"We have to dispense with these absolutes"
It’s a common motto among investors: Cash is trash. But Oksana Aronov, head of market strategy, alternative fixed income at JPMorgan Asset Management, says not so fast.
“I’ve been hearing about investors losing money sitting in cash, and that cash is trash for as long as I’ve been in this industry,” she said on this week’s episode of “What Goes Up.” “But the reality is that if you have been in cash for the last five years, you’ve essentially outperformed the Bloomberg Aggregate index year-to-date, over one year, three years, and, depending on the day, yes, even five years.”
Below are lightly edited and condensed highlights of the conversation.
Q: What do widening spreads in the credit market signal to you? Is it as obvious as a recession is on the way or is it more nuanced?
A: I’m going to zoom out and express a little bit of scepticism around the bond market’s ability to be that kind of predictive force. Because if that were the case, yields have been lower and lower and at new record lows for so many years indicating a recession, I guess, if we really believe in the indicative or in the predictive function of the bond market. That, of course, has not materialized -- or we had a pretty dramatic dip around the pandemic, but that was a very esoteric event. Outside of that, we haven’t really seen the kind of recession that the bond market would have been predicting at these record-low yields every year. That, of course, has to do with just the tremendous amount of meddling by central banks. That has, frankly, distorted the bond market’s ability to be that predictive or forecasting mechanism.
Having said that, we are seeing a levelling off of inflation expectations. The 10-year breakevens have stuck around in the mid-2s but you are seeing them climb up -- with respect to 2-year and 5-year breakevens -- so inflation expectations there are continuing to tick up or remain elevated. We still don’t have a positive, real return on the 2-year part of the curve. That’s, by the way, something that Powell and the Fed are very much focused on.
But taking a step away from that for a second to talk about the spreads -- yes, we have seen some spread widening. But to put it in perspective, the last time we had a hiking cycle and a tiny bit of inflation was the 2015, 2018 hiking cycle. We had inflation of barely above 2% maybe, the unemployment rate was higher and the hiking cycle was incredibly benign. We still saw high-yield spreads go into the mid-5s. We are barely crossing that threshold now with inflation at a four-decade high. No one can really tell you whether it is, in fact, moderating, or it will continue to tick up.
The unemployment rate is also significantly below where we were during the last much more benign hiking cycle. So I think to call this an opportunity to get invested, to call this a bargain from a spread standpoint, I think we’re far from that. At this point, all the carnage we’ve seen in the bond markets, whether it’s in the interest-rate-sensitive part of it or the less-interest-rate sensitive part like high yield, it’s all been interest-rate driven. Very, very little of it has actually been spread or credit-risk driven. We need to see that punch in order to start to talk about opportunities.
Q: We’ve talked in the past about going into cash, but in a 10%-inflation environment, you’re losing money on that cash. So what do you do?
A: I’ve been hearing about investors losing money sitting in cash and that cash is trash for as long as I’ve been in this industry. But the reality is that if you have been in cash for the last five years, you’ve essentially outperformed the Bloomberg Aggregate index year-to-date, over one year, three years, and, depending on the day, yes, even five years. And out to three years, that’s a positive return versus a negative return. So I think that we have to dispense with these absolutes.
This is one of the craziest things to me, frankly, about how our industry functions, because in fixed income, you absolutely have very identifiable tops. When the 10-year was at 50 basis points, it had nowhere to go but up. So why aren’t there widespread alarm bells sounding off about this? Do you remember hearing that? No. The rhetoric was the same -- cash is trash and you should be invested, and because something else yields more than Treasury, you should buy that, even though valuations there were equally overpriced.
So instead of resorting to these absolutes, we have to really think about what’s priced in. We have to think about inflation right now, it is a serious problem, and yes, you are earning 8% in high yield versus still significantly less in cash. But what is your price appreciation, or what is your capital preservation potential? And which of those are most important to you? Again, to us as absolute-return investors, we focus on capital preservation first.
Given all of the push-and-pull forces in the markets today, we look at it and we say we think that the risks are skewed to the downside. So we prefer to have a lot of liquidity in our portfolio because right now it serves as a free option, essentially, on any asset class in the world. We think that the opportunity set will continue to get better on balance, just like it has for the entire six months of this year. We’ve been hearing people about getting invested in January, February, March and in April, and it continues to get better. And we think that spreads will continue to go wider.
For us right now, again, as absolute-return investors that are trying to manage and outperform cash irrespective of whether the regime is a benevolent one for bonds or not, we’re not investing versus a market-risk-driven benchmark. We’re investing versus capital preservation. We believe that a focus on capital preservation continues to be warranted, and we prefer to be in very liquid structures at this point in a combination of liquidity, high-quality floating rate -- we continue to like that trade. Really for us, this is still a capital-preservation part of the cycle, although I think we’re closer to the end of it than we were a couple months ago.
Probably in the next month or two, we’re going to transition into the start-to-get-aggressive, start-to-go-after-those-returns part of the cycle probably in the next month or two as we see spreads widen and some of these more bearish expectations get reflected in the price. But at this point we think that capital preservation is still the name of the game.
Q: Why not go into very high-rated investment grade, very cheap bonds?
A: We don’t have a problem with someone doing that. Generally, right now, a laddered portfolio is an approach that we don’t really have a ton of problem with. I think where investors are going to struggle is, frankly, mutual funds because mutual funds have a perpetual maturity. Unlike a physical bond that you own, there’s no maturity that you mature up to or down to. You are sort of stuck at that price until the market gives you a better one. That’s really why the losses that mutual-fund investors have experienced are real losses. If they went and tried to sell right now, they would turn those paper losses into real losses.
But we don’t have a problem with someone buying deeply discounted bonds at this point and putting them into a laddered portfolio. We think that’s OK. Deeply discounted stuff, there’s really not a ton of it out there at this point. If something is deeply discounted right now, there’s generally a pretty good reason for why it is trading at that price. Some of the market sectors that we’ve been looking at that we think are starting to look more ripe for getting invested are around the edges of fixed income and have more equity-correlated risks. So things like convertibles, closed-end funds -- both of those tend to track equity risk more closely and have a higher beta to equity. We are seeing significant discounts there. That is maybe at the top of our shopping list in the foreseeable future. But we’ll see how the rest of this market plays out.