Cash is king, we used to say in uncertain times. Well, it depends. With current average inflation rates of 4.2 per cent in the eurozone and 6.2 per cent in the US, idle money is worth considerably less every month. In 10 years our king will have shrunk to midget size.
Yet there are nevertheless valid arguments to be made in favour of keeping some savings in cash. When markets fall and stocks or bonds deteriorate in value, cash can be put to good use by investing at lower levels.
One can look at ready money also in terms of duration. Duration is the time it takes to recover one’s initial investment and hence its sensitivity to interest rate movements. Bonds return an investment at an expiry date, tempered by regular interest payments which move investment recovery slightly forward.
Long-dated bonds, with returns stretching many years ahead, will devalue much faster when interest rates rise, as they represent income streams which have become unsatisfying in comparison.
Shares, which represent future dividend income and cumulated earnings growth, both discounted at today’s interest rates, have by definition a long ‘growth stocks’ which earn little to no money at all.
An extreme example is Tesla, which has an enterprise value of almost 400 years of current earnings. When interest rates rise, as we all now seem to expect, long-duration investments will lose value more dramatically than short-term investments. Cash, with zero duration, can therefore be considered a portfolio hedge.
Considering the all-time highs on most major stock exchanges it seems prudent to take some money off the table. Investment sage Warren Buffett is doing just that, cutting stakes in AbbVie, Merck, MasterCard and Visa while buying not much else. His cash holdings have grown yet again.
As a retail investor, I am not clairvoyant enough to call the peak of the stock market and sell with conviction. And I am not prepared to hold large swathes of cash at a loss, no matter how reassuring.
My cash comes from repaid bonds, which to my chagrin are all retiring now, while interest rates are still low, and real interest rates – nominal rates minus inflation – are deep in negative territory.
I feel like having to decide to better be quartered or burned on the stake. Should I lose by holding cash, perhaps even paying negative interest rates in euro? Should I put money in an exuberant, overpriced stock market which may turn south at any moment? Or reinvest in bonds with heightened solvency risks and meagre yields which will drop in value once interest rates start to rise?
Investment-grade bonds, even those with longer, hence riskier durations, yield little in nominal terms and guarantee losses in real terms. Investment-grade euro bonds pay negative yields, which means I have to pay for holding them.
Junk bonds, or bonds just within the limits of investment-grade, are per se more risky, but yield slightly more, but not enough to compensate for both heightened risk and inflation.
Everything considered, a decision which way to invest boils down to one’s opinion on inflation and what monetary authorities will do about it. Are today’s exorbitant price rises here to stay, or will they dissipate over time?
And should the central banks therefore raise interest rates and stifle exuberant growth better today than tomorrow to rein in inflation before it becomes a permanent problem, or should they sit on their hands and better do too little rather than crushing a fragile, uncertain recovery?
Many of today’s extraordinary price hikes are a consequence of the lockdowns and the subsequent recovery- Andreas Weitzer
The investment implications are not straightforward. It is a matter of dosage and a matter of timing. Small steps by central banks – a cautious reversal of quantitative easing and incremental interest rate rises may take the wind out of the sails of nervous bond markets and have a calming influence, flattening the yield curve rather than steepening it. Done with inflation today means low inflation and low growth in the future.
With inflation scares abating, bonds will not become unhinged and stocks will not drop precipitously. But the stock market by then may have lost some of its cheerfulness. If central bank tightening is overdone, every asset class will suffer, unemployment will rise and sovereign and corporate borrowers will increasingly fail. This is the scenario when cash as a momentary insurance policy will be king.
If central banks get it wrong and inflation becomes indeed a chronical problem, my bond investments will be a total failure, as will be cash holdings. Interest rates will rise too late, no matter how fast.
Only very few of those stocks which carry today’s stock market indexes to ever new highs are inflation-proof. Strictly speaking, today’s share boom is carried by a shrinking group of cheerleaders.
More than a third of the constituents of the Standard & Poor’s 500 are in negative territory already. Index ETFs will shudder, growth stocks will crash and real estate will burn.
Since the beginning of the summer the discussion about inflation prospects became increasingly partisan, with the ‘team transitory’ in one corner and the ‘team permanent’ in the other, with the former arguing that today’s frightening inflation figures will go away over time, and the latter insisting that inflation is already here to stay.
While nobody can claim today that inflation is a mere catch-up with the 2020s lockdown slump, both positions have plausible arguments.
Many of today’s extraordinary price hikes are a consequence of the lockdowns and the subsequent recovery. Shipping is in disarray, containers are missing, workers are not where they are needed while many refuse or still cannot go back to work, and everyone, including consumers, is over-ordering in panic. There is hope that price pressures will dissipate.
Yet consumer demand for goods is much higher than before the pandemic, 120 per cent up on 2019. To talk about mere supply bottlenecks becomes a hard sell, and the expression ‘transitory’ sounds wide off the mark.
Even scarce microchips, which hamper the production of all things from fridges to cars to cell phones, are churned out at a much higher rate than before the pandemic.
As it seems, we do not only have a supply problem, but a demand problem too, which plays in the hands of team permanent: throttle demand and all those supply bottlenecks will disappear, together with damaging inflation which will make life miserable, brings workers on the barricades and Trump back to office.
Today’s dramatic inflation spike is uneven. Only goods are up. Services like restaurants and travel are still below 2019 levels. The wild card is the pandemic rearing its head whenever we declare victory. See Omicron.
My mother country Austria, overwhelmed with Sars-Cov-19 infections, had decreed a three-week lockdown, with all non-essential shops closed and people incarcerated in their homes. For a short while this will again depress demand for goods, and central bank action may seem inappropriate and may be delayed.
But demand for services will oscillate or shrink further, and goods purchases will yet again continue their virus-induced inflationary march. Team permanent will prove vindicated. Cash will suffer, and so will every other asset class. Only dividend-paying, value shares may fare better.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com