- Cash can be viewed as the most expensive asset as negative real interest rates continue to destroy its purchasing power.
- Therefore, asset allocators should resist the temptation to invest in cash in the medium term.
- Central banks must address the impact of this ultra-easy monetary policy.
Should interest rates still be at emergency levels?
Cash is not king. In fact, I think cash is the least attractive asset class at the moment and most strategic asset allocations should avoid it. For sure, many asset classes are expensive now, but I argue none more so than cash. To make my case, I ask a simple question:
“Is it acceptable for a public institution to reduce a population’s standard of living over the course of a decade or longer?”
This question is directed at the world’s big central banks: the Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England amongst others. To be clear, I hold these institutions in high regard for their rapid and decisive response to the global financial crisis of 2008, which doubtlessly averted an even more serious outcome. Yet, a decade on, should we still be at emergency levels of interest rates?
Central bankers could retort:
“Why not, what’s the downside? Economic theory warns that an interest rate set too low can cause long term inflation; if there is little sign of excess inflation, why raise rates?”
The problem with very low interest rates
The reason is that there are other consequences of low interest rates. An unintended one, which I’ve observed over the last few years, is that a prolonged period of very low interest rates appears to affect investor behaviour.
Obviously, all of us are free to choose how much we spend versus how much we save. If the return from saving is low, then generally we will prefer to spend instead. Indeed, we may even choose to borrow to spend, as may corporations – to increase their output – all of which improves near-term economic growth. The idea behind the emergency measures the banks took in 2008 was, of course, to ensure money in the bank wouldn’t keep pace with inflation so as to encourage us to spend there and then.
Crucially, this decision to spend or save creates a link between the inflation rate and the interest rate. The real interest rate (the interest rate minus the inflation rate) must be positive in order to preserve future purchasing power. Every day it’s negative the amount of goods our money can buy is reduced. That’s bearable over short periods but not for long periods. A negative real interest rate has now prevailed in Western nations for almost 10 years and the compounding effect of this has done real damage to purchasing power. In Britain, what cost £100 in Jan 2009 now costs £119. Yet £100 in the bank has grown to just £104.
Standards of living have been affected
Chart: US cost of living
Source: Fidelity International, Bloomberg, April 2017
This is extreme. Standard economic models expect the interest rate to be close to the nominal economic growth rate in the long run. Economic growth can be decomposed into an inflation rate and a real economic growth rate, estimated to be about 2% - 2.5%. That means the real interest rate should normally be about 2%. That is significantly higher than the current, ever more negative real interest rates.
In the UK, the real interest rate is -2.0%.
Never before have real short rates been this low - as much as 4 or 5% below typical levels. And never before have they been negative for anywhere near the 9 years, and counting, of the current cycle.
Deconstructing investors’ ‘reach for yield’
Maybe if the choice was either to spend or to deposit money in the bank, people might spend when real interest rates are this low. But there are many investable assets. Since they’re all riskier than bank deposits, and investors require reward for bearing risk, these asset returns are expected to exceed the interest rate. Therefore, as people seek to maintain purchasing power, rather than save less they are investing more riskily, termed ‘reaching for yield’. Buying riskier assets comes with increased volatility and the potential for losses … which may further impact investors’ ability to meet their longer term goals. Hardly an environment to increase spending. The unintended consequence of this extended period of negative real interest rates is that it has changed investor behaviour rather than stimulating consumption.
The spectrum of investment expected return and risk are typically represented by an efficient frontier: a curve on a graph with investment risk on the horizontal axis and return on the vertical one. This efficient frontier represents the investment portfolios of maximum expected return for a given level of risk. Since we all prefer more return to less, and less risk to more, the frontier is upward sloping, with the left hand end sitting at the zero risk point which equates to a return equal to the interest rate.
Chart: risk/return spectrum
Source: Fidelity International
As an analogy, view the inflation rate as a water line, a line running horizontally across the graph, and view the efficient frontier as the profile of a boat at sea. We’ve already shown that the real short rate is typically about 2%, so the whole boat should float comfortably above the water line. However, with a -2% real short rate, our boat is sinking. At that level, a third of the efficient frontier is submerged. The only available portion that’s above sea level is the risky element. The safe haven of the bank deposit is no longer available to the investor choosing at least to maintain a standard of living. All those in the submerged cabins have made their way aft, up the risk curve.
Two key messages
The first of my two key messages is to implore central banks to address the impact of this ultra-easy monetary policy, as I suspect the situation will deteriorate shortly. Many retirees since the financial crisis had defined benefit pension plans, so haven’t borne the brunt of low interest rates. In future, most new retirees will be in defined contribution schemes and they will feel the impact: their pension funds won’t have grown enough to retire on; and annuity rates - which are related to interest rates - won’t be high enough to pay sufficient income in retirement. Furthermore, whilst defined benefit members are unaffected, the corporations and local authorities which must pay their pensions are going to find it increasingly difficult.
To put this into numbers as a case study, someone working for a local authority in the UK for 40 years will receive a defined benefit pension approximately two thirds of final salary, whereas someone making identical contributions into a defined contribution scheme will today be receiving an annual annuity of approximately one tenth of final salary. Not only is the latter too low for a comfortable retirement, but the local authority needs somehow to make up the difference between the level of income which has been promised to the defined benefit member and the rates on their own investments prevailing in the market to fund it.
The second message is to investors: Ultimately I suspect a continued deterioration of a population’s standard of living will put pressure on governments, who in turn will no longer tolerate independent central banks. To avoid a loss of independence, and also in acknowledgement that the emergency levels of interest rates set in 2008 won’t stimulate the economy for much longer, central banks will raise rates. Only then, as our sunken boat is raised, and investors return to safer assets, will the risk increase of an asset price fall. Until then, do something with your money – anything but putting it on deposit. To move into cash guarantees a return which will fail to keep up with inflation by an-ever increasing margin - it’s akin to moving back into the flooded cabins as the boat slips beneath the waves.