Our Perspective on 2023's Investment Returns
In our fifth Collingbourne annual investment review we look at the return of meaningful interest rates on cash deposits and the questions this poses for wider investing. In previous reviews we’ve covered:
2018: returns reality versus expectations
2019: ‘randomness’ of asset class returns
2020: investor behaviour in volatile markets
2022: inflation and how to protect assets
Most people are familiar with the recent story of interest rates; after over a decade of ultra-low rates following the 2007-08 financial crisis, the Bank of England’s base rate has surged from just 0.1% in late 2021 to 5.25% by August 2023, with 14 consecutive increases. A story broadly repeated across most western economies.
Data: Bank of England Database
Following this leap in base rates the returns on cash deposits soared in 2023, exceeded 1.5% for the first time since 2008. Following a strong last couple of months for many assets classes, 2023 turned out to be an almost universally positive year for investors, following 2022’s market falls:
Like cash, bonds also delivered their best return in years following rises in yields. The strong end to the year for risk-based assets was largely driven by an expectation that we are now at the peak for interest rates, with markets expecting rates to gradually come down from the middle of this year.
Cash is King
This is certainly the position UK investors took last year. Data from Calastone’s Fund Flow Index (1) shows where UK retail investors put their money in 2023.
UK investors typically invest about £5bn net each into bond and equity funds each year. In 2023 however around £1.25bn net was withdrawn from equity funds. I am sure you can guess where this money went.
A record £4.4bn net investment was made in money market (i.e. cash) funds. This was far more than in the previous 8 years combined (bond fund flows were about average). Even this record figure will be small fry compared to the amount placed into traditional cash savings accounts last year.
Why invest when cash is paying 4-5%?
A question we’ve been asked a few times over the past year and I suspect one pondered by many more. Savers and borrowers alike grew accustomed to the ultra-low interest rates we saw for 13 years, causing something of a shock as rates returned to broadly their long-term average. For savers you can see why current interest rates look attractive.
So why invest? The main reason is the cause of the surge in interest rates itself, inflation. Keep in mind that despite the rate rises over the past two years, most savers will still be out of pocket in REAL terms i.e. how much those saving can actually buy. A key question is, what should you expect cash to return after inflation moving forwards?
Well, if we look at interest rate and inflation data going back almost 70 years, we see an interesting picture. Depending on what measures you use for each, the figures show that cash tends to deliver around 0% - 1% p.a. above inflation BEFORE tax. This result also repeats in US data back to 1926 (about 0.5% p.a. above there). Based on history, it’s unlikely that savers will get a return above inflation after tax over the long-term.
This will of course be acceptable to some, whose financial circumstances don’t require any more return.
Moving forwards if inflation subsides to the low rates we saw for the decade before 2021, then interest rates will likely fall. If inflation remains high, then the real (after inflation) return on cash will likely remain low.
To gain an expected return above inflation over the long term (after costs and taxes) you need to invest in real assets such as equities and property, whose expected value – derived from dividend and rental income streams – tend to rise with inflation over the long-term.
Comparing Apples with Apples
Another issue leading people to question investing is comparing the 4-5% available on cash now with past returns on investments during an ultra-low inflation and interest rate environment – particularly for moderate risk portfolios, with significant bond holdings.
The returns on bonds are also linked to interest rates; the return investors demand for bonds is that on cash (risk-free rate), plus a premium for accepting risks. Both cash and bonds had lower returns when interest rates were low, both now have higher expected returns whilst rates remain higher.
This was discussed in a blog on bond returns in summer 2022.
Comparing 4-5% (nominal) cash rates now with previous returns on bonds and by extension a moderate/balanced risk portfolio, when rates were less than 1%, is not necessarily a helpful exercise. Such a portfolio has a higher (nominal) expected return in a higher inflation and interest rate environment than in a low inflation and ultra-low interest rate environment.
Market Timing is Dangerous
A possible attractive course of action for some will be, I will keep cash now whilst rates are high and invest if and when they fall. This however comes with its own perils.
Markets can move very quickly, with no announcement they’re about to do so. By the time you’ve decided to invest (having been in cash) you could miss out on a lot of returns. Similarly, markets can fall very quickly without warning; the worse case scenario being missing out on strong returns whilst in cash and then finally investing just before a market correction/crash.
We can see a small example of this last year; global equity markets were up by more than 10% in the last couple of months of 2023 alone (following modest returns over the first 10 months). As we would expect, Calastone’s figures show UK investors added £1.2bn net into equity funds in December, after markets had already risen noticeably.
(Our 2020 blog goes into the topic of timing and investor behaviour in more detail).
Conclusions
Most people we meet do not have financial plans and objectives (including helping family members) which will be fulfilled by long-term, below inflation (net) returns, which we can expect from cash (although some do).
If you need a real rate of return (after tax) to fulfil your plans and objectives then cash is not likely to make sense over the long term. And as described above, trying to make a timing call on holding cash in the short-term and then investing later can be a dangerous game.
The most sensible course of action for most individuals is to review their financial plans and arrive at the level of risk and return you need to fulfil your objectives and that you are comfortable with (this may involve trade-offs) and invest accordingly for the long term with discipline.
If you need any assistance with reviewing your plans, or wish to talk to us about any issues raised in this blog, please get in contact with us and we’ll be happy to help.
(1) https://www.calastone.com/category/fund-flow-index/
(2) As measured by the MSCI ACWI IMI (All Country World Index Investible Market Index)
Returns stated are Total Returns (including income reinvested) to 31/12/2023 of various indices representing individual asset classes. Indices are not available for direct investment and take no account of charges or tax. Data sourced from Dimensional Returns Programme.
Disclaimer:
This document should not be considered a recommendation to purchase or sell any particular investment. Care has been taken to ensure the accuracy of content, but no responsibility is accepted for any errors or omissions. We do not predict or guarantee the future performance of any individual security, investment, portfolio or asset class.
Featured Image Source: Unsplash
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