A year ago, in our paper ‘Optimising cash allocations in retirement portfolios’, we suggested that the RBA could take the cash rate to as low as 0% by the middle of this year. We had no idea that COVID-19 would be the trigger to get us there – but sometimes it’s nice to be right, even for the wrong reasons!
We also thought that even if cash rates weren’t cut further (from 0.75% at the time of writing), they would likely stay low for a long time. Our reasons for thinking the cash rate would remain lower for longer were that:
- structural trends in demographics, globalisation and technology were dampening growth and pushing inflation lower
- debt loads were high, and
- central banks were likely to continue to use their limited toolkits to pursue their narrowly framed (consumer) inflation targets for some time to come.
All of these reasons are still valid. We’ve also had the big cyclical shock of COVID-19, which has seen the RBA cut rates to 0.25% (effectively zero).
Could rates go negative?
Ideally the RBA’s cash rate would be lower still. Our modelling suggests that, based on the unemployment rate, inflation, and consumer and business sentiment, the cash rate should be about 3% lower than it currently is.
However, the RBA is unlikely to take rates negative, mainly because it thinks the side-effects could outweigh the benefits. Instead, the Bank is committing to buying enough bonds to keep the 3-year government bond yield at 0.25% – which is effectively a commitment that the cash rate will stay at least as low at 0.25% for three years. It may still take the cash rate slightly lower, to say 0.1%.
What does it mean for investors?
These yields obviously offer very little return for the cash investor. And indeed, the return on cash is negative after inflation, and potentially likely to become more so as the RBA holds the cash rate at its current level or lower for years.
With returns on cash so low, both now and for the foreseeable future, it’s increasingly important to consider alternatives to cash – and to do so sooner, rather than later. For retirees and other defensive investors whose primary objective is to preserve capital, every week or month invested in cash risks achieving precisely the opposite result, eroding the after-inflation value of their investment.
In our earlier paper we suggested that retirees should invest part of their existing cash allocation in defensively-oriented fixed income strategies – aimed at generating higher incomes while still largely preserving the key features of cash: certainty and liquidity. Given our even-lower-for-longer outlook for cash rates, we think the argument for substituting some fixed income for cash is even stronger now, and we make the same suggestion today.
Shouldn’t I stay in cash until fixed income yields are higher?
While it’s true that fixed income yields are materially lower than last year, anyone waiting on the sidelines for them to recover could be waiting a long time. Fixed income yields have fallen for similar reasons to cash returns – a falling cash rate and consequently lower government bond yields. As a result, they are unlikely to go much higher over the next few years, for the same reason that the cash rate won’t.
However, there is also good news. After the initial shock of the pandemic, credit spreads (the difference in yield between government bonds and other fixed income investments) have returned to around their historical averages, so that investors can once again earn a liquidity or credit risk premium, depending on the investments they select. As a result, the prospective return on a well-constructed, diversified fixed income portfolio is likely to be several times higher than cash over the next few years.
Wouldn’t I be better off in equities, where possible returns are higher?
The answer is yes, if an investor’s timeframe is long. But for the cash portion of a portfolio, where the timeframe is short and investors typically value certainty, the answer is no. The – stable returns and known cashflows from fixed income provide much greater certainty than variable dividends and the uncertain return of capital from equities. So, to keep the risk profile of your client’s cash bucket low, your client would be much better to be in fixed income than in equities.
What should investors do right now?
We believe retirees can meaningfully increase returns with little additional risk by allocating part of their cash portfolios to high quality fixed income strategies. To best achieve this aim, those strategies should be actively managed, liquid and diversified. Risk management is crucial to manage and control a portfolios aggregated exposure to a variety of risks. In particular, we seek to limit correlation to equity markets and to minimise volatility and manage downside risks.
In adopting an absolute return approach, the most critical element of the investment process is to identify which assets to own, how much to own and when to own them. Active management is important because it helps investors take advantage of the emerging opportunities in fixed income while avoiding possible risks (such as the heightened risk of default in some corporate bonds). This is then complemented by extensive research and expertise in the fixed income asset class. The targeted result is a well-diversified portfolio with exposures across global credit, rates and currency markets with the potential to deliver consistent returns, with high liquidity but with much lower risk than the equity market.
