Jul
01

Cash is not King!
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We are in a period of weak economic growth which one would expect will generate weak but positive returns in the capital markets. On the other hand, there are many serious risks facing the world over the next few years that could derail growth and possibly cause a new bear market if not an outright financial crisis. Under these circumstances, weak upside returns with the chance of a serious bear market, it makes sense to me to focus more attention on controlling portfolio risk and preserving capital.

The financial crisis has receded from our memories but it has left a legacy of weakness in economic growth in the developed world and fragilities that have the potential to develop into crises of their own. These fragilities include the European Monetary Union's problems with the so called PIGS (Portugal, Italy Greece and Spain) , our still slowly recovering banking system with its vulnerability to derivative contracts, and potential overheating in the emerging market economies. In some respects, these appear to be independent issues but there are many linkages which could cause a negative event in one to trigger one or more of the others. I do not believe any of these events are inevitable - yet I think it makes sense to have a plan in place prior to any occurrence.

You might think why not just go to cash equivalents or short term bonds, the classical answer in times of stress. Unfortunately cash is a lot less attractive now than it was in 2008 - even though the yield continues to be around 0.1%. In 2008 we were in a deflationary environment of around 1% per annum so the paltry yield was reasonable. Today we have the same paltry yield but it is accompanied by an inflation rate around 3%. This leaves the investor in cash equivalents with a guaranteed loss of 2.9% per annum. This is known in economics as a negative real yield. In economics, much of the terminology is a bit obtuse but the term "real" is a great descriptor of exactly what you get. Real yield is the return after inflation. Generally investors expect to receive a rate of interest that exceeds the rate of inflation by an amount that compensates for the credit and interest rate risk that they bear.

Negative real yields are abnormal but they have advantages for deeply indebted governments in that it allows them to use inflation to reduce the debt load at the expense of investors. Inflation reduces the purchasing power of money, so when the government repays their debt the cash given to investors purchases fewer goods and services.

If that was not enough the situation is worse in taxable accounts since the income tax system operates at the nominal rather than the real level. That is to say one has to pay income tax on the 0.1% of interest earned despite the fact that they have a loss in real terms. Unfortunately, I expect negative real yields to persist for a long time eliminating cash equivalents and short term bonds as an attractive risk control strategy. In my next post I will be discussing alternatives to using cash equivalents for risk control.

Written by Life After 65.