JP Morgan | Oksana Aronov: JPMorgan’s Aronov ignores ‘cash is trash’ refrain
“I hear about investors losing money sitting in cash, and that money has been trash since I’ve been in this industry,” she said on this week’s episode of “What Goes Up”. “But the reality is that if you’ve been in cash for the last five years, you’ve basically outperformed the Bloomberg Aggregate Index year-to-date, year-over-year, year-over-year, and depending on the day, yes, even five years.”
Below are the slightly edited and condensed highlights of the conversation.
What are widening spreads in the credit market telling you? Is it as obvious that a recession is coming or is it more nuanced?
I’m going to zoom out and express a bit of skepticism about the ability of the bond market to be that kind of predictive force. Because if that were the case, yields have been lower and lower and at new highs for so many years indicating a recession, I suppose, if we really believe in the indicative or predictive function of the bond market. That, of course, didn’t materialize – or we had a pretty dramatic drop around the pandemic, but it was a very esoteric event. Other than that, we haven’t really seen the kind of recession the bond market would have predicted at these record high yields every year. This, of course, has to do with the enormous amount of central bank interference. It has, frankly, skewed the ability of the bond market to be that predictive or predictive mechanism.
That said, we are seeing a plateau in inflation expectations. The 10-year breakevens have remained in the mid-2s, but you see them climbing – relative to the 2- and 5-year breakevens – so inflation expectations continue to rise or stay elevated. We still don’t have a positive real yield on the 2-year part of the curve. This, by the way, is something Powell and the Fed are very focused on.
But stepping away from that for a second to talk about the gaps – yes, we’ve seen some gaps widening. But to put that into perspective, the last time we had a hiking cycle and a tiny bit of inflation was the 2015, 2018 hiking cycle. We maybe had inflation just barely above 2%, the unemployment rate was higher and the up cycle was incredibly benign. We have seen high yield spreads hit the mid-5s again. We are barely crossing that threshold now with inflation at its highest level in four decades. Nobody can really tell you if this is in fact a moderation or if it will continue to increase.
The unemployment rate is also significantly lower than where we were during the last much milder up cycle. So I think to call it an investment opportunity, to call it a good deal from an allocation perspective, I think we’re a long way from that. At this point, all the carnage we’ve seen in the bond markets, whether it’s in the interest rate sensitive end or in the less interest rate sensitive end like high yield, it’s all been driven by the interest rate. Very, very few of them were spread or driven by credit risk. We need to see that punch to start talking about opportunities.
We’ve talked in the past about having cash, but in a 10% inflation environment, you lose money on that cash. So what are you doing?
I’ve heard of investors losing money sitting in cash and that money has been trash since I’ve been in this industry. But the reality is that if you’ve had cash for the last five years, you’ve basically outperformed the Bloomberg Aggregate index year to date, year to year, year to year, and depending on the day, yes, even five years. And over three years, it’s a positive return versus a negative return. So I think we have to do without these absolutes.
That’s one of the craziest things to me, frankly, about how our industry works, because in fixed income, you absolutely have very identifiable highs. When the 10-year was at 50 basis points, it had no choice but to rise. So why aren’t there widespread alarm bells on this? Do you remember hearing that? No. The rhetoric was the same – silver is trash and you should be invested in it, and because something else is worth more than Treasury you should buy it, even if valuations there were also overvalued.
So instead of resorting to those absolutes, we really need to think about what’s included in the price. We have to be thinking about inflation right now, it’s a serious issue, and yes, you’re earning 8% in high yield for still a lot less in cash. But what is your price appreciation or what is your capital preservation potential? And which of these are most important to you? Again, for us as absolute return investors, our focus is on capital preservation first.
Given all the push and pull forces in the markets today, we are looking at the situation and saying we think the risks are on the downside. So we prefer to have a lot of cash in our portfolio because right now it’s basically a free option on any asset class in the world. We believe the opportunity set will continue to improve overall, just as it has for the six months of this year. We heard people talking about investments in January, February, March and April, and it continues to improve. And we believe the gaps will continue to widen.
For us right now, again, as absolute return investors trying to manage and outperform cash, whether the regime is good for bonds or not, we’re not investing against a benchmark based on market risk. We invest rather than preserve capital. We believe the focus on capital preservation continues to be warranted, and we prefer to be in highly liquid structures at this stage in a combination of cash and high quality floating rates – we continue to like this trade. Really for us, it’s still part of the capital preservation cycle, although I think we’re closer to the end than a few months ago.
Probably in the next month or two we’re going to move into the part of the cycle that’s starting to get aggressive, that’s starting to go after these comebacks, probably in the next month or two as we see gaps widening and some of these more bearish expectations are reflected in the price. But at this point, we think capital preservation is still the name of the game.
Why not opt for bonds of very good quality, very cheap?
We have no problem with someone doing that. Generally, today, a laddered portfolio is an approach that we don’t really have a 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 possess, there is no maturity to which you mature. You’re kind of stuck at that price until the market offers you a better one. This is really why the losses incurred by mutual fund investors are real losses. If they tried to sell now, they would turn those paper losses into real losses.
But we have no problem with someone buying deeply discounted bonds at this point and putting them in a laddered portfolio. We think that’s OK. Deeply discounted stuff, there really isn’t a ton of it at this point. If something is heavily discounted right now, there’s usually a pretty good reason why it’s trading at that price. Some of the market sectors we have looked at that we think seem more ripe for investing are on the edge of fixed income and have more equity-correlated risk. So things like convertibles, closed-end funds — those two things tend to track equity risk more closely and have a higher beta relative to equities. We see significant discounts there. It may be at the top of our shopping list for the foreseeable future. But we’ll see how the rest of this market plays out.