210723 Yellen
The US debt ceiling talks loom large over stock markets. Even if a deal does happen, there are multiple scenarios investors have to factor in. Image Credit: Reuters

As I’m writing today, global stock markets are up 10 per cent this year, and just reclaimed the No. 1 ranking among major asset classes.

Let me share with you why we just decided to underweight equities for the first time this year and to add to our largest overweight ever on money market funds.

First, equities. The current rally is not irrational – anyway, the market is always right. The year started with a dream: inflation would recede, allowing central banks to cut interest rates before seeing too much damage to the economy. This logically pushed stocks higher, but it didn’t last long: with persistent inflation and booming employment, central banks only hiked further and markets plunged in March.

But they’re back: the MSCI World is now almost at its January peak and doesn’t show any sign of weakness. Again, there are reasons. First, the Q1 earnings season was much better than forecast on all possible metrics, including, crucially, strong operational margins.

This is precisely why we were not underweight equities until very recently: some will call it “greedflation”, but we had little doubt that companies would be able to pass their higher costs through their final prices.

Second key driver for the rally: a high level of pessimism, leading to a very conservative positioning. Market participants were not ready for good news: positive earnings, resilient economy, a swift and pragmatic response from authorities to the stress in the banking sector.

Finally, but importantly, there’s a new paradigm for the long-term: AI is going mainstream and equity investors are weighing the possibility of a dramatic boost in productivity that would turbocharge future profits.

Could the equity rally go further? It’s obviously possible: positioning remains low, the economy is still resilient, a pause in monetary tightening is in sight, and AI is definitely a strong long-term investment theme.

Check out money markets

We have two issues on a tactical horizon. First, valuation multiples are elevated. This can only be justified by an ideal scenario which may, or may not, happen. Second, implied volatility is cheap: markets are not forecasting any shock.

Put together, it creates an asymmetrical situation for stocks from developed markets. The upside potential is capped, and there is vulnerability to bad news. Or maybe even to good news: the next expected one is a deal being inked in Washington to raise the US debt ceiling.

No doubt, it’s much better than a default. But this will trigger a deluge of treasury issuance to replenish the US Federal Government account, in hundreds of billions. This is a serious liquidity drain markets will have to absorb.

Meanwhile, a good money market fund in dollars should return close to 5 per cent annualized, with virtually zero volatility and downside risk. Cash is not sleeping any more, this risk-free rate is the highest in decades.

From an investment perspective, it’s back as an asset to own, not anymore one to borrow. Does it compensate for inflation? Well, it certainly does if you live in the UAE: our country is far from having the same price pressures as the West, while our currency is pegged to the dollar.

Making cash ready for any action

The 5 per cent also fares well compared to market-implied future inflation, which is what matters more than backward looking numbers. Of course, we don’t know the future trajectory of inflation. If it rises, central banks will hike further, and money markets will follow. If it falls, there are two possibilities. If it’s because of a recession, you will be able to redeploy cash on risk-assets at a cheaper price.

If inflation recedes while growth is intact, which is the ideal scenario, then the fundamental upside potential of DM stocks is anyway limited: the loss of opportunity shouldn’t be too terrible.

Let me conclude on words of wisdom from Warren Buffet: ‘When people talk about cash being king, it’s not king if it just sits there and never does anything’.

Indeed, I am today telling you that cash is king, but importantly, it’s not forever. On a tactical horizon, its risk-adjusted return is simply unparalleled among all asset classes.

For anything below 12 or 18 months, you arguably do not need anything else in your portfolio. On a longer horizon, all asset classes are compelling, but being tactically overweight cash and safe sources of income makes absolute sense in a multi-asset perspective.

It’s also about flexibility: at a time when implied volatility looks dangerously complacent, we are ready to put King Cash at work if - or just when - better opportunities arise in risk assets.