For the first time in fifteen years, savers have received noticeably positive interest rates on cash. Over the previous twelve months I have noticed a series of reasonable suggestions, such as deploying cash into “money market funds”* or holding particular UK government bonds. The latter is, or perhaps was, indisputably a good idea for tax-paying UK clients given the very attractive after-tax returns for a low-risk asset.
I would like to highlight the often-overlooked danger of this strategy. That is one of “reinvestment risk”. Whilst the practice of investing in short-dated bonds at peak rates is remunerative over the near term, once the bond matures one must decide what to reinvest the cash into. If rates have remained at a similar level, then one can recycle into a similar instrument at similar rates. If rates are higher, then there is a greater prospective return from the same low-risk investment strategy. If, however, rates are significantly lower then one must reinvest at a lower rate of interest, thus lower future returns. Current market expectations are for several rate cuts during 2024. Guidance from central bankers is similar, albeit there is disagreement over the commencement of the rate cutting.
As investors experienced through the last quarter of 2023, if rates are predicted to fall and remain lower for longer, then almost all other asset classes are optimal to cash. Of course, if the markets and central bankers are wrong (that wouldn’t be a first) and rates rise from current levels then, as we recall of 2022, most asset classes will fall in value. With cash providing a short-term alternative to riskier assets such as equities, investors have significantly increased their allocations to money-market funds.
Therefore, with returns on cash at potentially their highest level for a generation and money market funds awash with investors shielding from uncertainty, what should clients do? Investors who are overly allocated to cash will be tempted and/or forced to chase markets higher when interest rates, as expected, fall. This, simplistically, explains the sharp market rally before Christmas.
It does, however, illustrate that market timing is difficult, and almost impossible on a consistent basis. Relying on tactical timing indefinitely is usually detrimental in both nominal and real terms. There are many graphs that demonstrate the effects on long-term wealth if an investor were to have missed the top ten and twenty days of equity returns.
Whilst a small allocation to cash adds liquidity and optionality within a carefully diversified portfolio, an over-allocation presents risks. As experienced long-term investors, we are paid to make these decisions and take related stresses away from clients by structuring well-researched balanced portfolios. If you are an existing Harris Allday client, please speak to your Investment Manager.
If you would like to discuss a gentle and thoughtful method of deploying cash into these markets, our author Anthony Snowden is available at [email protected].
The value of your investment can fall as well as rise in value, and the income derived from it may fluctuate. You might get back less than you invest.
* A money market fund (MMF) is a type of mutual fund that invests in cash, cash equivalents and short-term debt securities. Think of MMFs as a cash management investment solution intendent to offer portfolio diversification, liquidity and operations ease (Source: BlackRock).