About this time every year, articles extolling the virtues of particular investments for the coming year proliferate, each one a Popular Mechanics version of tactical asset allocating. But betting on the best-performing asset class or security for 2019 is a mug’s game. Think about it; if a fund manager were able to consistently pick the best stock, they’d only ever hold one, not a diversified portfolio. The presence of a portfolio is, itself, evidence of an inability to safely or successfully put all one’s eggs in the same basket.

Now, having apologised in advance for probably being incorrect, experience does suggest there are some investments that, on balance, should do better in 2019.

And one of those just might be cash.

Let’s start with the year just ended, 2018. It was a transition period for investors who will be forced, if they have not done so already, to confront a new reality. That new reality is that quantitative easing (QE) and declining interest rates have been replaced with quantitative easing tapering (QT) and rising interest rates. Unfortunately, while QE and falling rates had the effect of increasing asset prices and values, QT and rising rates must do the opposite. You cannot have it both ways.

The consequences of history’s greatest monetary experiment are now alighting upon the returns of investors. From mid-2018, record asset prices were always going to produce low returns. It’s an inescapable truism of investing – the higher the price you pay, the lower your returns. And thanks to QE and declining rates, asset prices got pretty ridiculous. By way of example, I wrote the following in September for The Australian:

“Take a look at the market capitalisations of some of [the] listed businesses whose share prices have rallied on the back of hopes of global domination: a2 Milk, Afterpay Touch, Xero, WiseTech Global, Altium and Appen have an aggregate market capitalisation of $29.5 billion, combined revenue of less than $2 billion and combined net profits of just $245 million. Of that profit, a2 Milk is responsible for $131 million. Xero and Afterpay Touch are losing money.”

That meant the above portfolio, without a2 Milk, was trading on almost 490 times earnings.

And about this time two years ago, I wrote:

“Back in 1981, the risk-free rate of return in the US – as represented by five-year Treasuries – was 15 per cent. Real rates were close to 5 per cent. To compete with high risk-free rates, assets were priced very cheaply. And [additionally] the 15 per cent hurdle rate forced companies to invest capital wisely and, where necessary, restructure.

“[Meanwhile] Financial leverage as measured by Total Credit Market Debt to GDP was less than half of what it is today. Back then, credit-fuelled growth lay ahead. Today, it does not. GFC-response policies have discouraged de-leveraging. In fact, leverage has risen.

“The period that followed 1981 was one of the greatest bull markets in financial history. So how can precisely the opposite environment (historically low interest rates, expensive asset prices and historically high levels of debt) to that which existed in 1981 also be a great investment environment?

It simply cannot.”

So low returns were already a given and something we wrote about somewhat copiously.

Low returns are still probable, given the CAPE Ratio of the S&P 500 has fallen only from 32 times to 29 times 10-year average earnings. With the exception of the tech bubble of 1999 and early 2000, there hasn’t been an occasion since the late 1700s when the CAPE ratio on the S&P 500 has indicated the market was more expensive.

Average returns over the next decade can still be expected to be in the single digits – probably the low single digits – given the extent of the S&P 500’s over-pricing.

The only question that remains is whether the low returns will be associated with higher or lower volatility. Given the picture forming in the bond market, I would suggest higher rates are more probable.

Bonds, the trigger for higher equity volatility?

The end of QE and its replacement with QT has removed the biggest buyer of bonds [the Fed] at the same time that the US Government’s fiscal deficits are expanding and being funded with the issue of even more bonds. Increase the supply of bonds and remove the biggest buyer and what happens? Bond prices fall. It would appear this is not cyclical as much as it is structural.

Of course, when Treasury bond prices fall, and their rates start rising, those Treasuries start looking more attractive than corporate bonds. And given a record 47 per cent of all US corporate bonds are rated the lowest investment grade, BBB, and a record amount of CCC-rated bonds are due for refinancing in 2019, it’s probably no surprise that investors want out of the weakest-credit corporate bonds.

The sell-off in the lower-rated issues must increase the cost of funding for corporations, squeezing margins and disrupting the smooth 45-degree hockey stick forecasts of equity analysts, who would otherwise prefer to assume currencies and rates stay about where they are, given nobody can accurately forecast these things.

So equities will probably deliver meagre returns and bonds aren’t likely to be much better. You can add residential real estate (negative yields) and retail commercial real estate (structurally challenged by the internet) to the mix, too.

That leaves cash. Yep, horrible, punitive returns. Cash.

Cash is not safe. Indeed, cash is not a risk-free asset at all. What could be riskier than being guaranteed to lose more purchasing power the longer you hold it?

As Warren Buffett explained, during the 50 years from 1964 through 2014, the S&P 500 Index returned 11,196 per cent, including reinvested dividends. During those years, the value of a dollar fell by 87 per cent.

Investing for long periods in cash is not desirable – you are guaranteed to lose purchasing power the longer you hold it – but while lots of cash held for long periods is terrible, a little cash in the short run is like an option over every asset class, with no expiration date and no strike price. Cash provides the option to sweep up a bargain when it becomes available and this must give it some value above the fact it earns almost nothing.

At this juncture, we believe there might just be value in holding some cash, because 2.5 per cent (with virtually no capital risk) is a darn sight better than minus-20 per cent and cash is always most valuable when nobody else has any. At Montgomery, our domestic and global funds have been holding a little cash for some time and while that was a drag on returns up to September 2018, in October and November it proved its worth.

If the volatility witnessed in the last quarter of 2018 is a precursor to more in 2019, cash might just be a very helpful asset class indeed.

Roger Montgomery is the chairman and chief investment officer of Montgomery Investment Management.
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