Is Cash King?

With the Reserve Bank of Australia (RBA) initiating a cut in the cash rate during the month, markets are now embarking on a new cycle. Whilst monetary policy moves in long cycles, and as such there is a small number of experiences to analyse, it remains constructive in these times of high uncertainty to ask whether easing cycles are a friendlier investing environment.

Chart 1 below illustrates the passage of cash rates over the last twenty years. There have been three major easing cycles. Starting in the early nineties the RBA embarked on an extensive easing cycle taking interest rates from their high of 18% down to a low of 4.75% in response to a weakening Australian economy and a declining inflation pulse globally. During the mid-nineties, cash rates were eased after inflation concerns as a consequence of ‘high’ enterprise bargaining wage outcomes passed and in the late nineties and more recently, rates were influenced by a declining global economy and weakening forward indicators on the local economy.

The other interesting aspect of Chart 1 is the rapid growth in term deposits that accompanies a peaking in cash rates.

Chart 1 – Interest rates and growth in term deposits

Source: Reserve Bank of Australia

There may be a number of reasons for this. Firstly, the absolute rate on cash deposits hits a psychological level that attracts investment, suggesting deposits are attracted by headline rates rather than real rates. A second explanation is a behavioural one. Peaking cash rates are normally associated with turning points in the economy with easing phases driven by evidence of economic weakness – falls in confidence, job losses and reductions in investment. These same periods have heightened uncertainty with the flow data indicating that there is a flight to safety and away from risky assets such as equities. This should sound familiar as we are currently in this phase.

That begs the question – should we fight our behavioural biases or let them run? One way of looking at the risk reward is to look at asset market performance around the cash rate cycle.

The data provides a number of interesting observations but firstly the caveats. There is not a long history of the current open market operations cash rate regime and as a consequence there are only three episodes. Secondly, as can be seen from the data below, there are wide differences in the behaviour of asset classes during each episode. This is to be expected given we are looking at the behaviour of asset classes in response to one monetary policy lever and ignoring other important variables such as valuation and asset market fundamentals.

The interesting observations are:

• A$ Riskier Assets (Equities, A-REITS) have always delivered positive returns over the twelve months after the initial interest rate cut.
• The currency has always been weaker in the same period.

Table 1 - Returns during the 12 months before and the 12 months after a peak in cash rates.

Looked at in a portfolio context where we consider a broader bucket of riskier assets (Domestic and International Equities) versus defensive assets (Cash and Fixed Interest) the message is the same as shown in Chart 2 below. Riskier assets have on average done better in the period after the start of an easing cycle with a hit rate of 66% whilst defensive assets usually do less well (only 33% of the time have returns exceeded the previous 12 months). Furthermore, as well as improving markedly, the absolute performance of riskier assets has been higher than defensive assets, early in the easing cycle, despite the uncertainty that normally surrounds these periods. Clearly there is a potential opportunity cost to becoming defensive at the wrong time.

Chart 2 – Performance before and after RBA rate cutting cycle commencement

Source: Bloomberg, Goldman Sachs JBWere Asset Management

Andrew Cooke, Chief Investment Officer

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