As real interest rates fall and fall, at first via central bank interest rate cuts then via rising inflation meeting central bank’s refusing to hike, cash gets less and less attractive. From UBS:
Eurozone inflation jumped by the most in over a decade in January, rising from minus 0.3% in December to plus 0.9%. This appears to have been driven by one-off factors. A similar bounce in near-term US inflation is expected, although the Federal Reserve has indicated it will look through any rise it views as transitory. Meanwhile, inflation expectations have increased in the US, yields have risen, and the curve has steepened, in part driven by the prospect of further fiscal stimulus.
But while higher yields and inflation expectations suggest greater optimism over the economic recovery, central banks have made it clear that policy rates are on hold. That means real rates will stay negative, and any lasting increase in inflation will drive them down further. In a world of negative real returns on bank deposits, we recommend investors consider putting excess cash to work.
•Why is cash bad? At current interest rates, holding excess cash reduces your wealth as inflation erodes its real purchasing power. Take the example of an investor with a USD 5 million portfolio and an annual expense of USD 250,000 that is rising by 2% each year due to inflation. Keeping the portfolio in cash would halve its value in just 10 years. Any further uptick in inflation would increase the erosion of real purchasing power.
•How much cash do you need? Professional investors typically keep very low cash balances. The seven biggest pension fund nations globally, which had total assets over USD 42,771bn in 2019, have an average of just 4% cash exposure, while holding around 45% inequities. While private investors may need more than this, especially as they near or enter retirement, we believe many hold too much cash. Our Investor Watch Survey for the fourth quarter of 2020 showed the average client holding 25% of their wealth in cash and cash equivalents. We recommend investors hold only enough liquidity to meet cash flow needs in excess of spending for three to five years, and not all of this liquidity needs to be held in deposits
.•How should I invest instead? Having set aside enough liquidity for upcoming needs, we believe investors should focus on finding yield and growth opportunities. For yield, we see opportunities in USD-denominated emerging market sovereign debt, whose 4.7% yield is around 360 basis points above US Treasuries. Meanwhile, equities are the main driver of growth in most portfolios. The average annual return on the MSCI All Country World index since 1998 has been 8% (USD total return), meaning investors have doubled their money roughly every 10 years. So, while cash holdings are necessary, excessive cash creates a drag on returns. We believe investors should consider their liquidity in three main tiers: Tier 1 for everyday cash needs in the coming 6-12 months; Tier 2 is savings cash for known needs over the coming 2 years; and Tier 3 is investment cash to meet potential investment opportunities over the coming 2-5 years. The first two tiers in our view should be mostly held in cash deposits, and investors who can consider taking on more creditor counterparty risk have the potential to earn higher returns in Tier 3, for instance by investing in short-term corporate bonds. Beyond this, we recommend investors put their cash to work in the markets to ensure they meet their financial goals.
Cash is trash!