What to do when everything is expensive

For a long time, central banks have sought to make cash as unattractive an asset as possible, but the more expensive bonds and equities become, the better the idea of not investing by holding on to cash becomes.

  • By Richard Barley,
  • The Wall Street Journal
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In a world where many markets look expensive, putting cash to work is hard. Simply hanging on to more of it might be a good idea.

That is particularly the case after the first half of 2017 has delivered good results across the board. Most strikingly, both bonds and stocks are up. The MSCI World index (.MIWO00000PUS) of developed-market stocks is up 9.7% so far this year, while long-dated bonds are also partying, with the 30-year Treasury yield falling around 0.25 percentage point to just 2.73%, boosting prices. Corporate-bond yield spreads are back to their tightest levels since the global financial crisis.

Yet falling bond yields and rising equity markets are sending conflicting signals: the former reflecting the lackluster picture for inflation; the latter hopes for growth. Bond yields are still ultralow, while equity valuations are high, with the S&P 500 (.SPX), for instance, trading for 17.6-times forward earnings. This disconnect only can hold if the path of global growth and inflation don’t change markedly. A divergence in either direction will mean that one of the asset classes will have to rethink its assumptions. The jury is out on what happens from here: hopes of a fiscal bump to growth led by the U.S. have faded, while the recent decline in oil prices may cause new worries about headline inflation.

More significantly, perhaps, the flood of global central-bank liquidity that has supported markets is past its peak: the Federal Reserve is raising rates, and the European Central Bank is inching toward an exit from ultra loose monetary policy.

While policy makers don’t want to shock markets, global output gaps are closing. The need for monetary largesse is therefore no longer as clear-cut as it was. The policy debate at the Bank of England is clear evidence of that, with a sudden and surprising shift toward potential tightening of policy.

In this environment, faced with unappetizing initial valuations, not investing might be a valid strategy. For a long time central banks have sought to make cash as unattractive an asset as possible—going so far as to introduce negative interest rates in Japan and Europe. But the more expensive financial assets like bonds and equities get, the less relatively expensive cash looks. The latest Bank of America Merrill Lynch global fund manager survey shows cash holdings at 5% of assets under management, above the 4.5% long-term average but lower than last year.

Building up cash doesn’t reflect a particular fear that a big shock, like a new recession, is about to hit. And there are still pockets in markets where the picture is fundamentally brighter, such as in European equities or in emerging markets. Instead, it is a tactical play—selling some assets and raising cash here is about locking in profits and creating room for maneuver. There have been big opportunities even as markets have continued their broad upward journey: think of the U.S. high-yield bond selloff that started in 2015, and the swoon in stocks in early 2016, as oil cratered. Or think of when bond yields rose in the wake of Donald Trump’s election. Those turned out to offer attractive buying opportunities as markets rebounded—if investors had cash to exploit them.

Different types of investors vary in their ability to keep some dry powder, of course. The catalyst for deploying it isn’t clear either. But, after a strong first half, raising cash to invest at higher yields or lower prices appears wise.

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