Why cash isn’t always king

Optimum Wealth Management Optimum Wealth Management

Why cash isn’t always king

After almost 15 years of near-zero interest rates, it feels strange to see them returning to levels in line with long-term averages. In such circumstances, it is understandable that investors consider putting their money in short-term high-yielding savings products. But, for clients with a time horizon longer than five years, these products are not likely to be suitable.

As the chart below shows, equities typically outpace other asset classes over the long term – 37 years in this example. In comparison, UK savings rates and inflation have largely kept pace with each other, so, in real or inflation-adjusted terms, there isn’t much to be gained by sitting in cash over the long term.

 

 

Equities have delivered higher total returns over the period, with a return of just under 9% annualised. If we compare this with the 9% inflation rate that we have experienced in recent months, equities are just about keeping up in the short term. However, inflationary periods tend to be short-lived, especially when inflation moves above longer-term averages causing central banks – such as the Bank of England – to raise rates to cool price growth.

When monetary policy is judged correctly, inflation tends towards the central bank’s target – which is set at 2% in the UK. This means interest rates are likely to pause and then decline once inflation starts to fall.

In addition, the severe shocks driving inflation higher over the past few years – including the global pandemic stressing worldwide supply chains and energy price volatility following Russia’s invasion of Ukraine – should wane over time and eventually mean inflation reverts to its long-term average.

A fall in the inflation rate is precisely what appears to be priced into the UK gilt yield curve, which captures the market consensus forecast for the future yields (and therefore prices) on government debt.

The yield curve shows the interest rates that investors demand to lend to the government for various periods of time; in other words, how much it would cost the government to borrow. It directly determines the value of bonds and provides important insights into how investors view the economy’s health.

If economy is healthy and growing with stable inflation, the yield curve will be upward-sloping, reflecting the marginally higher risk involved in lending for longer. But, when interest rates are expected to fall – most likely when inflation and/or growth is expected to fall – yields on short-term gilts are higher than on long-term gilts, as the chart below shows.

 

 

In the UK, investors collectively think rates will top out at around 5.5% and then fall back over the next three to five years to somewhere around 4% longer-term. This percentage is approximately half the total return that UK large-cap stocks have delivered over the long term.

So, while it is understandable that there is some renewed excitement among clients around short-term savings rates, they simply don’t seem to be able to keep pace with the total return from stocks over the medium to long term. Based on company dividends alone, investors expect the FTSE 100 index to have a dividend yield of 4.5% next year (before any changes in the underlying share prices).

We understand that clients may need cash for specific purposes and short-term savings products can play a key role in meeting those needs. However, taking a longer-term view, clients need to ask themselves whether savings products will fulfil their investment objectives.

Content provided by Tatton Investment Management