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September 8, 2023

Is cash king given higher rates? Examining the alternatives for asset allocation

There are alternatives to cash that can better withstand inflation despite the volatility.
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In-house blogger
Guest blogger
Meghna Shah
Macro Strategist & Chief Economist
All opinions expressed in this content are those of the contributor(s) and do not reflect the views of Macrobond Financial AB.
All written and electronic communication from Macrobond Financial AB is for information or marketing purposes and does not qualify as substantive research.

Global central banks have focused on one problem – inflation – since the start of 2022, resulting in steep rate tightening around the world.

The evolving macro dynamics during rate-tightening cycles impart substantial volatility and impact valuations for every asset class. 

The risk-off sentiment and higher rates raise a genuine temptation: should cash allocations be raised for capital preservation?

We are sceptical, considering the outlook for growth and inflation and the historical performance of different asset classes. For tactical asset allocators, there are favourable investment opportunities vis-à-vis cash, considering various investment horizons and macro scenario pan-outs.

Macro projections indicate room for both equities in the short term and government securities over the medium term

Rate-tightening cycles usually bring in risk-off sentiment in the markets. Tighter policy usually leads to higher borrowing costs for corporates and households, more expensive investments and consumption, risks of slower growth and a move to safe-haven assets.

Rate hikes and future rate expectations influence economic outlook, business cycles and shape-up varying demand for asset classes. Equities are supported by healthy growth prospects, while a recessionary outlook tends to benefit assets like UK gilts.

The Bank of England is projecting more rate increases through early 2024 to bring down inflation; its economic scenario anticipates slowing (but positive) growth. Until then, despite the not-overly-positive economic backdrop and given short term volatility, an overweight call on equities remains supported by earnings and dividend projections.

As the projections in the chart above reach the end of 2024, real GDP growth heads to zero – and the Bank of England seems to anticipate cutting interest rates. 

The current yield curve (which is steeply inverted) would, by then, imply a bull steepening of the curve – with the shorter end of the curve falling faster than the longer end. 

Such a disinflationary recession outlook would likely call for investors to be overweight governments bonds in the second half of 2024, anticipating capital gains driven by rate cuts.

Cash has tended to underperform in past cycles

This table tracks the performance of various asset classes relevant to a UK-based investor since 2016. We also added 2006, an example of a year that was late in a rate-hiking cycle.

Anticipation of better growth prospects (2006, 2017, 2019) in the UK led to relatively solid equity returns. Uncertainty post-Brexit (2016) and amid the Covid-19 outbreak (2020) led to outperformance by gilts. Commodities (especially gold) provided a better hedge against rate tightening in 2006, 2017 and 2018 than cash did.

The return on cash (computed as Bank Rate adjusted for inflation) has largely underperformed other investment options across rate cycles, and has yielded negative returns since 2008. The mean cash return stands at -2.2 percent since 2009. This chart shows how cash remained a poor hedge against inflation.

Prudent asset allocation can outperform the allure of cash

Cash becomes an interesting option around tricky inflection points closer to the end of rate hikes. 

So far in 2023, higher interest rates have not dampened growth significantly, and commodities and equities have outperformed cash.

Central banks are hoping for a soft landing, whereby inflation softens in the backdrop of sustained growth. This would have been ideal for equities over the medium term, too. However, it’s unlikely, as inflation may be sticky and remain above target for most central banks – which wouldn’t pave the way for rate cuts in the near term. 

The Goldilocks scenario is unsustainable, and macroeconomic data is likely to mark deterioration going into the second half of 2024. A slowdown and recessionary outlook may result in monetary easing – spurring demand for government securities.

Given these evolving scenarios, diversified and tactical asset allocation – targeting capital gains and hedging for inflation – can be structured and fine-tuned.

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