Challenge for investors: higher interest rates bode well for holding cash, but make for a high hurdle to allocate to other asset classes
Jeff Buckstein • Financial Post
Published Apr 23, 2024
Although inflation has dropped from 40-year highs, and some experts believe the threat of a serious recession might be receding, cash still has an important function inside an investment portfolio. It provides short-term flexibility to meet immediate financial needs, and can serve as a hedge against unforeseen economic shocks or downturns.
“When we look at asset allocation decisions for ultra-high-net-worth individuals in these times, in terms of how you should want to be positioned as an investor, cash is still king for fixed-income portfolios,” says Scott Smith, chief investment officer of Viewpoint Investment Partners Corp. in Calgary.
“Right now you want to be overweight cash in your fixed income portfolio,” he adds, explaining that overweight cash is equivalent to reducing the duration of the fixed income securities in a portfolio, which effectively favours shorter-term maturities over longer-term maturities.
“We’re likely in a scenario where we don’t get either a soft or a hard landing for some time,” predicts Smith. “We’re in a bumpy or no landing type scenario where interest rates have to remain high mainly because the U.S. economy in particular, is still running fairly hot.”
The challenge that all investors have now is that interest rates are high at about 5 per cent, which bodes well for holding cash, but this represents a high hurdle to allocate for various other asset classes, he says.
For example, if the earnings yield of the stock market is 4.7 per cent but an investor can earn 5 per cent on their cash holdings, “then as an investor I need to be confident that either stock market earnings will increase, or multiples will expand in order for me to earn a premium over cash,” Smith elaborates.
Illiquid holdings and USD scenarios
“Our families have cash positions typically less than 5 per cent, and in many cases less than 3 per cent,”
says Arthur Salzer, the founder and chief executive officer of Northland Wealth Management Inc. in Oakville, Ont. How much cash to hold in an individual portfolio, however, boils down to a matter of choice, taking into account personal financial considerations.
For example, families with many private businesses, and who hold private investments, equity, or real estate
“will tend to bifurcate and barbell their approach to hold higher cash weights. It could be 10 per cent to 20 per cent of their net worth, because they’ve got such a large proportion in illiquid investments,” says Salzer.
External conditions can also heavily impact investment portfolio decisions.
For example, notes Salzer, many ultra-high-net worth (UHNW) families in Canada are most likely to denominate their portfolio in U.S. dollars, which is the reserve currency of the world, and so they will primarily be assessing their situation in terms of factors underlying the performance of the U.S. dollar.
Their outlook will tend to be different than high-net-worth investors in Canada – with, say, a net worth of less than $10 million – whose portfolio will be primarily held in Canadian dollars, he adds.
UHNW investors whose assets are predominantly in U.S. dollars are going to be assessing conditions south of the border where, while the U.S. has experienced a slowdown in growth, “I don’t believe we’re seeing numbers that show there’s an economic recession there. In fact, the economic numbers in the U.S. are slightly stronger than what a lot of market participants have been estimating for 2024,” says Salzer.
As a result, it is less likely that multiple interest-rate cuts will happen as fast and as large for U.S. currency investors as they will in Canada, which has experienced several quarters of weak economic growth, says Salzer.
Furthermore, a large baby boomer cohort in the U.S., and to a lesser extent in Canada, isn’t as impacted by high interest rates, because that generation is less likely to have a mortgage or credit card debt.
In fact, they might be generating even more interest income from the savings they have in their account due to higher interest rates, which in turn is supporting consumer demand, says Smith.
“So we’re not really seeing the bite that central banks may have expected from higher interest rates,” he adds.
Funding short-, medium- and long-term needs
Brad Jesson, a principal in the Family Office Advisory at Northwood Family Office Ltd. in Toronto, says it is hard to try and “time the markets” because it is impossible to predict factors such as where inflation or interest rates are going to trend, or when or if a particular jurisdiction might be heading into a recession.
Therefore, it is most important that individual investment portfolios, including the cash allocation within that portfolio, be set up to reflect personal goals and aspirations.
“We create a balance sheet for our families and we match their assets, which are predominantly their investments, with their liabilities. Those liabilities are goals as to what is required to fund them over the next year, five years or even 10 years,” Jesson explains.
“We recommend clients hold cash for any goals, or liabilities, that need to be funded within the next year, as this provides them certainty that the funds will be there when needed. If markets were to shift during the year, they are not concerned, as the cash to fund their annual goals has been set aside,” says Jesson.
“That could be 5 per cent for some people, or it could be much higher for others, depending on their near-term goals,” he notes.
If the financial goals for which investors require funds are not immediate – say between one and five years – they can invest more into short-term fixed income investments that are typically capable of providing higher returns than cash. In some instances, depending on the strategy involved, a portion of the fixed income return is treated as tax-advantageous capital gains, says Jesson.
If an investor’s remaining portfolio is earmarked for funding longer-term goals spanning over five years or more, they may opt to allocate these funds into risk assets like equities or alternatives.
With their short-term goals adequately funded, they can sleep easier at night knowing they can hold onto these investments and withstand any market volatility that may arise due to factors such as economic or political instability, he says.
Jesson said his firm’s approach is that if an investor is holding excess cash and fixed income that is not required over the next five to ten years, they can contemplate deploying these funds into riskier assets over the longer term.
‘The market is never going to give you the all-clear’ to reallocate cash
When holding on to what the investor perceives as excess cash “the market is never going to give you the all-clear” to disperse that cash into other investments, says Smith.
As a result, investors should always maintain a well-balanced portfolio that also includes exposure to non-cash items, including equities, fixed income, commodities and alternative strategies, he adds.
Some family offices see cryptocurrency, despite its volatility, as a hedge against fiat currency debasement. And, like gold, some see it as an alternate store of wealth.
Salzer notes that Bitcoin, which is not fiat and has no counterparty risk, is one of the only monies available today that is not issued by a government.
“But it has provided a lot of additional return that still has liquidity. It is much more liquid than stocks. It is more liquid than private equity,” he explains.