The world feels like it’s in turmoil right now with investors still licking their wounds from 2022 and no feel-good articles in the news.
A big plus point (for savers) has been the rapid resurgence of rising interest rates. Last week the Bank of England (BOE) raised rates for the 12th month in a row to 4.50%. There are even forecasts that rates may hit the dizzy heights of 5.00% by the end of the year.
This naturally leads to questions like “Is cash a good investment now?” So, let’s unpack this…
Risk-free return
This is defined as the theoretical return you can get without taking any risk. There are various versions of this that you can find. Probably the most official version is SONIA (Sterling Overnight Index Average) which is maintained by the BOE which currently it stands at 4.1777%. What isn’t disputed is that the risk-free return has climbed rapidly in the last 12 months. At the same date last year, the risk-free rate stood at 0.9403%.This matches the kind of rises available in the cash deposit market.
Stock market investments (equities)
Stock markets have had a bumpy few years between Covid, the war in Ukraine and the problems with a few banks in the US. However, when planning for the long-term future, it’s important to remember that these wobbles are normal and to focus on the long-term evidence.
We all know that stock markets go up and down every day and can be volatile over the short-term. The reward for taking that risk is the equity risk premium (i.e., the long-term prediction of how much the stock market will outperform the risk free rate). Over the very long-term, this risk premium has been around 4.40% pa (JPMorgan Guide to the Markets, Q2 2023).
So, what does that mean? It means that as the risk-free rate rises, so does the expected long-term return for equities. This is because the return from stock markets is effectively the risk-free rate plus the equity risk premium. If the risk-free rate rises by 3%, then the future expected return for stock markets should rise by 3% too. It is not a case that cash is catching up with equities. They tend to move largely in the same direction, but with the equity risk premium always being a few paces ahead. In other words, the goalposts are constantly moving.Within our client portfolios we tilt towards other risk factors such as small companies and value companies. It stands to reason that when we add the risk-free rate to these risk premiums, that the expected long-term return will rise too.
This is some of the theory behind why companies such as Vanguard are predicting stronger stock market returns over the next 10 years.
What about bonds?
The role of bonds in the portfolio is as a diversifier to equities. Historically, they are more stable and provide protection against falls in equities. 2022 was an odd year where they did not provide capital protection against stock market falls. However, this was due to rapidly increasing bond yields.Ironically, because of the year they have had, bonds are now in an even better position looking forward. Anyone holding bonds is already enjoying a higher yield. Over time, this is more than likely to make up for the capital drop in 2022. With interest rates now significantly higher, bonds will also benefit from a capital increase if there are any interest rate cuts in the future.
So, what to do?
When looking at the above, it’s clear to see that there are good future returns to be had. But what about that first question… should you be holding cash over an investment portfolio?In financial planning, the main risk is not meeting your life goals. For the vast majority of people, the biggest risk to this happening is the effect of inflation. This single phenomenon can lead to clients having to adapt their lifestyle and not enjoying the dignified and fun life in retirement they deserve. Using the calculator on the BOE website (Inflation calculator | Bank of England), goods and/or services that cost £100 in 1993 would now cost you £200.77. This is a huge jump!
If we look at inflation, it is currently running at 10.1%. This is projected to drop, but not as fast as first hoped by the BOE. Using this figure, if you had 100% of your money in the risk-free rate, after 12 months you would have 4.1777% more, but prices will have risen by 10.1%. This means that your original £100 is now worth £94.08.
So, even though the risk-free return looks attractive, over the long-term it is not going to protect you against inflation. In fact, the gap between the risk-free rate of return and inflation has only widened in the last 12 months. It’s even more important now to have an appropriate investment strategy. For those already invested, the data suggests that future returns will make up for last year’s drop. You just need a bit of patience. For those sitting in cash, consider putting a chunk of that capital to work to benefit from the improved future returns picture.
History teaches us that the best defence against inflation is to hold a diversified exposure to the companies of the world. If we temper this with an allocation to bonds that is appropriate to the risk you are both happy to take and need to take, this is the base for a solid financial strategy.
Please note, past performance does not guarantee future results.
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