Market Update 5th August

Cash vs Investing

Since the 2007/08 global financial crisis, we have seen low interest rates consistently for over a decade. This has meant little to no return on cash, resulting in a lower allocation within portfolios.

For the first time in a long time, higher interest rates have made it appealing for investors to move money into cash or money market type investments. They have had and still have attractive yields without as much risk, and daily liquidity, so you can see why it made sense. Now however, with rate cuts beginning, is cash really the right place to be for capital growth or to sustain income?

Interest rates seemingly have peaked, with the European Central Bank already cutting rates in June by 0.25%, and markets are pricing in a 90% probability of a further cut in the September meeting. The Bank of England cut rates just last week by 0.25% as well, moving interest rates to 5%, but it was a close call at 5-4 votes for the cut. The Fed last week didn’t cut rates at their latest meeting but are potentially looking at cutting this year. A 0.25% cut by the Fed in September is priced into the Fed-funds futures, so that is expected currently.

Given events over the last few days, perhaps they are wishing they had. There are growing signs of a slowdown in the US, with the unemployment rate rising and weakness in non-farm payrolls. Markets globally have reacted very badly to this news and are falling as I write.

Rate cuts will mean yields on cash and money market instruments will lower quite quickly. Current yields on our money market funds for example are around 3-5%. By next year the cash rate yield is predicted to be around 3%, whereas most other asset classes currently offer higher than that today.

Let’s start with fixed income, high yield debt is currently trading at historically tight spreads over government debt, meaning you are not getting paid much for the extra risk you are taking. Investment grade debt is also historically tight, but relatively more attractive than high yield. Emerging market sovereign debt has also been relatively attractive vs developed market high yield debt.

The reason spreads have been tight is because defaults have stayed low despite the aggressive rate tightening cycle. Companies went into it in good financial shape, and have mostly been able to cope well. This is also one reason the equity market has continued to push upwards.

Dividend yields are more likely to increase. Dividend payout ratios are currently relatively low across developed markets. Increasing dividend yields will make risk assets more attractive for investors as money market yields begin to fall. But also, a lower interest rate environment should benefit all equities through a lower cost of capital. Sectors like utilities are an example and could become more attractive in this environment.

Global equities (MSCI ACWI) and the US market are an exception, which have had low yields. Share buybacks are more common in the US. Around 65% of the MSCI ACWI is in the US and mostly in large cap, which as you may know has been dominated by tech, so low yield but historically has had high capital appreciation. In fact, the top 6 constituents of the MSCI ACWI are mag-7 stocks, and only one stock in the top 10 is not in the US. This year Meta launched its first dividend of $0.50 (39p) – giving it a yield of 0.4%. I’m not saying this will attract income investors, but maybe we will start to see particularly large cap US stocks launching or increasing dividends in the future.

The large rotation out of equities and bonds and into cash a few years ago was right at the time but now with the future holding a relatively lower interest rate environment we may start to see that rotation reverse. Income from other asset classes vs cash may become a bigger part of portfolio total return in the future. This is welcome as a mix of growth and income should help portfolios rather than just relying on purely capital appreciation or purely dividends for total return.

Emily Cave – Research Analyst

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