PERSPECTIVE3-5 min to read

With interest rates set to fall, are you holding too much cash?

Research from Schroders shows that US stocks and bonds have historically performed well after the Fed cuts interest rates. It may be worth revisiting the case for an investment portfolio that includes both asset classes, especially if you have a significant allocation to cash.

05/02/2024
Fed

Authors

Charlotte Swing
Portfolio Director
Grace Lavelle
Investment Strategy Director
Duncan Lamont, CFA
Head of Strategic Research, Schroders

Cash has been a very comfortable refuge over the past two years. A UK-based investor in global shares may have achieved a marginally higher return than a saver, but it would have come with far more volatility and stress along the way.* However, as central banks consider cutting interest rates, cash may now be starting to look less attractive compared to other investment options.

We tend to think of cash as free from market risk, but this is not really the case; when central banks cut interest rates, it quickly flows through to lower returns on deposits. Financial markets also come with risk, of course, but our research suggests they have tended to perform well when interest rates are cut. Looking at long-term US market data, shares have delivered the strongest return on average, but less risky assets such as bonds have also performed well. As a result, you do not need to take on the full risk of equity markets to benefit from the more favourable outlook for investing over saving. Tax and income considerations may also favour a multi-asset portfolio over cash, as we explore below.  

Interest rate cuts: good news for stocks and bonds

Analysts at our parent-company Schroders have looked at almost 100 years of US data to understand how different markets perform when interest rates are cut.

The research shows that US shares delivered an average return 11% ahead of inflation – and 9% ahead of cash – in the year after the Federal Reserve starts cutting interest rates. Shares have even beaten inflation and cash when a rate cut coincides with a recession, though the performance is not as strong in these cases. More broadly, it is not just equity investors who benefit from stronger returns following rate cuts. US government and corporate bonds have also delivered returns ahead of both inflation and cash, providing a tailwind for more risk-averse investors. You can read the research in more detail here.

Figure 1: Stocks have outperformed bonds which have outperformed cash when the Fed has started cutting rates, on average

12-month real returns

Table-insights article: With interest rates set to fall, are you holding too much cash?

Past performance is not necessarily a guide to the future and may not be repeated

* indicates recession occurred within 12 months. Source for return data: CFA Institute Stocks. Bonds. Bills, and Inflation (SBBI) database, and Schroders. Source for Fed Funds data: Post-1954 is direct from FRED. Earlier data is based on the Federal Funds rate published in the New York Tribune and Wall Street Journal, also sourced from FRED.

There are two important caveats to bear in mind. Firstly, we don’t know that interest rates will be cut any time soon. It is possible that inflation rises again, forcing central banks to keep rates high – or even raise them. Secondly, these are average figures and there have been periods where stocks and / or bonds performed poorly, despite interest rates being cut. 

We know that protecting wealth is a priority for many of our clients, especially at a time when both political and geopolitical risk is high. So investors can take comfort from the fact that our portfolios typically hold a range of asset classes, which can help to reduce volatility. Alongside equities, we will often hold bonds and alternative investments. Both asset classes offer opportunities for attractive risk-adjusted returns in their own right. They could also help protect portfolios if shares don’t perform as well as expected.

Aren’t US equities very overvalued?

One argument that could be made against investing today is that stocks are unusually expensive, making the historical record less relevant. We don’t think this is the case.

It’s true that the incredible performance of America’s “Magnificent 7” stocks – Alphabet (parent of Google), Apple, Amazon, Meta (parent of Facebook), Microsoft, Nvidia and Tesla – has raised eyebrows. Some of these companies are now worth more than individual European or Asian stock markets.

We assess each of these companies on their own merits and have preferences for some over others. Broadly speaking, however, these businesses have seen profits and cash flows grow very quickly, which means that their valuations haven’t risen by as much as share prices might suggest. On average, they are now valued at around 33x forecast earnings for 2024.** This is a very simplistic valuation measure, but it does suggest that talk of late-1990s style bubble – when share prices became completely disconnected from earnings – is misplaced.

Excluding the Magnificent Seven, the US stock market trades at a much more modest 17x expected earnings for 2024.** That’s broadly in line with the long-term average and does not suggest that valuations are a particular concern. It is also worth noting that we invest on a global basis. Some stock markets, such as the UK and Japan, are much more attractively valued and could present interesting opportunities.    

Cash provides me with a reliable source of income. Can other assets do this?

One reason for holding cash is that it generates regular and reliable income. But with interest rates likely to fall, a multi-asset portfolio could be a more resilient source of income than cash over the coming years.  It would include assets such as corporate and government bonds, as well as equities. The former can provide a higher degree of certainty over the level of income, while the latter offers the potential for income growth through rising dividends. 

Depending on your tax position, it may also be worth considering a “total return” approach. Rather than focusing on income-generating assets, this strategy would seek to maximise your overall investment return and make sales to fund a regular distribution. Our assumptions on long-term investment returns and inflation suggest that a portfolio should be able to support a distribution of 3 - 4% per year while keeping pace with inflation. 

Tax on interest income

For the past two years, paying tax on interest income has once again become a painful chore to be completed along with your tax return. It was less of an issue when interest rates were very low and even large cash balances generated little interest.

Unless you are holding cash in an ISA or other tax-advantaged vehicle, there is no way round this. It should be factored into your calculation of the potential return on cash.  

Investments are also likely to be subject to tax, but they may offer greater scope to minimise the “tax drag” on returns. For example, a portfolio focused on capital growth rather than income could mean that more of your returns are subject to capital gains tax as opposed to income or dividend tax. The former is charged at a lower rate than the latter for higher and additional rate taxpayers. Holding a basket of investments within a single fund can also help you manage any exposure to capital gains tax.  

Is cash still king?

As interest rates rose over the past two years, cash performed relatively well compared to other investments. Yet we know that over the long term, stocks, bonds and other assets have a much better track record at protecting capital against inflation than cash. There is of course no certainty that this stronger performance will be repeated – or that it will materialise imminently. However, the first interest rate cuts in over two years could well be a sign that it is getting closer.

If you have any questions or would like to discuss any of the issues raised, please do get in touch.  

*Source: Cazenove Capital. The MSCI All Countries World Index delivered a total return of 6.9% in sterling terms between 31 December 2021 and 31 December 2023. Before any currency adjustment, the index lost 18% in 2022 and gained 23% in 2023. The average Bank of England Base Rate during the period was 3.1%.

** Source: Refinitiv Datastream

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.

Authors

Charlotte Swing
Portfolio Director
Grace Lavelle
Investment Strategy Director
Duncan Lamont, CFA
Head of Strategic Research, Schroders

The value of your investments and the income received from them can fall as well as rise. You may not get back the amount you invested.