Rate cuts further erode the appeal of cash

Thought of the day

by Chief Investment Office 19 Sep 2019

The Federal Reserve's quarter-point rate cut this week was another setback for cash savers. It took the real US interest rate (after inflation) to just 0.25%. The real return on cash in the Eurozone, Japan, and the UK is already negative. Central bank policy meetings over the past week in the US, Switzerland, and Japan underlined that rates look set to remain lower for longer.

Retreating to cash can be tempting, especially in uncertain times. But while we are tactically underweight equities amid continued US-China trade tensions, we still advise investors to hold risk assets for the long term. Our recent slide publication "10 reasons to stay invested" explains why investment risks can be reduced by a longer time horizon, along with asset class and geographic diversification, rather than cash.

  1. Holding cash is costly, and the drag is increasing. Since 2004, cash stored in US dollar accounts would have lost roughly 11% of its real spending power, while euros would have declined in value by around 8%. The Swiss franc has been an exception here, managing at least to preserve wealth over this period, due to low inflation. But even here cash did nothing to increase net worth. The futures curve now has Swiss rates in negative territory for most of the coming three decades. If the interest rate trajectory priced by the markets is correct, CHF 1m deposited now would be worth just CHF 918,500 in 30 years (based on an average negative rate of 0.28%). Add in an average forecast inflation of just 0.3%, and real purchasing power declines to CHF 838,700. Factor in the opportunity cost of being out of the markets, and the cost of cash is even higher. With a 20-year time horizon, 100 dollars invested in stocks in 1998 would be worth 380 dollars today vs. 270 dollars if invested in Treasuries and 150 dollars if invested in Treasury bills.
  2. Investors looking to reduce risks from owning stocks have a few options. One is to lengthen time horizon. Of course, markets are volatile. And for any given week, there is a roughly 43% chance that investors will do better by investing in cash – in USD terms. But the chances of cash doing better over a year falls to 31%. And with a 10-year investment horizon, the probability of equities earning excess returns over cash rises to 95% from around 70% with a one-year investment horizon and 83% with a three-year investment horizon. After 20 years, the probability of cash beating equities has historically been zero.
  3. Diversification – both in terms of geography and asset class – also lowers risks. Starting with asset class diversification, fixed income helps stabilize portfolios in times of stress. US Treasuries have typically rallied during periods of economic, political, or financial turmoil – helping to offset drawdowns in stocks. During the 2011 Eurozone crisis, for example, a broad index of US Treasuries gained around 5% in value, and the 10-year bond gained nearly 16%, helping to cushion a 24% fall in global equities. Geographical diversification also helps lower volatility. The MSCI All Country Index is less prone to large drawdowns than most of the individual major indexes – with the exception of a few markets with highly defensive characteristics – including the Swiss and UK markets. Since the start of 2018, the MSCI All-Country World index has only had eight days with drawdowns in excess of 2%, versus 20 days for the US Index, 29 days for MSCI China, and 53 days for MSCI Brazil.

Of course, liquidity has a part to play in our Wealth Way Framework*, for meeting spending needs over the coming three to five years. But an excessive allocation to cash greatly reduces your chances of meeting your financial goals. For more detail, see our slide deck "10 reasons to stay invested" or reach out to your advisor for a copy.

*UBS Wealth Way is an approach incorporating Liquidity. Longevity. Legacy. strategies that UBS Financial Services Inc. and our Financial Advisors can use to assist clients in exploring and pursuing their wealth management needs and goals over different timeframes. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment.

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