Cash has become a forgotten asset class, but it wasn’t a forgotten asset class in the 1980s when yields on money market investments reached over 15%.

In 2011 Money Sense published a magazine entitled ‘Guide to the Perfect Portfolio’ that took asset classes to a whole new level. It identified fifteen different asset classes, including six different classes of equities and five different classes of bonds.

If the goal is to make the choices more complicated, then suggesting fifteen asset classes, many with similar characteristics, will likely do the trick. Yet cash was not included among the asset classes even though it provides completely different characteristics from any of the fifteen listed.

Cash includes highly liquid investments such as the balances in your savings accounts, money market funds, treasury bills or bonds maturing in less than one year. It is money you can access and spend on short notice, usually without fees or penalties for withdrawal.

It is easy to scoff at cash as an investment when rates are low but it isn’t always that way. Just because an investment is out of favor doesn’t mean it shouldn’t be included as an asset class. Every asset class will have periods where it may be the best performing investment or the worst.

Two characteristics of cash are its price stability and its liquidity. Investors can be relatively certain of what the value of their cash investments will be if they need to access them and they know they can access that cash very quickly and easily.

In normal conditions cash carries a lower interest rate than longer term fixed income investments and in normal conditions the rate of return on cash investments should be higher than the rate of inflation. In recent years central banks around the world have artificially lowered short term rates to levels below the rate of inflation.

When short term rates are higher than long term rates, yields are said to be inverted and this can often be the precursor to an economic recession.

Economic recessions can lead to stock market corrections and a decline in equity values. In these circumstances cash becomes an important asset class and should not be overlooked.

When short term rates are lower than inflation, a different problem is created. The purchasing power of an investor’s cash will become less and less as time goes on. This deterioration in purchasing power can lead some investors to deploy a portion of their cash in other asset classes. In the past gold has often been a beneficiary when this situation occurs.

A quick glance at rates on treasury bills or a six month GIC, for example, should reveal a rate that is higher than inflation but lower than long term rates. If this is not the case, something is amiss.

Perhaps the best choice for cash in a portfolio is government treasury bills. They are extremely safe and highly liquid, meaning that cash is available on short notice. Unfortunately, the minimum amount available for investment is sometimes beyond the average investor. A compromise may be a money market mutual fund or a high interest savings fund.

Short term GICs (with less than one year to maturity) are less appealing because they lack the liquidity of a treasury bill. Cashable GICs are somewhat better but may carry a slightly lower rate than a short term GIC.

The asset allocation exercise will indicate, more or less, how much of the portfolio should be apportioned to cash. Tactical considerations, such as an inverted yield situation, may imply a slight variation from the proposed asset allocation. From there, the investor can decide which of the various cash investments best suits their needs.

Cash valuations

 Cash may be the most stable of all the asset classes - the principal value rarely fluctuates. The rates of return vary far less than other assets and that rate is primarily linked to inflation. If inflation rises, the interest rate on cash investments usually follows.

From time to time, governments and central banks in their wisdom try to push the interest rate on cash below the rate of inflation. That means your cash will buy less in the future than it will buy today, even when you add in the interest it may have earned.

It is done in an effort to get people to spend their money before its purchasing power declines and thereby stimulate the economy. Many economists will tell you that it doesn’t work; many others will tell you that it does.

The yield on cash and other short term investments relative to the yield on longer term bonds is an indicator that is watched by many market strategists and economists. When the yield on cash is higher than on ten year bonds, for example, there is a good chance that an economic recession is right around the corner. It is not a guarantee that a recession will occur but it happens with disturbing regularity.

In the past, recessions have led to a period of sub-par stock market performance.

All of this is related to an inventory cycle where a build-up of inventory and low sales affect corporate profits.

The following charts are examples of how short term rates compare to long term rates in a normal interest rate environment and in an inverted interest rate environment.



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