Returns on cash are likely to lag behind inflation for years. Bank of England Governor Mark Carney recently said that rates will rise “at a gradual pace and to a limited extent”, and this only if the “fog of Brexit” lifts. Futures markets are pricing in a three-month rate of only 1.2 per cent by December 2021, which means real interest rates will be negative for at least another three years.
Despite this, there is still a strong case for investors to hold at least some cash, simply as protection against the dangers facing other assets.
Yes, there are reasons to expect equities to rise this year: a high dividend yield on the All-Share index and foreign selling of US shares in the past 12 months are good lead indicators of rising prices. But they are not perfect predictors. There is always the danger that past relationships between lead indicators and subsequent returns will break down.
There are also dangers for bonds. Gilt yields are determined largely by yields on overseas bonds. These could rise if investors fear that the Fed or European Central Bank (ECB) will raise rates. Of course, the weakness of the eurozone economy, plus the fact that inflation there is far below its target, mean there is no pressing need for a rate rise. But the ECB has for years been overpredicting inflation and so has kept monetary policy too tight. Fears that it might repeat these mistakes could push bond yields up.
At low yields, these risks matter because small changes in yields cause big price moves. Terence Moll at Seven Investment Management points out that a one percentage point rise in yields – which would still leave them very low by historic standards – would cause a 10 per cent price fall.
If markets were to fear rising rates, commodities could also suffer. This is because their prices are sensitive to interest rates. When you hold commodities, you lose the interest that you could be getting from having cash or bonds instead. When interest rates and bond yields are low, this loss is small, which means commodities are attractive. As rates rise, however, the sacrifice increases and so commodities become less attractive.
It’s possible, therefore, that we could see losses on non-cash assets. Worse still, we could see them at the same time. Yes, bonds protect us from some risks to equities, such as the dangers of weaker growth or of investors’ loss of appetite for risk. But they don’t protect us from all such risks, such as the possibility that higher interest rates will trigger a reversal of the “reach for yield” or fears of a slowdown in economic activity.
This correlation risk isn’t the only danger that cash protects us from. There are at least three others:
- Liquidity risk. Some assets such as property or private equity become especially difficult to sell in bad times. Having cash prevents us from having to do so. It allows us to be a long-term investor and thus to pick up liquidity risk premiums.
- Tail risk. The most you can lose in real terms on cash obviously depends on the rate of inflation. Because this is likely to be quite stable, this loss will very probably be small. But the same cannot be said for worst-case scenarios for other assets. Big losses on equities, bonds and commodities are more likely than a normal distribution would predict; a cubic power law is a better description of the distribution of extreme returns. If you care about minimising worst-case losses, then cash is for you. A 5 per cent real loss on cash over the next 12 months is improbable; the same cannot be said of equities, commodities or bonds.
- Fire sale risk. People who are fully invested, or worse still have borrowed to invest, can sometimes have to sell otherwise good assets simply to raise cash in an emergency. This was the story of the collapse of Long-Term Capital Management in 1998, the banking crisis of 2008 (a lot of mortgage derivatives turned out not to be worthless) and it’s also been the story of many over-geared property owners. If you’ve ever been lucky enough to buy a cheap house, it’s probably because you took advantage of somebody’s forced selling. Having cash protects you from falling into such a situation.
Many of you might think there’s another advantage of cash – that it allows us to buy shares when they become very cheap. I’m not sure about this. Equities only become genuine bargains when investors are panicking. But when they are doing so, you might not feel like buying either.
In truth, though, we don’t need this motive to hold cash. Cash’s virtue is that it protects us from dangers that other assets don’t protect us from.
You might object that these dangers are small - haven’t I myself recently said that the outlook for global equities is very bullish? True. But the four most important words in the English language are: “I might be wrong.” The biggest virtue of cash is that it protects us from our own ignorance. And this is always greater than we think.
