Cash crash

  • Author : Dermot Hamill
  • Date : April 2013
Dermot Hamill is Head of Wealth Management at Collins Stewart Wealth Management, Isle of Man

There are many uncertainties in today’s economic and investing environment, but it is certain that interest rates will remain at current levels at least for this year. I believe it is likely that UK interest rates will remain low for the foreseeable future, and indeed the anecdotal evidence is that the rates being offered by many major UK banks are beginning to fall, heaping more pressure on investors who rely on their bank savings.

If the current low rates do persist, they also pose big dangers for fiduciaries that are entrusted with managing the wealth of others. It is likely that not only will the return on such assets be negligible, but there will also be a loss of the real value of such funds, as inflation will remain relatively high. Consequently, the maintenance of a (conservative) cash-only or cash-heavy investment strategy could lead to problems in later years for trustees and fiduciaries. Advisors should be actively looking for ways to improve the returns from cash or, alternatively, look to invest that cash to at least maintain its purchasing power.

The interest rate outlook

Current consensus is that the UK base rate will remain at or close to its current level throughout this year and the next, and that any increase thereafter will be moderate and gradual. The table below is from the Bank of England’s November 2012 Quarterly Inflation Report.

The conclusion that must be drawn from the term structure of UK money market rates is that UK cash rates are likely to remain very low in absolute terms and negative in real terms for another three years, at least. With the UK economy enduring a technical second recession and 2013 GDP growth anticipated to be no more than 1 per cent, expectations for the timing of any potential increase in UK base rates are being pushed further into the future.

How long can rates remain so low?

There is a striking similarity between the interest rate environment since 2007 and that following the Wall Street crash of 1929 (see graph below).

In both cases interest rates quickly fell below 1 per cent. They have fallen from 5.5 per cent at the beginning of the financial crisis in 2007 to virtually zero currently in the US. In 1932 rates went below 1 per cent but didn’t rise above 1 per cent again until 1948. Indeed, over this period inflation remained relatively high and cash investors would have lost over 38 per cent of the nominal value of their capital if they remained in cash.

Many believe an increasing reliance on unconventional monetary policy and a lack of a clear path to sustainable fiscal policy raises the long-term risk, particularly of rising inflation. The current expectation is for Consumer Prices Index inflation to remain at 2 per cent until 2015, although Retail Prices Index (RPI) will be higher.

One thing is certain: the more cash portfolios hold, the greater the loss will be in real terms for investors. It is my view, therefore, that investors should begin to tilt their portfolios towards real assets such as index- linked gilts, commodities, property, infrastructure and higher-yielding (but lowly leveraged) equities. This will entail accepting higher short-term investment risk, but over the long term will offer greater investment protection.

So where should investors focus their attention?

Gilts

The Bank of England has been active in its pursuit of non-conventional monetary policy, undertaking two additional programmes of quantitative easing since last October despite UK inflation having stayed stubbornly above its 2 per cent target rate since November 2009. Gilt yields have consequently reached unprecedented lows. I expect that the current policy of ‘yield repression’ (the deliberate forcing of yields lower than would otherwise be the case) will be with us for some time yet.

Once this policy ceases, however, there is potential for a strong upward move in yields. Gilts are expensive (2 per cent for ten years and 3 per cent for 30 years), but quantitative easing is likely to remain supportive for some time. Eventually, yields are likely to rise and return closer to long-term averages.

The current ten-year UK gilt is yielding 2.09 per cent, having hit a low of 1.43 per cent in August 2012. While gilts undoubtedly offer solid risk management and diversification benefits in a multi-asset portfolio, there is better value in the corporate bond market.

Yields in the corporate bond market currently vary from 2.9 per cent for AAA paper to 4.4 per cent on BBB issuers. In turn, these reflect higher yields of 0.8 per cent and 3.18 per cent over the comparable UK gilts. The spreads relative to gilts have also narrowed in considerably over the past 12 months, reflecting the continued demand for such instruments from yield-hungry investors and the general improvement in global sentiment. In fact, the lower down the credit spectrum one goes, the higher the returns have been in recent months. In addition, the recently reported relaxation of Basel III capital requirements has proven to support those bonds issued by financial institutions and bonds generally.

Index-linked gilts

Investment in index-linked gilts may also be regarded as a strategy intended to reduce or mitigate the risks associated with holding cash. Index- linked issues provide some diversification and protection against a potential increase in inflation that would undermine the real value of monetary assets.

For example, the 2024 index-linked gilt was originally issued in December 1986 at a real yield of 2.5 per cent. Over time, investors have been willing to buy index-linked gilts at much lower yields.

Index-linked gilts protect against UK RPI inflation because both the interest payments and the capital value that will ultimately be received at maturity are increased in line with inflation over the life of the gilt. The value of the UK RPI when the 2024 index-linked gilt was issued was 97.67. The current index reading is 243.

This equates to approximately GBP248.8 as an ‘indexed’ or inflation-adjusted value of the capital. As the capital value, i.e. the price, is currently approximately GBP334, this is roughly 34 per cent higher than the inflation indexing earned to date. Essentially, the value of capital invested now will be protected from future inflation only after the inflation indexing has caught up with this premium – i.e. about 34 per cent higher than now. The income is unaffected as it is automatically calculated and paid according to the original terms.

Historic returns from equities

In a period of relatively low economic growth, I believe that dividends will provide a greater proportion of total return. Moreover, if growth over the next few years proves relatively anaemic, those companies paying high, safe and growing dividends will outperform.

Since 1931 dividends have accounted for over 40 per cent of the total return on stocks (in the US). In lower growth environments, however, dividends actually made up a greater proportion of the index’s return than capital appreciation – for example, in the 1930s, the 1970s and the 2000s, the latter being a decade of zero capital appreciation.

Historically, equities have provided investors with positive, long-term real returns, although in recent years they have been mixed with negative returns on several occasions.

Despite recording a sharply negative return in 2011, equities have still provided positive historic returns over longer periods in real terms and have comfortably exceeded returns from cash over the past 20 years, albeit eclipsed by gilts over that period as yields have fallen to multi-decade lows.

The table below illustrates the performance of equities against cash and gilts. For example, the first column illustrates that over a two-year holding period, equities outperformed cash 74 times out of a total 111 times in the entire sample, or 67 per cent of the time.

The incidence of equity market outperformance increases as the time horizon is extended, with equities outperforming cash 99 per cent of the time over 18-year holding periods and outperforming gilts 88 per cent of the time.

I believe investors should focus on stocks that have a high, well-covered dividend, preferably via companies that are not highly leveraged.

I am focused on global equities with strong dividend growth prospects, global listed real estate, and selected infrastructure projects linked to ‘inflation plus’ returns.

Summary

In spite of all the current economic uncertainties, interest rates will remain at current levels at least for this year and probably much longer. Given this, it is vital that advisors and investors actively manage their cash positions to at least maintain the real value and avoid issues in subsequent years. For those of a lower-risk disposition, gilts, index-linked gilts and corporate bonds will be suitable alternatives, but for those with a longer investment horizon exposure to higher yielding equities, infrastructure, commodities and healthcare should be considered.


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