The Bank of England raised rates in August for a 14th time, bringing the base rate to 5.25%, and signalling that it isn’t done yet.
You’ll be forgiven if you’re starting to feel punch drunk. This is already the largest number of consecutive rate increases in Bank of England history, and the longest period of consistent monetary tightening since the two inflation shocks of the 1970s.
With a decent return and a high degree of capital security, it’s a legitimate question to ask if cash is now the most compelling asset class.
As multi-asset investors, we say no. Cash offers no hedge against inflation and there are stronger returns to be had for those willing to accept short-term volatility. Even in the short term, we see better opportunities elsewhere.
In the long term, where inflation matters most, cash can be the riskiest
We’re currently running low levels of cash to fund overweight positions in stocks and high yield bonds. If and when rate hikes finally take full effect and the world economy slides into a disinflationary recession, we’re likely to move overweight government bonds, in anticipation of gains as the market moves to price in rate cuts.
In the short term, where capital preservation is key, cash is usually the safest asset class. In the long term, where inflation matters most, it can be the riskiest.
Interest rates are probably close to their peak level for this business cycle. Our economist Melanie Baker expects base rates to average around 3% per annum over the next 10 years. If inflation turns out to average 2%, then fine, you’ve made a small real terms gain by investing in cash.
The problem is cash offers no hedge against unexpected inflation, as we saw over the last year. And this cost of living crisis may not be a one off. Demographic trends, an unravelling of globalisation and an uncertain geopolitical backdrop as we transition to net zero all point to the risk of what we term ‘spikeflation’, a period like the 1970s with high average inflation caused by a series of discrete price level shocks.
There is no stage of the business cycle across which cash has been the best asset class
For long-term investors willing to accept short-term volatility there are more attractive options. A portfolio invested solely in equities or property, with dividends or rent reinvested, would have seen its purchasing power in 1988 increase to anywhere from five to eight times its initial size.
Cash would have offered a much less impressive return over this period, failing even to double in real terms. In fact, since the 2008 financial crisis, persistently low interest rates would have seen inflation erode the real value of your savings by more than a third, even with interest reinvested.
Over medium-term time horizons, cash is seldom the best performing asset class. We use an Investment Clock approach to help us judge which asset class is likely to perform best across different phases of the global business cycle.
Cash beats inflation on average when inflation is falling but it lags inflation when it’s rising. There is no stage of the business cycle across which cash historically has been the best asset class. Either stocks, government bonds or commodities have done better in every instance.
The allure of cash as an investment may seem tempting
The same logic applies at the current juncture. If the world economy shrugs off higher interest rates and picks up steam, we’d expect commodities to beat cash in a return to overheat conditions.
If inflation drops enough for central banks to cut interest rates and deliver a soft landing, stocks should continue to post strong returns in what could turn out to be a sustained and disinflationary recovery.
If higher interest rates take effect and we slide into recession, as is our base case, then this would set the scene for a new round of central bank reflation with government bonds outperforming in anticipation of interest rate cuts.
Against the backdrop of rising interest rates and lingering recession fears, the allure of cash as an investment may seem tempting. However, a diversified portfolio of assets, including some that can keep pace with inflation, is likely to prove the better long-term outcome, especially if you have an investment process that allows you to adjust exposures as the business cycles evolves.
Trevor Greetham is head of multi asset at Royal London Asset Management
