Interest rates: Insights and Implications

Spotlight: How much cash should I hold?

As the saying goes, “cash is king” but is this true for all the money you hold? In the UK, some people hold large amounts of cash savings at the expense of investing in assets such as stocks and bonds. According to findings from the Financial Conduct Authority's Financial Lives Survey, of the c10 million wealthier individuals in the UK with more than £10,000 in investable assets, almost 60% of them allocate most or all of their assets to cash. While cash savings are crucial for day-to-day expenses and emergencies, official guidance recommends maintaining three to six months' worth of living expenses in easily accessible savings accounts. Beyond this, investors may consider investing in assets, like stocks or bonds, to meet longer-term financial goals (i.e. five years away or more). Holding excessive amounts of cash exposes individuals to the effects of inflation, which reduces the spending power of money over time. There is also a risk of missing out on potential gains offered by the stock market by only holding cash.

Recent data from the Office for National Statistics (ONS) showed that the UK economy shrunk by 0.1% between June and September, and shrunk 0.3% between September and December last year. When the economy shrinks two quarters in a row, we call this a “technical recession”. The Bank of England (BoE) could take steps to alleviate some financial strain in the economy typically by reducing the policy rate to make borrowing cheaper for businesses and households thereby helping to stimulate the economy. However, inflation still remains above the BoE’s 2% target (and reducing the policy rate could keep it higher for longer) so they have decided to keep the policy rate unchanged at 5.25% while waiting for inflation to fall further. The BoE anticipates its first policy rate cut in the autumn, while markets optimistically speculate it could occur as early as June. This is significant for investors as historical data suggests a trend in market reactions following interest rate cuts. Looking back at UK stock market performance since 1975, it has been observed that on average, the stock market has outperformed inflation (called a “real return”) by 13.9% over the one-year period following an initial rate cut (source Quilter, BoE, ONS). Bonds have also reacted similarly – in the US, government treasuries have historically outperformed inflation by an average of 5% over a one-year period following the initial rate cut and corporate bonds surpassed inflation by c.6% over the same period (source Quilter).

Lower interest rates mean lower borrowing costs for businesses and households but it also means that low-risk assets like cash become less appealing due to declining savings rates. Thus the benefits of staying invested in the stock market become more pronounced. Quilter analysed 30 years of global stock market performance and discovered that if you had missed the top 10 performing days during that period (e.g. by mistiming a trade from cash into the stock market), your investment would only be worth around half as much compared to if you had remained invested (see chart below). The current global economic landscape is uncertain with various factors contributing to the future path of inflation and policy rate decisions for global central banks. While the BoE expects inflation to ease from c.4% to 2% in the coming months, it also foresees a potential uptick later in the year. When investing for the long-term, remaining invested in a globally diversified portfolio is a sensible way to navigate the market responses to inflation and interest rate moves.

The Noise

All eyes were on the US inflation data released on Wednesday. Inflation in the US this year has proved more persistent than other major developed economies such as the Eurozone and UK, the central banks for which are firmly situated in the ‘when’ category for cutting interest rates. This is counter to the position of the Federal Reserve which is still hovering around the ‘if’ category. The year-on-year figure came in at 3.4%, which was in line with forecasts, and 0.1% lower than the previous month. This lower-than-expected print was consistent with two other metrics which are used to measure US household demand, the US consumer credit growth and the Michigan consumer sentiment index, both of which were published lower than expected. Equity markets reacted positively to the news on Wednesday, as traders understood the falling inflation figure to be consistent with the Fed cutting rates in the near future, although some have urged caution with regard to the marginal decrease inflation against a backdrop of slowing retail demand and high valuations.
Attention now turns to Europe, for which the inflation data published on Friday for the Eurozone showed no change from the previous release of 2.4%, and the UK, where the latest year-on-year inflation data will be published next Wednesday. If the figure continues the downward trend of inflation in the UK, equity markets are likely to respond positively as traders make the same interest bets as their counterparts on the other side of the Atlantic.
After the first quarter of net negative outflows from US environmental, social, and governance (ESG) themed funds in Q4 of 2023, the space was dealt another blow last month with the largest net outflows ever recorded in one month, at $4.6 billion. Analysts at Bloomberg qualified this data with the caveat that rather than being a “mass exodus” from ESG themed investments, the outflows were concentrated to a few funds, which has coincided with a corresponding lack of inflows, impacting the net flow figure. The Europe ESG fund market, the largest in the world for this type of investment, was not subjected to the same pressures and saw net inflows of $10.9 billion.

The Nuance
With the Fed remaining resolutely ‘on the fence,’ the cooling household demand is a crucial element in the interest rate picture. Signals such as waning retail sales will give the market confidence that cuts are on the horizon whilst retaining confidence in US companies’ earnings potential, which would be in line with the soft-landing scenario that is currently playing out.

The old adage is that “when the United States sneezes, the world catches a cold,” but here it is the inverse. With the US equity market comprising more than 70% of the value of global developed markets, it is seen as a bellwether for global financial markets’ outlook and resulting performance. Given the positive stock market reaction to a very slight reduction in the rate of inflation, a rate cut would clearly have a more meaningful impact.

Foreign exchange rates are also heavily influenced by interest rates. A sticky rate of inflation, and resultant ‘higher for longer’ interest rate in the US will lead to a stronger dollar versus other currencies, which was especially evident in the first part of the year. Although a weak currency can benefit a country by stimulating exports, it can drive inflation higher, most notably in dollar-denominated imports such as oil. Earlier this month, the Fed Chair Jerome Powell affirmed that the next move is not likely to be a rate hike, but that is unlikely to entirely reassure global policymakers, such as those in Japan, whose currency is trading at 34-year lows against the US dollar.

The next Fed rate decision is 11-12 June.

Disclaimer

All investment views are presented for information only and are not a personal recommendation to buy or sell. Past performance is not a reliable indicator of future returns, investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.

Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice.