With a view to bringing inflation under control, the Bank of England has raised interest rates 14 times since December 2021, taking Bank Rate from a historic low of 0.1% to 5.25% currently1. As a result, savers, who were faced with derisory rates of interest during the 13 years following the financial crisis can now get a half-decent nominal return on their cash in the bank. A quick look at moneysavingexpert.com reveals that savers can get 5.2% in an easy access account and just under 6.0% if they are prepared to lock up their money for a year2. In light of these numbers, and against the backdrop of the elevated financial market volatility witnessed in recent years, it is unsurprising that some investors are asking whether it still makes sense to plough money into stocks and bonds.
At times like these, it is worth reminding ourselves about the perils of holding too much cash in savings, and how a well-diversified portfolio stands a better chance of producing inflation-beating returns over the long-run.
The problem with cash
Holding part of one’s wealth in cash has several advantages. In nominal terms at least, it is safe. With the Financial Services Compensation Scheme (FSCS) providing protection of up to £85,000 for accounts held with any one banking group, any funds that are deposited with a bank are likely to be returned in full, with interest. Cash is also liquid, meaning that it can be easily accessed if needed without having a significant impact on its value. It is clearly prudent to hold a certain level of cash to meet day-to-day spending needs plus some ‘rainy day funds’ that can be drawn on in the event of job loss or an unexpected bill.
However, cash does not make for a good investment over the long term. It has a poor track-record of beating inflation, meaning that its real value tends to fall over time. Even though interest rates have risen sharply over the last year, they have not kept up with the rise in the consumer price index (CPI), which during the year to September was up 6.7%3. As a result, the purchasing power of cash in the bank has been eroded. Indeed, if 10 years ago you had put £100 in a savings account that tracked the Bank of England’s Bank Rate, it would be worth around £109 now, an increase of 9%. However, the price level, as measured by the CPI, has risen by around 33% over that period, with the result that in ‘real’ terms, your purchasing power would have fallen by around 24%4.
Looking forward, the Bank of England’s latest forecasts anticipate inflation falling to just above 3% by the end of 20245. This suggests that, assuming the Bank’s forecast is correct (admittedly a big assumption), the near 6% rate currently available on some 1-year fixed rate deposit accounts is likely to deliver a real return of just under 3%. Not bad. However, as inflation falls back, there is a good chance that interest rates will also come down.
Reinvestment risk
And this brings us on to another problem with cash: reinvestment risk. While it is currently possible to get 5-6% on cash in the bank, these rates will change over time as the Bank of England adjusts interest rates and as market expectations for future rates vary. With inflation in the UK now falling back, there is a growing expectation that the Bank of England’s policy interest rate is at or near its peak. Bank of England Governor Andrew Bailey has said that monetary policy needs to remain restrictive for an extended period, and that it is too early to be thinking about rate cuts. However, the Bank’s Chief Economist, Huw Pill has suggested that it was reasonable for markets to expect rate cuts from the middle of 20246. As it stands, the market expects Bank Rate to fall to around 4.5% by the end of next year7. If this trajectory comes to pass, the prevailing 5% cash deposit rate is likely to be closer to 4% in a year’s time, and 1-year rates could potentially be even lower.
This is because there is a good chance that pressure on the Bank of England to cut interest rates will grow. With GDP stagnating during the third quarter8, the economy is struggling to cope with real (i.e. after inflation) short-term interest rates at current levels, and recession risks are elevated. Moreover, with a general election expected in 2024, political pressure for a reduction in interest rates is likely to mount. Interest rates seem unlikely to return to the near-zero levels witnessed during the 2010s, but considering that estimates put the neutral interest rate (i.e., the rate that is neither stimulative or restrictive) in the range of 2-3%9, they could still come down quite a bit from current levels, especially if the economy falls into a recession.
Locking in yields with bonds
Investing in bonds can potentially overcome some of the problems posed by cash. As regards reinvestment risk, when you buy a bond directly and keep hold of it until it matures, you lock in the yield prevailing when you bought it (assuming the entity that issued the bond does not default, which would be unlikely if buying an investment grade instrument). If you buy a 10-year UK government bond, or Gilt, with a gross redemption yield of 4.3% (as is the case currently10), this is the equivalent annual return you will achieve if you hold the bond to maturity. For investors prepared to take on a little more credit risk, investment grade corporate bonds of a similar maturity are currently yielding around 6%11.
In the period between buying a bond and it maturing, its price will probably move up and down (the price of a bond moves inversely with its yield) as interest rates and interest rate expectations change. However, if held to maturity, the yield you buy the bond at is the yield you will get. As a result, buying a bond reduces reinvestment risk in the event that interest rates fall, and also provides a greater degree of certainty regarding long-term returns compared to cash.
Some types of bonds can also provide protection against inflation. So called index-linked or inflation-protected bonds adjust both the value of coupons and principal by an inflation index. In the UK, index-linked gilts (ILGs or linkers) have their coupons and principal adjusted by the retail price index (RPI) to take account of accrued inflation since the bond’s issue date. Like a conventional bond, the price/yield of an inflation linked bond still moves up and down with changes in interest rates and interest rate expectations. Indeed, index-linked Gilts have suffered large mark-to-market losses in recent years as interest rates and bond yields have risen from historically low levels12.
However, the sell-off in the linkers market has now left them looking more attractive, with real, or inflation-adjusted yields now close to 14-year highs. Having been negative for most of the last decade, and therefore pretty much uninvestable, the real yield on the 10-year index-linked Gilt now trades around 0.7%, meaning that if held to maturity it will produce a return of 0.7% above the rise in the RPI. This clearly is not a fantastic real rate of return. However, given the considerable uncertainty over the inflation outlook and the risk that we could be entering a period of structurally higher inflation (see our commentary of February 2023), it is not a bad proposition from an investment that carries little to no credit risk, and it will probably beat returns from cash.
Greater upside potential from equities
Equities provide no guaranteed returns and are likely to experience bouts of volatility, but over the long term they stand a better chance of providing inflation-beating returns with greater upside potential. UK equities have been far from the best performing stock market over the last decade, and have been trounced by the tech-heavy US market. However, even UK equities have provided a total return (i.e., with dividends reinvested) of around 63% over the last 10 years, comfortably beating the 33% rise in the CPI13.
Indeed, the 2023 Barclays Equity Gilt Study shows that there is a 91% probability of returns from UK equities beating cash over any 10-year period during the past 123 years14. Given the ups and downs of the stock market, equities are generally only suitable for investors who are prepared to remain invested for a minimum of 5 years. Moreover, it is worth remembering that these periods of outperformance mostly occurred when the Bank of England’s policy rate was above today’s levels (the period of near-zero interest rates during the years following the great financial crisis being a somewhat exceptional period historically).
A better long-term bet
The attractiveness of holding cash versus stocks and bonds hinges crucially on a number of factors, including the risk appetite, appropriate capacity for loss and the investment horizon of the individual investor. Unlike cash, the value of bonds and stocks will move up and down with market conditions, and at times could see violent swings. However, if history is any guide, they are likely to provide better long-term returns than cash. Government bonds have suffered sharp mark-to-market losses in recent years as yields have risen. However, the higher starting yields currently available and the general expectation that policy interest rates in the developed world are close to peaking provide something of a buffer against further losses.
Moreover, with yields now back to more normal levels, government bonds are now more appealing from a portfolio diversification perspective, with prices likely to rise during risk-off periods when equity prices could be volatile. For example, if investors become concerned about the prospect of recession, yields on government bonds, both conventional and index-linked, are likely to fall, as a result of safe-haven buying and reduced interest rate expectations. Consequently, unlike cash, the prices of government bonds are likely to rise, providing some offset to weaker equity valuations, which could fall as profits forecasts are revised down.
The optimal allocation to bonds and equities will depend on an individual’s attitude to risk, and it is always a good idea to consult a financial adviser before making investment decisions. We should also be aware that past performance of financial assets cannot predict the future. However, from a general economic perspective, for long-term investors it still makes sense to hold a diversified portfolio of stocks and bonds, even when cash in the bank earns 5%.
29 November 2023
1 https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate
2 https://www.moneysavingexpert.com/savings/savings-accounts-best-interest/
3 https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/september2023
4 FE Analytics
5 https://www.bankofengland.co.uk/monetary-policy-report/2023/november-2023
6 https://www.ft.com/content/e5070880-f665-47b1-b8ad-dc3fbc3f5978
7 https://www.bankofengland.co.uk/statistics/yield-curves
8 https://www.ons.gov.uk/economy/grossdomesticproductgdp/bulletins/gdpfirstquarterlyestimateuk/julytoseptember2023
9 https://www.federalreserve.gov/econres/notes/feds-notes/longer-run-neutral-rates-in-major-advanced-economies-20221201.html
10 https://tradingeconomics.com/united-kingdom/government-bond-yield
11 https://www.spglobal.com/spdji/en/indices/fixed-income/sp-uk-investment-grade-corporate-bond-index/#overview
12 https://www.ftadviser.com/investments/2022/11/10/why-have-returns-from-inflation-linked-bonds-been-so-abysmal/?page=1
13 FE Analytics
14 https://www.schroders.com/en/global/individual/insights/uk-shares-the-70-shot-at-beating-cash/