Holding cash is preferable to holding any fixed income assets at the moment, as inflation could finally spell the end of the 35-year bond bull market, according to Schroder’s Marcus Brookes (pictured). 
The manager, who heads up the £955m Schroder MM Diversity fund, currently holds 28 per cent of his portfolio in cash despite being relatively positive on the global economy at the moment.
This is because his fund has roughly equal weightings at any one time in equities, alternatives and fixed interest & cash.
“The backdrop is incredible. If you go back to 1870, the yield on a 10-year bond has never been so low in absolute terms,” Brookes said.
“If you think about it, two world wars have happened through that time. In real terms, 10-year Treasury bonds yields have a negative real yield and that just doesn’t seem to make sense.”
“There are some investors that have to hold long duration assets, but we prefer cash over bonds.”
The manager points out that the bond market is already beginning to wobble, given that both UK government bonds and investment-grade sterling corporates have taken a tumble recently.
Data from FE Analytics shows that, over the past three months, the Bank of America Merrill Lynch Sterling Corporate Bond and FTSE Gilts All Stocks indices are down 5.61 and 6.81 per cent respectively.
Performance of indices over 3months
Source: FE Analytics
“[Investment-grade corporates and gilts] are super safe bonds, these are the ones that people think nothing can go wrong with and they have been absolutely outstanding. As equities have gone up they’ve made money but as equities have continued to go up more recently they’ve lost money,” Brookes said.
“This feels like a more normal market environment where people feel optimistic and optimism in the economy will not be great for these bonds. It’s cash over bonds, absolutely.”
The manager isn’t the only investment professional to believe the outlook is murky for fixed income assets. In his latest quarterly economic outlook, Hermes’ chief economist Neil Williams warns that traditionally ‘safe’ fixed income assets are likely to encounter a reversal in fortune.
“After a year of political surprises, we could see tectonic shifts in economic policy,” he reasoned.
“Speculation, rightly, that major economies will open their fiscal box is currently causing ‘reflation trades’ to puff up growth assets, raise inflation expectations, and make the 30-year bull-run in government bonds look even staler.”
Brookes agrees and says we are currently in an inflationary growth environment. He therefore believes that, while long-dated bonds look unattractive, commodities, emerging market equities and gold assets could present potential buying opportunities.
Given that governments can now borrow money while interest rates are at their lowest ever point, he believes fiscal spending is highly likely which would in turn boost inflation.
A particularly notable example is president-elect Donald Trump, who has announced plans to cut taxes and increase infrastructure spending throughout the course of his tenure.
While inflation would be bad news for bonds, it could be argued that the value of cash will also depreciate.
However, Brookes still believes that holding cash at the moment is prudent given how bearish he is on bonds.
“We can do things about that - we hold JP Morgan Income Opportunity Plus, it is run by a high conviction investor, it is almost run like a fixed income hedge fund, but it is long high yield,” the manager explained.
Performance of fund vs sector since launch
Source: FE Analytics
“We can continue to do that. We just don’t feel we should hold an asset where we genuinely think we can lose money. Holding cash is in lieu of wanting to buy bonds, but [we will] when they’re at a much better level.”
“The capital losses [in bonds] will have hopefully been worn by others and therefore you could generate a little bit of income and a little bit of capital whereas, at the moment, I can see persistent weakness.”
“Normally that cash drag would be a problem, but historically we’ve also managed to put the cash into different currencies and make money that way instead.”
Brookes says that his bearish view on fixed income is actually an optimistic play on the economy given that he thinks inflation will rise.
He also believes that, as economic fundamentals strengthen globally, investors will rotate out of quality growth stocks and so-called ‘bond proxies’ into value plays.
“The sorts of funds that have done really well have been the classic quality growth funds. We just think in this environment though we need to have a slightly different approach,” the manager continued.
“We like Artemis Global Emerging Markets – it’s a relatively new fund. With emerging markets, you either have the super-safe holdings that grow consistently or you have the super cheap holdings, such as Russian banks and Russian energy companies.”
“Somewhere in the middle is where you want to be, so you want a relative value long emerging market equity portfolio and I think the Artemis Global Emerging Markets fund does that really well.”
Launched in April last year, the £60m fund is managed by Peter Saacke and Raheel Altaf and aims to provide long-term returns through both growth and income generation.
Examples of its largest holdings Taiwan Semiconductor Manufacturing Company, Samsung and Tencent.
Since its launch, the fund has lost 7.6 per cent compared to its sector average’s loss of 11.36 per cent and its benchmark’s loss of 11.41 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
In the UK, Brookes likes Alastair Mundy’s Investec UK Special Situations fund and FE Alpha Manager Andrew Green’s GAM UK Diversified fund.
The former is renowned for its deep value investing style and has a significant overweight in banks, holding the likes of HSBC, Barclays, Lloyds and RBS in its top 10 holdings.
The latter has a concentrated portfolio of just 24 holdings across the cap spectrum, which are chosen based on Green’s belief that they have been consistently undervalued by markets. Its largest holdings include Shell, National Grid and BP.
“If you want a value theme in Europe it would mean going overweight financials - somebody like Jeff Taylor over at Invesco Perpetual is doing a really great job,” Brookes said.
“In Japan, our favourite is Stephen Harker. Again, it’s a financials call. Japanese banks got crucified when the central bank turned rates negative. They seem to have realised the error of their ways.”
“We think Japan is a really good area. The yen has weakened in this strong dollar environment, so we think Japanese shares will be really good.”
During Brookes’ and co-manager Robin McDonald’s tenure, Schroder MM Diversity has returned 50.64 per cent compared to its sector average’s return of 39.04 per cent and its UK Consumer Price benchmark’s return of 22.96 per cent. This means the fund has comfortably met its aim of providing a total return in excess of inflation over a market cycle.
In terms of risk metrics, it is in the top quartile for its annualised volatility and maximum drawdown – which measures the most money lost when bought and sold at the worst times – over the same time frame.