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. Amid episodes of stress and illiquidity, continuing central bank action and changing regulatory frameworks, investors
sought refuge through three traditional avenues to capital preservation: investing cash with depository banks, buying U.S. Treasury bills directly and
buying shares in regulated 2a-7 money market funds.
Until now, these strategies mostly succeeded in preserving capital. However, regulatory and market forces are changing the landscape, and these traditional
schemes 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. As monetary stimulus in the U.S. winds down, 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.”
Traditional strategies: played out?
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 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 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. The opportunity
cost for investors will rapidly become apparent. In short, we believe the return prospects for money funds and T-bills will be structurally subdued after
the Fed’s hiking sequence commences.
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.
Fine-tuning for the changing market environment
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 U.S. monetary policy from accommodative and “QE-centric” since the
financial crisis to less accommodative, tighter conditions that reflect the improving U.S. economy is one source of this volatility. The prospect of Fed
hikes over the next few quarters is at times unsettling to investors exposed to risk assets or interest rate risk.
Gaps in market performance – volatility – have become synonymous with lack of liquidity in the marketplace. However, this is a bit of a misnomer. While
liquidity conditions have changed over the past few quarters, it is not necessarily a valid contention that the markets are lacking liquidity. Instead, we
believe what they lack is inexpensive liquidity, a big change compared with the past decade. Banks, market makers and other quasi-traditional
sources of liquidity have been forced to recalibrate their business models, and the once-cheap capital used to facilitate the greasing of the marketplace
wheels has been repriced to reflect the higher costs of capital and global regulatory requirements today. The New Normal for obtaining liquidity is
generally one of higher transaction costs and wider bid-offer spreads.
Investors should be cognizant of the higher implicit costs involved in frequent repositioning due to the changes in liquidity conditions. Active managers
can weigh these costs against the benefits and potentially capture attractive liquidity premiums and subsequent excess returns. Being positioned
appropriately assumes investors are willing to adopt a more proactive approach to capital preservation, which we believe will be highly beneficial for
investors in today’s environment.
Rising inflation: Flip to the B-side
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 to preserve
their capital while assuming a limited volatility profile for their investments.
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, and the real cost of such strategies will be seen in negative real returns after inflation – even as rates begin to rise.
We suggest investors begin to listen closely to capital preservation’s “B-side.” We are on the brink of a New Normal for liquidity management and
conscientious capital preservation. In our view, all investors – retail and institutional – can benefit from an active approach
that not only takes into account changes to portfolio and market liquidity but also aims to offer enough capital return to protect purchasing power. While
B-sides by definition are less popular than A-sides, history shows that many have carried their own weight and become just as embraced. Consider famous
B-sides: “I Am The Walrus” by the Beatles or “The Sweetest Thing” by U2. Initially considered outliers, they both now hold prominent places in rock music
history. Similarly, we think New Normal approaches to capital preservation will soon be mainstream hits with investors.
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, such as PIMCO Low Duration and PIMCO Short-Term Strategies, seek to preserve purchasing power, as well as
capital, by investing in assets that may offer more yield and the potential for higher total returns in exchange for a minimal increase in risk.