Let’s keep it real. Why invest in markets when cash rates are so high?

The days of receiving virtually nothing for the privilege of keeping your money at your local bank are apparently over. In August, the Bank of England’s base rate rose to 5.25% – its highest level since April 2008. That’s up from 0.01% in December 2021. 

With cash savings rates so high, why remain invested?

In this article, we explore why investors with medium-to-long term horizons and limited liquidity needs may want to look past present volatility and remain invested in non-cash assets.  

Doing nothing will cost you   

Whether metaphorical or not, keeping your cash “under the mattress” will see the value of your savings fall in real terms due to inflation. This concept is nothing new, but never in modern times has it been as much of an issue as it is today.

UK inflation rose to 7.9% in the 12 months to June. That’s the sixth highest print since the 30-year high peak of 11.1% reached in October 2022. In practice, this means that what £10,000 would have bought you a year ago will require £10,790 today. In other words, that’s a loss in purchasing power of £790.

Another way to look at it is that, at today’s inflation rate, it would take around eight years for your cash savings to halve (assuming no returns on cash). This compares to 34 years with inflation at 2%, which is the average rate that prevailed for most of the last three decades.  

Money illusion?

Investors should be wary of falling prey to what the American economist Irving Fisher called “the money illusion”. The theory states that the average person tends to view their wealth and income in nominal terms instead of real terms, which is ultimately what we should really care about.

Purchasing power can change if the price of goods increases/decreases, or if inflation increases/decreases. A higher real income means a higher purchasing power since real income refers to the income adjusted for inflation.

Nominal interest rates in the UK are very attractive but, as shown in the graph below, the differential between nominal interest rates and the rate of inflation in the UK (i.e. the real return on cash) has plummeted to its lowest level in years. 

Time in the market and not timing the market

During periods of pronounced downward volatility it becomes very tempting to exit the market in an attempt to 'reduce risk'. This can often be the worst time to do so, for several reasons.

One being that future returns are often more attractive once markets have fallen. A second reason is that this decision relies on re-entering the market at the right time. And we know that the average investor typically waits too long to do so.

Figure 3 shows the historical performance of a £10,000 investment in global equities, starting in 1999. There are two lines. One shows the performance of an investor who remained invested over the full timespan. The other shows the performance of an investor who missed the 10 best days of performance. In this scenario, the return is nearly 50% lower. This demonstrates the importance of time and patience when it comes to investing.

The best days for markets tend to follow the worst. As such, even if you think you can avoid the worst, you are probably likely to avoid the best too.

Another example is an investor in the S&P 500 who shifted to cash after the first 25% decline during the Global Financial Crisis. They would find their portfolio still underwater today. This compares with breaking even in mid-2013, 4.8 years later, if they had remained invested in the stock market.

Let’s keep it real

One of the positives that comes out of severe asset price corrections (like the one investors experienced in 2022) is the prospect of higher future returns as valuations normalise over time.

Our colleagues at Invesco Solutions produce Capital Market Assumptions (CMAs) for over 170 asset classes. These are risk and return estimates, focusing on a 10-year investment horizon. Currently, their estimates suggest that cash will deliver very little ‘real’ return over that time period – i.e. limited return after inflation. Other assets, on the other hand, are likely to perform better in real terms, as Figure 4 shows.

Equities are a good example. At first investors will discount equity valuations at a higher interest rate due to rising inflation. This is to compensate for the fact they are worth less in today’s money.

In time, equities can often act as a buffer against inflationary pressure. How? Well, inflation leads to increased nominal revenues for those companies that can maintain their pricing power, and ultimately increased earnings for those who can also manage their input costs. Earnings in particular are a powerful driver of share prices over time.

Staying on course

So, for those with limited liquidity needs, it may be more prudent to stay invested in assets that are more likely to deliver a positive real return (and therefore grow the real value of your money) over the coming years.

Our analysis suggests that a portfolio of diversified assets such as equities, high yield credit and emerging market debt is well placed to do just that.

This is why within our Summit Growth and Summit Responsible multi asset fund ranges we look beyond short-term volatility to find the best risk-adjusted opportunities in markets with exposure to asset classes that can protect against inflation over the long-term.