Cash is not king

During June, the Bank of England surprised markets by increasing the UK base interest rate by more than expected, to 5%. This represents the highest level since prior to the Global Financial Crisis, in 2008.

Many retail banks have been slow to pass on these rate increases to savers, but with a little searching, it is now possible to obtain a fixed-term cash deposit at rates in excess of 5%. This is leading some to question the merits of investing in the stock market when the returns on cash are at their highest in more than a decade.

The problem with holding cash when interest rates are high is that this typically occurs when inflation is also high, as increasing interest rates is the main tool of a central bank, such as the Bank of England, to control inflation. This means that the real (i.e inflation-adjusted) return on holding cash is still relatively poor. This is the situation we have currently in the UK, with inflation remaining stubbornly high. The latest consumer price inflation reading in the UK for June dropped to 7.9%, but this is still comfortably higher than the return that can be generated by holding cash.

Fortunately, we have an investment tool at our disposal that does have a good track record of outperforming inflation over the long term, namely equities. This mainly stems from the fact that many businesses can pass on their higher input costs to the prices they charge for their products and services. This ensures that their earnings can grow during high inflation periods.

For an example of the attributes of equities during high inflation periods, we can look back to the 1980s and 1990s. As we entered 1980, the UK base interest rate stood at 17%. It then proceeded to stay above the current level of 5% for the whole of the next twenty years. Over this period, a cash investment (using the Bank of England Base Rate as a proxy) would have returned close to 540%, meaning £1 would have been turned into £6.40. However, an investment in international equities would have roughly quadruple the return over the same period. The same £1 invested in the MSCI World Equity Index would have turned into close to £23.

Each year Barclays Research produces a study comparing the performance of various asset classes since 1899. Helpfully, the research shows the probability of equities outperforming cash over relatively short periods. We can see from the latest study, covering the period until the end of 2022, that over all two-year periods, the probability of equities outperforming cash is 69%. For periods of ten years, the probability of equity outperformance increases further to 91%.

Source: Barclays Research

Whilst we would always recommend that clients hold a portion of their portfolio in cash, history would suggest that holding too much cash will likely be detrimental to long-term performance, regardless of whether the interest rate on cash is low or high. This is especially the case when the impact of inflation is factored in.

Mike Evans – Portfolio Director