In the last 18 months the world and global economies have completely flipped on their heads.
We’re in a whole new investing environment and facing new challenges for long term investments. Investors are considering the benefits of bonds as a defensive asset class and the opportunity for in a higher interest rate environment. Common questions are ‘is it time to get out of the stock market given all the apparent risks?’ and ‘should I be investing in cash, now it’s made a triumphant comeback as an income providing asset class?’
However tempting, for anyone with a long-term investment time horizon the answer is likely to be ‘hold your nerve’.
Diversification is the only free lunch
When it comes to investing, it’s long been said that the only real free lunch is the ability to put your eggs in different baskets. Diversification is your friend in the good times and the bad. Take the classic example of the 60/40 portfolio. When one asset class is performing badly, diversification affords the opportunity of another asset class potentially doing better.
In the 20-year period shown in the chart below, the 60/40 portfolio has returned 6.4% annualised. Each asset class listed will have a different return profile and level of volatility which, when combined, can help long term investors achieve reasonable risk adjusted returns. It also shows that cash, when compared to the standard diversified portfolio, has lagged by around 4% on an annualised basis and within the range of asset classes (except commodities) has lagged in total returns over the longer term.
Despite the short-term attractiveness of any asset class, it’s wise to remember the actual historical returns produced.
Source: JP Morgan
The importance of staying the course
Stock markets are emotional beasts. They react to news quickly, and without prejudice. From announcements about rising interest rates to geo-political events, stock markets will digest the information and decide on the trajectory almost instantly.
Even in the best climates, trying to time these moves can be pointless. By holding on through the ups and downs, investors have the opportunity to participate in sharp rallies, which could lead to better longer-term returns. Exiting the market for any length of time can have stark consequences on returns. Look at JP Morgan’s graph below showing the impact of missing the 10 best days the S&P 500 experienced over the past 20 years. An investor’s annualised return would have been nearly half that of someone fully invested over the same period.
Source: JP Morgan
However tempting the current rates on cash, the lack of volatility alongside a 4-5% interest distribution – think ahead. When interest rate tightening cycles are at their peak and investors are feeling the pain in equities, bonds or, the forward returns from those points have been historically, incredibly enticing.
The chart from Charlie Bilello below shows the S&P 500 has done its best over the past decade, following the highest FED funds rate (both on a nominal and real basis). We don’t know for certain when the current tightening cycle will come to an end but given (generally) declining levels of inflation, it seems most of the Central Bank’s work has been done. To that end, divesting into cash before the potential inflection point could have a material impact on future portfolio returns, not to mention unnecessarily realising losses.
Source: Charlie Bilello [1]
Bonds vs Cash
Our intention isn’t to ‘trash’ Cash as an asset class. It certainly has its uses – some investors use it to take advantage of investment opportunities or to meet shorter term obligations. Interest rates on Cash have transformed over the past 18 months as Central Banks have tightened policy at record rates to try and quell persistent levels of inflation. This has been to the detriment of bond markets, as we saw throughout 2022, and to the benefit of cash funds and the applicable interest rates payable.
However, bonds provide something that cash doesn’t: the potential for capital appreciation plus delivering attractive coupons along on the way.
The starting yield for has historically been a key indicator of future returns, and yields are currently at attractive levels within Investment Grade Credit and Government Bonds. When tightening cycles are at their peaks, the potential for capital gains is at its greatest. The example taken from J.P. Morgan Asset Management Guide to the Markets, shows the potential capital gain scenarios for 2- and 10-year US Treasuries. In addition to receiving 4.6% and 3.4% respectfully, the potential for meaningful capital gains when the rate cutting cycle begins is clearly demonstrated .
Reinvestment risk is another significant consideration for investors, particularly those with fixed income assets like bonds or the rates on cash accounts. Reinvestment risk refers to the uncertainty and potential loss of future returns when the proceeds from maturing investments are reinvested at different interest rates. This can be risky as interest rates can fluctuate over time due to economic factors, monetary policy, or market conditions.
When interest rates are declining, investors, especially long-term investors, face the challenge of reinvesting their funds at lower yields, usually with diminished returns on their investments and a negative impact on their overall portfolio growth.
Investors have to decide whether to hold on during the difficult times. Those that do are usually rewarded, and those that don’t find themselves buying bonds back at lower yields and missing out on any capital appreciation.
Source: J.P. Morgan Asset Management
The silent assassin
One thing remaining constant throughout the years is the effect inflation can have on an investor’s capital and its ability to erode that capital if it’s not invested in real assets. As attractive as cash interest rates look at the moment, when they’re adjusted for inflation, the story is completely different.
A quick search for the best savings accounts in the UK produces results showing banks and building societies offering 4.5% - 4.7% for deposit accounts. This, on a nominal basis compared to the last decade is enticing, however the UK’s year-on-year inflation rate is running at 7.9% so at the time of writing, even the best deposit account isn’t keeping up with the rate of inflation, and the real value of savings is diminishing.
Let’s look at two charts from J.P. Morgan Asset Management – the graph on the left shows how the interest received on bank deposits in 2022 were well below that of the income required to beat inflation, whilst the right-hand chart shows how inflation can erode the purchasing power of cash over time. It’s clearly challenging to beat inflation by holding cash deposits.
Source: J.P. Morgan Asset Management
The current economic environment differs quite distinctly from that of the last decade. We’ve experienced an almost perfect environment for risk assets - quantitative easing and supportive fiscal policy has rewarded investors handsomely.
As the chart below shows, equities have achieved phenomenal returns from the 1900’s through to 2022, coming in at an annualised real return (return minus inflation) of 5.0%. Bonds, given their typically lower risk and volatility characteristics have returned 1.1 % annualised but the laggard throughout this 122-year history has been cash, delivering an annualised 0.6% real return. History proves buy and hold investing to be the best method of increasing wealth and retaining purchasing power for those investors who have the propensity to withstand short term fluctuations in the value of their investments.
Source: J.P. Morgan Asset Management
The King has been dethroned
It’s clear that cash is not King when it comes to long term investing.
As we’ve discussed, even a small amount of time spent in cash can be detrimental to your long-term savings, due to the possibility of missing the best days in the markets. Despite cash being a useful element of a financial plan, (as a source of liquidity or in case of emergency), the longer-term benefits of investing in real assets are clear to see.
Markets ebb and flow, and sometimes the frequency and severity of these flows can be extreme but it’s important to maintain discipline in your long-term investment strategy and not to capitulate in the face of short-term adverse conditions. Remember, it’s always darkest before the dawn.
[1] The Week in Charts (16 July 2023) by Charlie Bilello.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.
Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.