11 April 2019
Cash is not king
The opportunity costs of fear.
By Frank O’Nomics
Sometimes it feels as if the world is on its way to “hell in a handcart”. A slowdown in global economic growth (the IMF downgraded forecasts for the UK and the world this week), ongoing trade wars and Brexit are leaving both retail and institutional investors in a very cautious position, holding near record levels of cash. This caution extends into the UK corporate sector, where private companies (excluding financial institutions) have salted away £173bn since the Brexit vote, to leave them with a record cash mountain. This corporate money may be awaiting a Brexit settlement but, as with stock market investors, there is a dangerously large opportunity cost involved in sitting on cash and defensive investments such as bonds.
So just how extreme is the situation? Looking at retail investors the seasonal flows into the tax year-end paint a very cautious picture. The amount of cash held in stocks and shares Isas at Hargeaves Lansdown has doubled in the year to date, and Bestinvest say that cash holdings are up 25% year on year. When self-invested personal pensions are included the total amount of cash held rises still further. This process has been going on for some months and has seen especially large sums leaving UK funds (£11.5bn since the Brexit vote). While some has gone into international funds and bonds, much is parked awaiting reinvestment, while a large proportion of bond holdings are almost indistinguishable from cash given very low yields. This phenomenon is not restricted to individuals, or the UK, as illustrated by the State Street Global Investors Confidence Index, which is at its most risk averse since 2012. The Bank of America global fund manager survey shows that institutional investors have a 40% overweight allocation to cash, an allocation which is 1.5 standard deviations above its long-term average.
One might argue that there is much to be said for adopting a cautious stance when there is a high level of uncertainty. If this helps you sleep at night then it is hard to argue against the policy. However, it is very important to be aware of the risks. First, the bears have already missed out on a very big market move. The FTSE mid-cap index is up 12% year-to-date, with the MSCI Europe ex-UK index up 10%. Those who parked their money in cash on the Brexit vote in 2016 have missed a total return of 29% in the FTSE All Share Index, in exchange for peace of mind and an infinitesimal return from a bank account. Those in bond markets may have done better, but given that the interest yields are now significantly below inflation (and actually negative in nominal terms for much of Europe), the prospective opportunity costs have increased markedly.
Surely there is a case for at least some caution? Well, based on historical data, unless you really believe that you have considerable expertise in market timing, waiting for better opportunities, over the longer term, is a mug’s game. If you had invested £1,000 in the FTSE 250 30 years ago, you would now be sitting on around £24,000, an annualised return of 11.3%. If, however, your attempts at market timing meant that you missed out on the best 10 days over those 30 years the sum falls to £14,000, and if you missed the best 30 days it would only be £7,000. £17,000 foregone on a £1,000 investment, just for trying to be clever. Much of the problem, as ever, stems from compounding effects. Over the last 25 years an investment in the MSCI global index would have returned almost twice as much if the dividends were reinvested as if not. Not only has it not paid to sit on cash, it has not paid to wait to reinvest dividends.
Just looking at the situation year-to-date highlights a significant cost of caution already. If (here’s hoping) a Brexit solution and a US-China trade deal were to be announced it would not be unreasonable to expect a significant market rally. How much of the cash mountain will be agile enough to get invested before a significant proportion of the returns have been missed? the chances of one of those key market movement days have to be quite high. Investors have been caught out already by the disconnect between sentiment and market pricing. The market has acknowledged that global central banks have already shifted their stance away from tightening and the possibility of some renewed help – particularly in Europe where growth is slowing at an alarming pace – which would be very supportive of equities, while investors are still sidelined by growth and geopolitical worries.
What of that pile of corporate cash – surely that must wait for a Brexit solution? Here it is important to understand how much money is currently idling. Private companies excluding financial corporations are now sitting on £747bn of cash – a historic high of 35.3% of GDP. This may get many analysts excited about a ‘Brexit deal dividend’, but, for corporates looking for a 10%+ return on equity, having a sub-1% return while they wait for greater certainty represents a sizable opportunity cost.
It is not unreasonable to argue that the current lack of personal, institutional and corporate investment is the fault of the politician’s inability to negotiate trade deals or Brexit. The uncertainty created is certainly hampering growth, forecasts for which have been revised down yet again. However, for all investing sectors history would suggest that action taken prior to any resolution to these great issues increases the risk of missing out. We may be close to the end of 10 years of progress for equities, but history tells us that the last year of a bull market generates 20% of the total gain.