From the SEC’s money market fund reform to the seismic shift from prime funds to government-only money market funds, change has been a constant for cash and short-term investors over the past few months.
Now, the comfortable climate of range-bound interest rates may also be a thing of the past: Firming economic data are expected to spur the Federal Reserve to raise the policy rate, likely in December, and the U.S. election results are increasing market volatility as investors try to figure out which path President-elect Donald Trump will take. The evaluation over the next several months of possible pro-growth initiatives, such as tax cuts and infrastructure spending, or the more populist route, which could include trade barriers and immigration reform, will certainly test investors’ mettle.
Through all of this, we have prescribed three antidotes to uncertainty for cash and short-term investors: Prepare for volatility associated with potential Fed moves, consider limiting money market fund exposure (as these funds may very well fail to protect purchasing power), and actively manage cash and short-term allocations in an effort to maximize returns.
Now that we have clarity on the U.S. election and seem to be on the precipice of a Fed hike, it is time to refresh the rules for investing for capital preservation. We call them the Four R’s.
Rising rates. With economic data continuing to improve and the clouds of political uncertainty beginning to part, we think the Fed’s conservative playing style will wane. PIMCO still expects terminal rates to remain lower than historical norms (what we call The New Neutral), but investors should expect the Fed to be more responsive to an improving jobs picture and higher inflation. As a result, we think investment allocations should be defensive in their interest rate exposure, potentially avoiding the front end of the yield curve, and we favor floating rate notes. We think actively managed fixed income strategies should outperform passive strategies in this environment, as they have more scope to dynamically increase and decrease their exposures in an effort to maximize returns and minimize volatility.
Reflation. With inflation indicators starting to edge upward, investors should prepare for increasing, although we believe historically modest, inflation. Given the low level of absolute rates, even small increases in inflation could have a significant impact on returns. It is paramount to focus on preserving capital not only in nominal terms, but also in real, or inflation-adjusted, terms. The minimal income from money market allocations currently can do little to protect purchasing power; this should become more apparent as money-fund yields remain structurally subdued, even as the Fed embarks on a route to higher rates.
Repatriation. With a Republican Congress and administration, investors can begin to prepare for a variety of expected outcomes. Fiscal stimulus is one, although the size remains in question. Another potential outcome is the repatriation of foreign profits by U.S. entities: Lower corporate tax rates would likely drive a flood of cash back into onshore investments and banks. This is a potential paradigm shift that would affect corporate leverage, issuance patterns and front-end rates, and we think investors should be poised to capitalize on it.
Regulation. Perhaps the most profound yet unexpected outcome of the U.S. election for financial markets will be the evolution of regulation. At the very least, the new Republican administration will likely reevaluate many of the regulatory measures implemented since the financial crisis. More likely, it will look to revise, redact or refuse to implement many, from Dodd-Frank to money market reform. With the recent resignation of SEC Chairwoman Mary Jo White, President-elect Trump can appoint three (out of five) SEC commissioners, which could greatly alter the market and investment landscape for years to come.
Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the PIMCO Blog.