Cash rates are a mirage

Today’s cash rates are likely to disappear as we get closer to a recession. If they stay high, the whole investment landscape will have changed.

With short-term interest rates at their highest level since 2008, it is easy to sympathise with the view that cash looks tempting. If investors can get 4-5% with no risk of capital loss, why engage with stocks? And with no additional yield on offer from longer-term bonds, why is there any need to take on more interest rate risk?

But today’s cash rates are a mirage. They are likely to disappear as we get closer to a recession. If they stay high, it will be because the whole investment landscape has changed.

Consider the three most likely paths ahead for the global economy:

In a soft-landing scenario, where economies prove more resilient than we expect but inflation is not troublesome, cash may be a better option than government bonds, with central banks not needing to deliver on the interest rate cuts that are currently priced. Yet in this scenario, parts of the stock market would likely see some uplift as recession risk diminishes, outperforming cash. That upside could be substantial in cyclical parts of the market like small caps where valuations are currently modest.

In a mild recession, currently our base case, interest rates eventually bite. Consumer spending runs out of steam, businesses pull back on investment and weakening labour markets lead to a mild recession that helps to bring inflation back towards target. In this scenario, the attractive cash rates available today will no longer be available in a year's time, as central banks, convinced that their work is done, finally start to ease off the brakes. Sitting with large cash allocations therefore entails significant reinvestment risk. We would expect core bonds to outperform, as they have done in the two years at the end of each US rate hiking cycle since the mid-1980s.

Stagflation, the final scenario, where the economy rolls over but interest rates are not cut, is arguably the most difficult and where cash has its appeal. Central banks could be forced to hike rates even further in a desperate bid to retain credibility and to keep inflation expectations anchored. Stocks would come under pressure due to a much weaker earnings outlook, while bonds would fall as investors repriced the path ahead for interest rates.

However, there are still options that we would expect to outperform cash, in both nominal and real terms. The best cash-beating solutions would be those in the private markets, with real assets such as infrastructure and timber well positioned to repeat their strong performance of 2022. Liquid solutions include commodity stocks and hedge fund strategies.

Over a much longer time horizon, cash looks even less attractive. $1 invested in 1900 in money markets would have amounted to just $2 by 2022 in real terms, i.e. adjusted for inflation. Bonds would have returned $4 over the same period. By far the best performer on a real basis was equities, returning $386. Hunkering down in the safety of cash is never the right investment strategy over a longer time frame.


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