2022 was a definitive year in many respects for investments as it arguably ended the low interest rate and low inflation rate environment experienced since the global financial crisis.
This, along with last week's news of another interest rate rise and recent high inflation figures, could markedly change the real rate of return clients will demand from their investment portfolios
When we look at the real rate of return, we’re not just comparing different asset classes’ returns, but also what those returns would be after costs and inflation, the latter of which has seen a significant shift.
Cash has always had a certain appeal, mostly due to it safety element
Out of a standard investment universe, equities, fixed income, alternative and property, it certainly offers compelling security over the shorter term. It’s also true that there is a younger generation that for the first-time can actually earn a noticeable return from holding cash. These are all relatively compelling arguments, but does it meet the investors’ requirements and expectations for their wealth?
Cash merits very serious consideration for investors when interest rates are high and not exceeded by inflation. This is not the case now – and historically would have been the exception, rather than the norm. Furthermore, the seemingly attractive returns seen advertised from banks tend to also have a number of limiting factors, for example, lacking the facility to withdraw cash at any point as well as shorter-term time horizons, for example, only being available for a short period of time.
Traditionally, both equities including capital and dividends and fixed income has managed to outperform even the most attractive of interest rates. According to JPM Guide to Markets 2023 Long Term Capital Market Assumptions, which looks at expected returns over the coming 10 to 15 years, cash is the least attractive asset class, offering just over 2% with the next least attractive being UK inflation linked gilts offering nearly 4%. Compared to various regional equity markets offering potential returns of between 6% – 10% when averaged over the medium to long term, cash returns look somewhat benign.
That said, cash is always an important part of the diversified portfolio
It allows the investment manager to manage risk, but also to take advantage of opportunities when they arise. In addition, for clients in income drawdown it allows for their income to be held pre-emptively therefore reducing the impact of sequencing risk, while also benefiting from a return, albeit small. But as highlighted above, achieving a real return is not so straightforward. If expected cash returns over the next 10-15 years for cash is in the region of 2% this would be in line with central banks 2% inflation target, so real returns would be potentially negligible.
As we highlighted above there is a cohort of the younger generation who are benefiting probably for the first time from gaining some form of interest on their cash savings; there’s also a cohort of younger investment managers that will need to prove that their decisions in equities and fixed income can achieve an expected rate of return above that of cash. A scenario which really has not been in play since before the financial crisis.
This does highlight that the investment strategies that may have worked post the financial crisis are not necessarily the strategies that are likely to work over the next 10 years. Given that the last 10 years can be considered abnormal when you look at a broader history, arguably we have now moved back to a more normalised environment where cash alongside other asset classes can become a key ingredient to the investor’s overall returns, but it still is unlikely to be the dominant asset class of choice.
