The volatility profile of long-duration assets necessitates a broader reconsideration of portfolio construction norms. Cash - often considered a drag on performance - is reclaiming a position of strategic significance amid elevated market uncertainty.

• Long-dated sovereign bonds in the UK and the US recently exhibited volatility levels comparable to equities.
• The traditional classifications of risk-on and risk-off assets are being challenged due to recent dynamics in the global economic policies and geopolitical realignments.
• Amid heightened turbulence and episodic dislocations, the virtues of money market funds - liquidity, stability, and some shelter from macroeconomic and policy decisions - are being reconsidered.

As the policy uncertainty associated with trade wars unfolds, investors are grappling with the intricacies of market dynamics that defy traditional classifications of risk-on and risk-off assets. The volatility of long-end government bonds has prompted a re-evaluation of traditional investment strategies, particularly for those with a cautious outlook. Amidst this uncertainty, cash emerges as a low-risk diversifier to equities where long duration government bonds have recently failed to live up to their expectations as an uncorrelated asset class, particularly during periods of elevated market volatility when investors need that protection most.

Rethinking our labelling of market environments

Historically, assets have been categorised as risk-on (equities, high yield credit) or risk-off (bonds, investment grade credit), based on the economic backdrop. In normal market functioning, good economic news typically boosts risk-on assets, while bad news benefits risk-off assets. However, this binary classification has faced challenges in recent years, particularly in a supply-driven cycle where traditional demand-driven indicators of economic health are not the driving force of sentiment.

Recent volatility triggered by US tariffs has highlighted the limitations of this classification. Despite adverse economic news and collapsing equities, long-end bonds in the UK (see chart below) and US have performed poorly. This anomaly can be attributed to fiscal fears and market flows, but it also underscores the need to redefine what is a risky asset. It seems we can no longer lump equities in one camp (with risk-on assets) and bonds into another (risk-off). We need more room to distinguish different types of fixed income, for example, between long-end government bonds and money market assets.

The most important thing is risk

Volatility, a key indicator of risk, has shown intriguing patterns in recent times. The chart below shows that long-dated UK government bonds have exhibited volatility levels comparable to or even higher than equities, while short-dated UK government bonds have maintained significantly lower volatility over the last 3 years. This change in the volatility profile highlights that long-duration assets, traditionally viewed as safer, now have more in common with equities than front-end bonds (for example, those with a maturity of less than 3 years).

In such a volatile environment, investors typically flock to cash and government bonds to protect portfolios against drawdowns. Cash, with its inherent stability, offers a stark contrast to the unpredictable nature of long-duration bonds and equities. The lower realised volatility of cash means that it can be better used a reliable place to invest assets during volatile market conditions.

Rolling 60-day volatility of various asset classes in the UK

Cash makes a comeback

Cash had its heyday in the high-interest rate period for delivering attractive returns with relatively little risk, but cash also has a place in portfolios as an uncorrelated asset class for when volatility spikes. For cautious investors, the primary concern is capital preservation. In times of heightened uncertainty, the focus shifts from the return on capital to the return of capital. Cash, as a low-risk asset, potentially offer investors more confidence about the future value of their holdings. This predictability makes cash an attractive option.

Cautious investors, wary of the unpredictable reactions of long-duration assets and equities to uncertain swings in policy, can find solace in cash. Today’s cycle is atypical, which makes us inclined to think that the elevated volatility in long-dated bonds is here to stay. In contrast, money market strategies are less affected by macroeconomics headlines. For investors that are sensitive to negative total return outcomes, cash offers a sensible alternative to navigate the complexities of today’s world where risk-on and risk-off do not have the same meaning they once did.

Risk Warning

• An investment in a money market fund is different from an investment in deposits, as the principal invested in an money market fund is capable of fluctuation. Fidelity’s money market funds do not rely on external support for guaranteeing the liquidity of the money market funds or stabilising the NAV per unit or share. An investment in a money market fund is not guaranteed.
• Bond investments: These funds invest in bonds whose price is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall.  The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity.  Default risk may, therefore, vary between different government issuers as well as between different corporate issuers.
• Corporate bonds: Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds.
• Money market instruments: The investment policy of these funds means they can be more than 35% invested in transferable securities and money market instruments issued or guaranteed by an EEA State, one or more of its local authorities, a third country or a public international body to which one or more EEA States belongs.
• Other: Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investors should note that the views expressed may no longer be current and may have already been acted upon.
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• Past performance does not predict future returns. The funds returns may increase or decrease as a result of currency fluctuations.
• Please refer to the Prospectus and KID of the fund before making any final investment decisions. The investment which is promoted concerns the acquisition of units or shares in a fund and not in a given underlying asset owned by the fund.

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