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Cash crash T


2012 Q4(b)


November 0.4 August


0.3 here are many


uncertainties in today’s economic and investing environment, but it is certain that interest rates will remain at current levels at least for this year. I believe it is likely


that UK interest rates will remain low for the foreseeable future, and indeed the anecdotal evidence is that the rates being offered by many major UK banks are beginning to fall, heaping more pressure on investors who rely on their bank savings. If the current low rates do persist, they also pose big dangers for fiduciaries that are entrusted with managing the wealth of others. It is likely that not only will the return on such assets be negligible, but there will also be a loss of the real value of such funds, as inflation will remain relatively high. Consequently, the maintenance of a (conservative) cash- only or cash-heavy investment strategy could lead to problems in later years for trustees and fiduciaries. Advisors should be actively looking for ways to improve the returns from cash or, alternatively, look to invest that cash to at least maintain its purchasing power.


The interest rate outlook Current consensus is that the UK base rate will remain at or close to its current level throughout this year and the next, and that any increase thereafter will be moderate and gradual. The table below is from the Bank of England’s November 2012 Quarterly Inflation Report.


DERMOTHAMILL WARNS THAT OVER-RELIANCE ON CASH NOW IS STORING UP TROUBLE FOR THE FUTURE


The conclusion that must be drawn from the term structure of UK money market rates is that UK cash rates are likely to remain very low in absolute terms and negative in real terms for another three years, at least. With the UK economy enduring a technical second recession and 2013 GDP growth anticipated to be no more than 1 per cent, expectations for the timing of any potential increase in UK base rates are being pushed further into the future.


How long can rates remain so low? There is a striking similarity between the interest rate environment since 2007 and that following theWall Street crash of 1929 (see graph, opposite). In both cases interest rates quickly fell


below 1 per cent. They have fallen from 5.5 per cent at the beginning of the financial crisis in 2007 to virtually zero currently in theUS. In 1932 rateswent below 1 per cent but didn’t rise above 1 per cent again until 1948. Indeed,over this period inflation remained relatively high and cash investors would have lost over 38 per cent of the nominal value of their capital if they remained in cash. Many believe an increasing reliance on


unconventional monetary policy and a lack of a clear path to sustainable fiscal policy raises the long-term risk, particularly of rising inflation. The current expectation is for Consumer Prices Index inflation to remain at 2 per cent until 2015, although Retail Prices Index (RPI) will be higher. One thing is certain: the more cash portfolios hold, the greater the loss


Conditioning path for bank rate implied by forward market interest rates(a) Per cent


2013


Q1 Q2 Q3 Q4 0.4 0.3 0.3 0.3


0.3 0.2 0.2 0.2 2014


Q1 Q2 Q3 Q4 0.3 0.4 0.4 0.5


0.2 0.2 0.3 0.3 2015


Q1 Q2 Q3 Q4 0.5 0.6 0.7 0.8


0.4 0.5 0.6


(a) The data points consist of 15-working-day averages of one-day forward rates to 9 November 2012 and 1 August 2012 respectively. The curves are based on overnight index swap rates. (b) The November figure for the fourth quarter of 2012 is an average of realised spot rates up to 9 November, and forward rates thereafter.


SOURCE: BANK OF ENGLAND INFLATION REPORT NOVEMBER 2012


will be in real terms for investors. It is my view, therefore, that investors should begin to tilt their portfolios towards real assets such as index- linked gilts, commodities, property, infrastructure and higher-yielding (but lowly leveraged) equities. This will entail accepting higher short-term investment risk, but over the long term will offer greater investment protection. So where should investors focus


their attention? Gilts


The Bank of England has been active in its pursuit of non-conventional monetary policy, undertaking two additional programmes of quantitative easing since last October despite UK inflation having stayed stubbornly above its 2 per cent target rate sinceNovember2009. Gilt yields have consequently reached unprecedented lows. I expect that the current policy of ‘yield repression’ (the deliberate forcing of yields lower than would otherwise be the case) will be with us for some time yet. Once this policy ceases, however, there


is potential for a strong upward move in yields. Gilts are expensive (2 per cent for ten years and 3 per cent for 30 years), but quantitative easing is likely to remain supportive for some time. Eventually, yields are likely to rise and return closer to long-term averages. The current ten-year UK gilt is yielding 2.09per cent,having hit a low of 1.43per cent inAugust2012. While gilts undoubtedly offer solid risk management and diversification benefits in a multi-asset portfolio, there is better value in the corporate bond market. Yields in the corporate bond market currently varyfrom2.9 per cent forAAA paper to 4.4per centonBBBissuers. In turn, these reflect higher yields of 0.8 per cent and 3.18 per cent over the comparable UK gilts. The spreads relative to gilts have also narrowed in considerably over the past 12 months, reflecting the continued demand for such instruments from yield-hungry investors and the general improvement in global sentiment. In fact, the lower down the credit spectrum one


78 APRIL 2013 WWW.STEPJOURNAL.ORG


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