term strategies.
Jerome Schneider is a managing director and head of PIMCO’s short-term and funding desk.
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