Can rising interest rates save our cash?

Over the past six months, our conversations with clients on the topic of cash have significantly shifted. Many clients had the opportunity over 2020 and 2021 to build their cash chests due to dramatic spending cuts, opportunistic fund raising on accommodative markets, and sympathetic government and regulatory policy. Some clients postponed cap-ex spending either by choice or due to prevailing restrictions during an unprecedented global pandemic, all of which added to their cash reserves. These chests offered comfort to boards, a safety-net during times of global uncertainty. The maintenance cost associated with these cash reserves was relatively small – a slightly negative interest rate that many were or are in a position to negotiate back to zero with their banking partners. The opportunity cost of holding a not-performing-yet not- not-performing-asset was sometimes raised but with the backdrop of a global pandemic where global growth was muted at best, it was not of major concern. An increasing rate environment improves the expected return outlook for this cash but inflation and maintaining purchasing power is fast becoming a much more dominant factor.

Interest Rates are back 

In the EU, we have grown accustomed to low to negative interest rates. When discussions began around the rise in rates in early 2022, expectations were low as many believed inflation would calm and central banks would be cautious and look to avoid doing any harm to euro economies. The below chart depicts expected interest rates for the following ten years as of 31st of December 2021 and the same ten year expectation as of August 31st 2022. These numbers have jumped significantly over the past 6 months – as inflation has refused to settle and central banks remain focused on muting inflation above all else.

Source: Bloomberg 23/09/2022

Inflation on the rise

Although there are numerous reasons why inflation is remarkably high at present (post-COVID-19 bounce and the Russian invasion of Ukraine being the two most significant ones), most expect inflation to remain elevated (compared to the last fouteen years) for the foreseeable future.

Investors are often more agitated by negative or low interest rates than by high inflation, but these are two sides of the same coin- it’s just that the interest rate is explicit.  Additionally, as inflation rates rise, its impact is significantly more costly. It is true that we do not explicitly know today what inflation will be over the coming months and years, but the picture is becoming clearer that inflation will outsize interest rates for some time to come (as would have historically been the case). For clients with cash today, earmarked for cap-ex over the coming years, inflation is becoming a key business risk.

What can investors do?

Although there is no simple alternative asset that is risk-free and produces a return above interest rates plus inflation, there are options that all investors could be considering.

At Davy, we utilize a framework which helps guide our clients to identify their financial goals and objectives and to understand the trade-offs that may need to be made to achieve them. We work with clients to forensically look at their financial commitments across all elements of their organization to determine the most efficient way to allocate your capital to achieve your goals.

Source: Davy

For cash or cash equivalents, we focus on the base of our capital pyramid and work with clients to critically appraise their cash-flow planning. We encourage the creation of sub-objectives for each of your underlying capital commitments focusing individually on each sub-sector, examining what are the greatest risks to each sub-sector and what appropriate expected returns might be.

The meaning of risk has lost its way as a useful investment planning input. Risk is individual, and we work with clients to drill it down to underlying objective. For some, it is volatility, maximum drawdowns or tracking errors. For others it’s not being able to meet capital commitments as they are called or meeting this year’s salary roll.

As an example, if we have a client with a significant capital project planned, the client is usually aware of their payment plan and what contingencies are necessary. We look at whether our client is exposed to building inflation – materials and labour, and if they are, whether it would be more efficient for some of the capital set aside to be invested to meet that inflation cost. The role of Davy as an Adviser, is to inform clients of the various risks they are mitigating or introducing with each of their investment options, and facilitate the client making an informed discussion.

For some clients, they chose to diversify the risk – holding cash and accepting the negative interest rate and the inflation risk for some projects and hedging the inflation risk for others. Working with the Davy advisory team allows clients a deeper insight into what their options are and how they can best position their capital to improve their chances of achieving their objectives.

Speak with your Davy Adviser today or request a call from one of our team.