April 2016

David F. Lafferty, CFA

SVP Chief Market Strategist

On the Sidelines
Are you tired of reading about central banks and monetary
policy? I know were sick of writing, blogging, and tweeting
about it. This month were going to avoid (mostly) talk of the
central banks and instead focus on investors and their
portfolios.
In Q1 I had the chance to travel and spend some time with our
U.S. advisor and investor clients. While no two portfolios are
identical, I was struck by one major commonality: the amount
of cash and uninvested balances left in portfolios. On a recent
trip to the West Coast, advisors frequently noted portfolios
with 10% - 40% (!) cash. These are probably outliers, given the
conversations occurred during the January/February
correction and rally that seemed to paralyze investors.
Moreover, allocation trends from our Portfolio Research and
Consulting Group indicate that cash levels are running only
slightly above their longer-term averages. However, it stands
to reason that as the macro storm clouds have gathered,
investors would become more hesitant to expose their
portfolios to market risks.

growing investor apathy as measured by investors who

consider themselves neutral on stocks.
Adding to investors post-crisis confusion is a macroeconomic
environment full of apparent risks. China either is or isnt in
the midst of massive debt-fueled growth bubble. Greece,
Brexit, and a refugee crisis are creating existential questions in
the European Union. And collapsing commodity prices are
pressuring emerging markets, impairing credit, and increasing
geopolitical risks. No surprise that investors are perhaps
feeling more skittish than ever.

Slow Death vs. Quick Death

So if market outcomes are highly uncertain, shouldnt
investors be more cautious before committing capital? Yes,
but cash is still an asset that is likely to have a negative real
yield; that is, a return less than inflation. While inflation rates
have fallen around the world, so have return expectations, so
maintaining real purchasing power is still a challenge. Only in
economies experiencing outright deflation would a near-0%
return not be hazardous to real wealth.

Real Return on Cash

How Did We Get Here?

Jun-14

Dec-15

Jun-11

Dec-12

Jun-08

Dec-09

Jun-05

Dec-06

Jun-02

Dec-03

Jun-99

Dec-00

Jun-96

Jun-93

Dec-97

60.0

Dec-94

AAII "Neutral" Sentiment

Real Return on Cash

50.0
40.0

Source: Bloomberg, Natixis ISG (Dec. 1991 Mar. 2016)

30.0
20.0
10.0

AAII "Neutral" Sentiment

Jun-15

Oct-11

Aug-13

Feb-08

Dec-09

Jun-04

Apr-06

Oct-00

Aug-02

Feb-97

Dec-98

Jun-93

Apr-95

Oct-89

Aug-91

0.0
Dec-87

% citing "Neutral" Sentiment

5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
Dec-91

Investor Apathy Rises Post-Crisis

Percent (%)

6-mo CD Yield - Core CPI YoY

Investor apathy has been rising for some time. After two major
bear markets since 2000, investors have become hypersensitive to volatility. This leaves them with a set of poor
choices: Buy in mid-crisis hoping youre at/near the bottom
(fear) or jump in too late, after the market has already
rallied significantly (regret).

12-Mo. Moving Average

Source: Bloomberg, Natixis Investment Strategies Group (Natixis ISG)

(Dec. 1987 Mar. 2016)

The situation is no better for savers overseas. While inflation

rates in Japan and across Europe are lower, cash rates are also
lower and in some cases negative. Thus, for most global
investors, moving to cash becomes a choice between an
almost certain slow death in terms of losing purchasing power
versus the possibility of quick death if potential risks morph
into an actual sell-off.

Skeptical on Tactical
While bullish and bearish sentiment can change quickly, data
from the American Association of Individual Investors (AAII)
shows that the only constant since the 2008 crisis has been

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So if cash is likely to be a negative real return asset, are there

any compelling reasons to stay on the sidelines? The most
frequently cited argument is the Dry Powder strategy that

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could be well rewarded from any material pickup in inflation.

Conversely, with inflation expectations already so low, TIPS
offer little in additional downside risk relative to nominal
bonds. With ultra-low yields around the world, portfolio
ballast (i.e., high quality fixed income) is expensive, but at
least TIPS offer a possible kicker if inflation eventually
surprises to the upside.
U.S. TIPs: Implied Breakeven Inflation Rates

5-Year Breakeven %

Jan-16

Jan-15

Jan-14

Jan-13

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
Jan-02

Percent (%)

goes something like this: The uninvested portion of the

portfolio will be quickly redeployed in cheap assets once the
sell-off or bear market occurs. Warren Buffett would be
proud! However, Dry Powder sounds far better in theory than
it works in practice. The strategy assumes investors will (1)
recognize the value created by a sell-off and (2) buy the worst
performing assets at the point of their highest perceived risk.
Common sense and boatloads of academic research argue that
this scenario is highly unlikely. Advisors with non-discretionary
asset have much the same problem convincing their clients
to buy the stuff thats getting killed. Advisors with discretion
over client accounts are in a far better position, but they still
have to overcome the downside inertia of the market and be
willing to accept their clients second-guessing. While we
applaud the purchase of assets that are temporarily on sale,
we also have a healthy bit of skepticism about whether these
tactical moves will actually be exercised. Tactical is fine, but
be realistic about your ability to execute. (Automatic portfolio
rebalancing may be a better solution as it mitigates the
emotional baggage associated with buying falling assets.)

10-Year Breakeven %

Source: Bloomberg, Natixis ISG (Jan. 2002 Mar. 2016)

Putting Cash to Work

Is it a portfolio imperative to be fully invested? Probably not.
Readers of this note know that we are hardly bullish on the
broad equity indexes which likely offer positive but sub-par
returns given full valuations and low earnings growth.
Likewise, high quality bonds at low to negative rates are hardly
a compelling reason to take on interest rate risk. In this
environment, perhaps some cash is OK. But excessively high
cash levels (>20%?) are an implied bearish bet with a real
cost (factoring in inflation). With that in mind, here are a few
ideas for putting some cash to work if you have too much on
the sidelines. The idea isnt to load up the truck on any of
these but nibble a bit to reduce drag and gain some potential
portfolio efficiencies.
Credit With stocks fully-valued broadly speaking and high
quality bonds paying almost nothing, one of the cheaper parts
of the capital market is credit; more specifically, high yield
bonds and/or bank loans. While spread levels remain
attractive, credit risk is elevated due both to the carnage in the
energy sector (rising defaults) and recessionary fears (which
we believe are overstated at this point). After adjusting for risk
factors, credit isnt pound the table cheap, but it is certainly
worth a look.
TIPS If you hate high quality, low yielding sovereign debt,
what would make Treasury Inflation Protected Securities (TIPS)
attractive? Granted, the inflation component of TIPS hasnt
been worth much recently, but extremely low forward
expectations for inflation around the world create an
asymmetric return opportunity. QE programs and a massive
expansion in the global monetary base havent generated any
significant inflationary pressuresyet. But with current
breakeven rates for 5- and 10-year maturities near 1.5%, TIPS

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Gold We have no idea if gold will go up or down and neither

does anybody else. Gold does however have some unique
asset allocation properties that investors can take advantage
of. Specifically, gold is one of the few investments that can
benefit from both inflationary and deflationary pressures. In
the short run, gold is hardly a perfect hedge to inflation.
However, in the long run, when fears of monetary expansion
and fiat currencies grow, gold tends to rally. Conversely,
gold is seen as safe haven during times of calamity or deflation
and can potentially offset losses in other risk assets. Investors
should keep in mind that gold is highly volatile and its
correlation benefits are fleeting, so moderation is the key.
Revisit risk Most importantly, investors can use this time to
address the two most fundamental asset allocation questions:
Is my asset allocation consistent with my risk tolerance and is
it likely to achieve my long-term goals? There is nothing wrong
with holding some cash out of the market, but make sure this
is an intended bet that isnt simply creating an unnecessary
drag on returns. Long-term investment gains are a byproduct
of exposing your assets to various risk premia which are ever
present. Risks are like sharks teeth: when one falls out,
another one slides into its place. If youre waiting for the all
clear sign from the markets, youll never invest (or achieve
your return goals).

David F. Lafferty, CFA

Senior Vice President Chief Market Strategist
@LaffertyNatixis
David T. Reilly, CFA
Vice President Investment Strategist
Investment Strategies Group (ISG)

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