Time to reconsider stashing cash

Why prudent savers should look elsewhere

The world has changed – and not just because of the coronavirus pandemic. Since the global financial crisis of 2008/2009 it has been nearly impossible for cash to deliver reasonable returns. For cash to be worth holding, the interest earned needs to offer returns above inflation – and this is no longer the case.

If you have been keeping cash deposits in formerly reliable accounts such as National Savings & Investments, Premium Bonds or government bonds, and you have seen interest rates falling, it's time to rethink your arrangements. At Canaccord Genuity, we will be happy to discuss alternative ways of investing your capital while aiming to achieve returns above inflation. If you'd like to speak to us, you can get in touch with us either through your existing Investment Manager or click here for one of our wealth managers to contact you. 

In this article, we look at the reasons why cash might no longer be a sensible solution for prudent investors, and the history behind the current situation.

Clash of the titans: interest rates vs inflation

With the current level of interest rates, investors cannot earn real returns from their cash deposits. And our view is that, regrettably, this situation isn’t going to change any time soon. Cash deposits will not provide any protection against the worst scourge of the prudent investor: inflation.

Looking back to the 1960s, we can see how interest rates – in this case measured by the Bank of England base rate – have fluctuated over time. It is noticeable that interest rates plunged to near zero from the end of 2008 and have flat-lined ever since.

However, this tells just part of the story.

We also need to consider the effects of inflation. The prices of goods and services generally rise over time, which means that the purchasing power of a nominal sum – say £100 – reduces as time goes by. What you can buy for £100 today is far less than in the 1960s. To protect against this, those with cash in the bank want their rate of interest to exceed inflation. Sadly, this is no longer the case.

Here we have plotted the Bank of England base rate again, but this time we've subtracted the inflation rate, as measured by the Retail Price Index. Any reading above zero indicates that interest rates are sufficient to protect against inflation; a reading below zero shows that the after-inflation (or 'real' value) of cash held in the bank has been eroded.

For most of the past 60 years, interest rates have managed to offset inflation. The exceptions were the 1970s, when sky-high inflation overwhelmed base rates, which reached 17% in 1979 and, crucially, from 2009 until the present day.

In the 10 years to September 2008, UK interest rates averaged 4.9%, whereas Consumer Price Inflation (CPI) averaged 1.7% – so cash earning interest could reasonably be expected to grow in real terms. However, in the 10 years to September 2020, the situation has changed completely: interest rates have averaged under 0.5%, whereas inflation has averaged over 2%. Cash in the bank has fallen in real terms.

If we plot the actual levels of interest rates against CPI over the last 20 years, the orange shaded areas represent periods when inflation has exceeded the rate of interest.

Why inflation figures often don't reflect reality

The official statistically calculated inflation rate may not accurately reflect the increase in an ordinary person’s cost of living. Inflation rate calculations supplied by government agencies are adjusted in ways that may over- or underestimate the true inflation rate experienced by you and me.

One way this happens is when trying to account for the fact that the quality and/or functionality of certain items change over time. A mobile phone may have cost £500 in 2000, and £600 today. However, a mobile phone now is clearly much more sophisticated than it was 20 years ago, and today’s price may be adjusted to reflect the fact that £600 buys a much more powerful device than the £500 option at the turn of the century. 

The other fact is that inflation figures are based on a representative 'basket' of goods and services – but we all have different spending habits. Some people buy more clothes than others. Parents are subject to the changing costs of childcare, but changes in school fees or childcare costs make no difference to your personal inflation rate if you are childless. In fact, many people find their own inflation rate far exceeds the published figures.

What happens next?

1. How will interest rates and inflation change in the coming years?
2. What options other than cash are available if you want a moderate degree of income and are not prepared to see the real value of your investment diminish over time?

In response to the first question, we find it inconceivable that UK interest rates will rise meaningfully in the short to medium term. In fact, interest rates could fall further. Because of the coronavirus pandemic, the UK base rate was cut to 0.1% in March, but it could still fall into negative territory and follow in the path of the eurozone and Japan.

Even if the interest rate isn’t cut further, it would be an economic catastrophe if borrowing costs were raised any time soon. Every lever of central bank and government policy is being pulled to try and support growth in these unprecedented times and this will persist for as long as needed.

Why the government needs to keep interest rates low

The effect of the interest rate on the economy can be viewed as like the accelerator or brake pedal in a car. If you want to slow down, rates are raised or held at a high level; if you want to speed up, rates are lowered or kept at very low levels. The last thing any economy needs at the moment is to have the brake pedal pushed; most economies are struggling to keep their speed up as it is.

Interest rates will only rise if growth accelerates to such a pace that the danger of further economic retrenchment is seen as having passed, or inflation increases to such an extent that to leave it unchecked could threaten the UK’s financial stability. Neither condition is anywhere near being met at the moment.

Outside of supply shocks (such as occurred in the 1970s with the oil price), high inflation is most often driven by excess demand – too much money chasing too few goods. It is difficult to envisage this particular problem afflicting the UK economy any time soon. In short, the current situation of interest rates running below inflation is unlikely to change in the near term; if anything, the relationship is likely to deteriorate further.

What alternative options are available?

Be warned: comparing cash to other opportunities is like comparing apples to pears. The ultimate no-risk investment (assuming a deposit with a reputable, regulated entity, fully covered by a deposit protection scheme) is cash. Other investments will offer different risk and return trade-offs, with the overriding principle that potentially higher returns involve a higher level of risk. There is no such thing as a free lunch; an allocation to cash and low-risk investments should always be considered as part of a balanced portfolio strategy.

National Savings & Investment (NS&I)

Most people in the UK will be familiar with NS&I, offered by a state-owned savings bank and including a range of options including Premium Bonds, Income Bonds and Investment Accounts. These products are a viable option for anyone whose bank deposits are greater than the compensation from the Financial Services Compensation Scheme. However, the same problems which currently plague cash deposits also apply to NS&I products: the interest rate does not currently offer returns above inflation.

From 24 March 2020, the interest on Income Bonds and Investment Accounts dropped to 0.01%. Premium Bonds offer a return of 1% from December 2020, but this does not constitute either a guaranteed or regular income; it refers only to the overall annual prize fund paid from the total prize pool.

Government bonds (gilts)

Like cash, government bonds were once a viable option for investors who wished to earn a potentially higher return than cash, but still with the comfort of a very low-risk profile. Here again, the yield currently available from government debt across most of the developed world has fallen significantly, and it is unlikely that yields will rise meaningfully in the current environment.

The chart below shows the yield of 10-year government debt relative to inflation in a similar format to that shown for UK interest rates. The same problem exists; inflation is currently higher than the yield being offered and, assuming the gilt is held to maturity, a negative real return is likely.

Shorter-dated issues offer an even worse return profile. At the end of October 2020, the yield on a generic 5-year UK gilt stood at -0.04%; investors could expect to lose money in both nominal and real terms if held to maturity. The same issue affects debt issued in the euro area, Japan and the US to a greater or lesser extent.

Equity-based investments

Here there is some hope for prudent investors, although again with the caveat that equities and cash are not like-for-like investments. The value of stocks and shares fluctuates, often significantly, and any dividend stream is not guaranteed and will change (but hopefully grow) from year to year.

That aside, equities are one of the few assets which currently offer a yield above inflation, as shown by the dividend yield of the FTSE All-Share relative to CPI.

While short-term volatility can be unsettling, share prices tend to move in line with company earnings over the long term, as shown below. We have used the US stock market, given its status as the largest and most liquid of the world’s equity markets:

While many companies have been forced, or chosen, to cut dividends in 2020, this has happened before, and the long-term correlation between equity prices and company profits should still feed through to higher payouts over the medium to long term. Between 1997 and 2019, the dividend per share of the FTSE All-Share has risen by an average 6.6% pa.

While the yield on cash and bonds falls as interest rates decline, there is clear evidence that the capital value of equity markets responds positively to low interest rates. Meanwhile, the dividend yield from the UK equity market stood at 3.5% in November 2020, far in excess of cash and government bonds and, crucially, above the UK’s 0.5% year-on-year rise in CPI inflation. Investors are at least being offered some reward for the risk of investment.

Experience would suggest that corporate profits and dividends will recover more quickly than interest rates will rise. Indeed, it is almost a prerequisite, as there is little chance the Bank of England would countenance higher borrowing costs until there is clear evidence of a corporate recovery. That recovery will be in the form of higher profits and an expected rebound in dividend payments.

Conclusions

If you are concerned that inflation is winning the battle with interest rates and bond yields, then investing any excess balance – according to your personal circumstances – may be the best option available. Even a move toward corporate rather than government debt will offer some increase in yield, though still probably insufficient to offset inflation without a meaningful level of capital risk.  We could also argue that the corporate bond sector is not rewarding investors enough for the risks they are taking.

Meanwhile, equity-based investments also offer a range of options. These include real estate investment trusts, individual companies with an unbroken track record of dividend pay-outs and dividend growth, open-ended equity income funds, and infrastructure-related assets. There is more than enough choice.

If you are looking to earn an income from your investments, you might want to consider equities for at least part of any excess cash balances for the foreseeable future. Get in touch with us to find out how we can help you protect your capital against inflation.

Speak to one of our experts

If you have any questions about the current environment or about your investments, please get in touch with us or email questions@canaccord.com. 

Please remember, if you hold an account with Canaccord, you can check your portfolio value at any time, through Wealth Online or by getting in touch with your Investment Manager.  

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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

The information contained herein is based on materials and sources that we believe to be reliable, however, Canaccord Genuity Wealth Management makes no representation or warranty, either expressed or implied, in relation to the accuracy, completeness or reliability of the information contained herein. All opinions and estimates included in this document are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information contained herein.