Monday, May 28, 2012

The Safety Conundrum: Cash, Gold, or T Notes?

MONDAY, MAY 28, 2012

Investors--professional and individual alike--need a safe place for at least a portion of their assets.  Cash or money-market funds historically served this purpose.  

The most esteemed professional investors, who effectively have carte blanche when managing client assets, can set aside large portions of clients' assets when the investment outlook is cloudy or exceptionally risky.  Unfortunately most managers aren't permitted the latitude to do so and must remain close to 100% invested, regardless of the overall investment outlook.  

The expression "put money to work" is one of the most hackneyed in the professional investment business.  Watch CNBC for only a short time, and you are likely to hear it as a defense of putting cash reserves in the stock market.  A variation is, "Clients don't pay us a management fee to sit on cash."  The simple point is that there is considerable pressure on most professional investors to look like they are earning their fees by being active, regardless of whether valuations are sufficiently attractive to provide a favorable return/risk tradeoff.

This is especially true currently, as cash yields almost nothing.  It is even more difficult to be patient in waiting for better investment opportunities under this condition.  

Similarly for individual investors, savings and money market account yields of nearly zero percent exert pressure to earn potentially higher returns from bonds that expose the investor to the possibility of large swings in portfolio values from either bonds or stocks.  The notion of "saving for a rainy day" seems quaint these days, as "cash is trash" more aptly describes today's mindset.

There has been an effective alternative to cash since 2000.  Gold not only provided a superb alternative store of value by exceeding the rate of inflation.  It was a superior investment as well, with an annualized return of approximately 17% since 2000 (versus low to mid single-digit returns for stocks and bonds).  

Lately, however, the price of gold has fallen 18% since its peak last autumn.  Short-term supply/demand problems from India and Europe are probably factors for the decline.  Yet, the underlying global monetary policy environment is supportive of gold prices.  Short-term interest rates are still negative after subtracting the rate of inflation, and gold prices have tended to rise historically under this condition.  What is an investor to do?

Some of the largest investors who can't or won't hold cash or gold have used U.S. Treasury Notes as a safe place to park funds.  U.S. Treasuries are easy to buy and sell, and when anxiety forces selloffs in stock markets, Treasuries have risen in price.  But U.S. Treasuries are not risk-free.  With the U.S. Federal Reserve aggressively intervening to support markets and economic activity to an unprecedented extent, it seems only a matter of time before inflation rises or investors lose confidence in holding U.S. Government securities in anticipation of higher interest rates (and consequent capital losses on Treasury securities).

Another potential problem for U.S. Treasuries could be unexpectedly positive developments in Europe.  If the European financial crisis impels the Euro nations to agree to issue bonds for the entire Euro nations--including those financially strong and those financially weak--that could produce a flow of investment funds away from U.S. Treasuries and toward Euro bonds.  Price of U.S. Treasury securities would fall and those of Europe would rise.

Since the 2008 financial crisis, there seems to have been an inexorable decline in yields on U.S. Treasury notes and bonds.  But this actually has gone on for much longer than that, as long-term U.S. Government bond yields have been declining since the peak in 1982.

This 30-year period of declining interest rates (and rising bond prices) must be coming to a close.  While the yield on the 10-year U.S. Treasury Note could fall further from the current 1.75% level, particularly if Europe has further setbacks, I would look to exit U.S. Treasury holdings.  

So is there a reliable store of value for the short to intermediate term?  I think there are three:  cash, gold, and short- to intermediate-term investment-grade corporate bonds.

Steve Lehman

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