Why Wells Fargo says investors have key decisions to make amid Fed easing cycle

Investing.com — The time may have come for investors to make key decisions about their cash alternative allocations and fixed income positions as the Federal Reserve embarks on a campaign of policy easing, according to analysts at Wells Fargo.

In a note to clients, the analysts said carrying cash has provided investors with a steady stream of interest while avoiding fluctuations in the bond market since the Fed began raising interest rates to more than two-decade highs in 2022. Cash investments may come with lower levels of risks, albeit for normally lower returns.

However, they flagged two risks around continuing a cash-focused strategy in the current trading environment.

First, those who have an outsized cash position face reinvestment risk, or the chance that they may lose the opportunity to reinvest future cash flows at the current rate of return, the analysts said.

A second risk revolves around money market funds becoming a “cash drag” over a longer period of time, they said. The term refers to holding a part of a portfolio in cash rather than investing it in the market.

“Over time, riskier assets have outperformed cash and cash-alternative vehicles,” they wrote. “Our long-term capital market assumptions study shows that US equities have beat cash returns […]. The power of compounding returns has generally benefited riskier assets like equities while leaving cash in a disadvantaged position […].”

As a result, they cautioned investors to avoid cash as a long-term investment strategy or signficant allocation.

Instead, they recommended allocating cash across asset classes, adding that this focus on diversification offers a “blend of growth potential and risk-management provisions” particularly for “investors with a strategic time horizon.”

The analysts argued that, with uncertainty surrounding both the Fed’s policy plans and the outcome of the US presidential election, portfolios should emphasize quality — especially large-cap companies over small- and mid-cap firms.

Recent volatility in equity markets, meanwhile, should push investors into sectors like communication services, energy, financials, industrials, and materials and trim positions in areas such as consumer discretionary, consumer staples, real estate and utilities, they added.

Elsewhere, bond investors should expect short-term investments to fall in tandem with additional expected interest rate cuts by the Fed before the end of 2024. The central bank already moved to lower borrowing costs by 50 basis points last week.

“[T]he relatively high yields that investors have enjoyed over the past couple of years in high-quality short-term investments will be decreasing,” the Wells Fargo analysts said.

“On the other hand, moving into long-dated maturities to lock in higher yields exposes investors to the potential for significant market price movements and potential losses in the event that the economy reaccelerates and longer-dated yields move higher next year.”