From a fiduciary perspective, the investment environment will remain one where trustees are heavily incentivised to diversify away from cash and reduce liquidity, particularly where income generation remains a priority. Justin Oliver of Cannacord explains how this can be done.
With the fi nancial community currently pre-occupied with establishing when – not if – interest rates will begin their inexorable rise back towards levels which might have been considered “normal” just a few years ago, some may feel that the pressure on fi duciaries to deploy any spare cash balances in a more productive manner will ease. We do not believe that this is the case. Indeed, we expect that this pressure will remain as keen as ever.
The rationale for this view lies with the fact that, ultimately, interest rates in the UK, US and Eurozone are likely to remain at low levels for years to come. Even an historically moderate level of five percent may be years away. On this basis alone, there will be many assets, other than cash, which offer a far more attractive income stream and risk/return profi le. This does not even require that a signifi cant level of additional risk is borne. Unless deflation takes hold interest rates will remain below inflation; even then the Eurozone experiment of negative interest rates might be a feasible policy response from UK and US authorities. Consequently it is difficult to envisage a scenario whereby the value of cash does not continue to erode in real terms for the foreseeable future.
In terms of the interest rate environment our view is firmly that interest rates on both sides of the Atlantic will peak at much lower levels than would have been considered normal even a few years ago, while the transition to higher rates will be gradual in the extreme. Indeed, Central Banks have told us this is exactly what will happen. Granted, a profound shift in the economic landscape could alter this benign outlook. However, excepting this scenario, Bank of England Governor, Mark Carney, has assured us that interest rate rises will be “gradual and limited” and that “even when spare capacity is used up, (the) bank rate will need to be materially lower than in the past in order to keep the economy operating at its potential, and infl ation at its target”. As recently as October, members of the UK’s Monetary Policy Committee expressed concerns that a “premature” rise could leave the economy vulnerable to shocks and on the basis of continued low levels of inflation.
In this vein, one of the other impediments to rate rises is the fact that economic output, while expanding, is not sufficiently robust to withstand much in the way of tightening and growth is certainly well below the pace which would normally be expected at this stage of the cycle. While US GDP recovered from its first quarter “winter swoon” the year on year real (after inflation) growth rate of 2.3 percent is well below the post-1945 and postrecession averages of 3.5 percent, and 4.5 percent respectively. Indeed, growth has been consistently below trend since the economic recovery began four years ago.
The US is not alone in this regard. The UK’s economic performance is nowhere near as robust as the headlines would suggest and it should not be forgotten that of the G7 major economies only Italy has taken longer to regain its pre-crisis size. Output per head is still four percent below its pre-crisis level.
A further reason that policymakers will be in no hurry to boost borrowing costs is the fact that they don’t need to – inflation remains extremely subdued. Since its short-term peak of 5.2 percent in September 2011, Consumer Price Inflation in the UK has moderated consistently and at its current level of 1.2 percent it is far from an issue for policymakers. With the UK inflation rate almost perfectly explained by the change in the sterling price of commodities and natural resource prices – particularly oil – continuing to decline, inflation appears well anchored. With economic activity far from rampant, an air of fragility being discernible in the employment market and unemployment not yet at unsustainably low levels, it remains difficult to foresee the employment backdrop yet sparking an inflation scare.
Finally, in addition to the arguments that policymakers neither want to, need to and shouldn’t raise interest rates aggressively we can add the fact that, certainly in the UK, households can’t bear a marked increase in borrowing costs. Mark Carney warned as such when citing an internal Bank of England analysis. This showed the proportion of “vulnerable” households, defined as those who spend more than 35 percent of their disposable income on monthly payments, would double to one in five mortgage borrowers if rates rose to 2.5 percent. In addition, almost half of borrowers would need to make economy drives if rates rose to this modest level. So too, the number of households which would struggle to pay their mortgage would double to 2.3 million by 2018 even with a series of gradual rate rises.
On this basis, where might fiduciaries look in order to more productively deploy cash balances which are likely to continue earning less than inflation in the months to come?
For those who remain extremely wary of the investment environment at the very least the slight yield increase, which might be delivered by placing money on a fixed term deposit, should be considered. At the time of writing overnight bank borrowing rates stand at just shy of 0.5 percent. A fixed deposit for 12 months could feasibly earn one percent; not a significant premium we admit, but so too we judge that the probability of interest rates being significantly higher in a year’s time are slim and receding.
Secondly, while the headline yield on high, investment grade bonds is low – the very reason that the States of Guernsey has recently approved the issue of a £250 million bond –it is possible to further boost potential returns without necessarily being required to accept a significant increase in risk. A word of caution is required however. Yields generally have fallen over the last few years and, in our opinion, investors are no longer being sufficiently compensated for taking risk in previously higher yielding areas of the bond market. In our experience, one of the most under-appreciated aspects of the current interest rate environment is the fact that it is not currently possible to earn a five percent yield in the fixed income universe without assuming a meaningful level of risk. Billions of dollars continue to pour into “frontier bond markets” offering yields, which, until recently, would have been viewed as unfathomably low. The Ivory Coast’s ten year, $750 million bond was more than six-times oversubscribed, attracting orders of $4.75 billion. This issue currently yields a modest 5.5 percent. While political stability has been restored to the country of late it should be remembered that it was only in 2011 that payments were suspended on a particular government issue.
Finally, there remain opportunities in “alternative” asset classes. Certain closed-ended infrastructure funds, for example, currently yield approximately five percent and have demonstrated low correlation to bonds and equities in recent times. While such characteristics may not persist indefinitely they may at least be considered as a viable alternative for part of any surplus cash balances.
Ultimately, with interest rates set to remain at historically low levels we believe that fiduciaries should not view the forthcoming turn in the interest rate cycle as a reason to defer continuing efforts to diversify cash balances.
Justin Oliver, Deputy chief investment offi cer Canaccord Genuity Wealth Management in Guernsey