With inflation dropping to zero last month and being expected to turn negative in the months ahead, cash suddenly doesn’t seem like such a bad investment. After all, you can receive an interest rate of around 1.5%, which is the same as your real return (i.e. after inflation). And, looking ahead, the spending power of cash looks set to increase even further in the months ahead, with cash also providing you with liquidity and flexibility should you wish to keep your options open.
The Short Run
Clearly, deflation is likely to be a major concern for the Bank of England. After all, it can be a rather persistent problem that sucks confidence out of the economy and can lead to a recession. Certainly, a falling oil price has not helped, but we remain in a deflationary period that has existed since the credit crunch, with numerous rounds of QE and low interest rates helping to stave it off until now.
As a result, there is a distinct possibility that interest rates could move lower before they move higher. At the very least, though, they are unlikely to move upwards at a brisk pace, since policymakers will likely be too fearful of inducing a deflation-led spiral which could end up causing a recession. As such, the short term outlook for bonds could be somewhat positive, although their long term prospects remain somewhat lacking as interest rates will eventually move higher, which will act as a downward pull on their pricing.
Property is also likely to benefit from lower interest rates and this on its own is likely to increase demand for bricks and mortar, while a lower interest rate also makes mortgages more affordable, too. However, the risk of prolonged deflation makes borrowing less attractive, since there is no erosion of the capital outstanding (in terms of its spending power) and so borrowings become even more difficult to repay. This could act as a brake on the housing market, as could uncertainty following the General Election, with London’s status as a safe place to invest unlikely to last if the UK has a weak minority government.
The Long Run
While shares could benefit from a lower interest rate, the future prospects for the FTSE 100 are less closely aligned with the performance of the UK economy than are bonds or property. UK government bonds (gilts), for example, could see their prices come under pressure due to uncertainty with a minority government, while UK GDP figures will impact on the performance of the UK property market, since the majority of buyers live and work in the UK.
However, for shares, most of the major companies in the FTSE 100 rely on the rest of the world for their sales, rather than the UK. As such, they may be better shielded from the challenges faced by the UK economy in future, with the US and China now starting to turn a corner and (with the odd exception) post improving economic data.
Furthermore, the FTSE 100 remains relatively good value, has a yield of 3.5% and, although its price level could be hit in the short term by political uncertainty in the UK, it would equate to a superb buying opportunity rather than a reason for long term investors to be fearful. That’s because the high quality nature of most stocks on the index means that they are likely to have bright futures.
So, while bonds and property could run out of steam, it could be worth holding some cash in preparation for a potential opportunity to buy shares for the long haul. After all, where else can you buy at the click of a mouse, receive a 5%+ yield on a number of high quality companies, and have the chance to enjoy considerable capital gains over the long run?
