Why invest in a higher interest rate world?

The more pertinent question now is: why invest? Investors can get a 5-6% annual return in a savings account without taking any significant risks to their capital. Volatility in bonds and stocks in 2022 will be fresh in the minds of many investors, despite their stronger performance in 2023. Investors could be tempted to take the bird in the hand of cash rather than deal with the highs and lows of the stock and bond markets.

For some, this could be the right choice, particularly those with a short-term horizon or lower risk investors.

Cash can also bring some flexibility for financial planning and enabling investors to take advantage of opportunities as they arise. However, there are two reasons why investing in the stock market remains important: inflation and compounded growth.

Investors may be getting 5% interest on a savings account but that is often fixed for many savings accounts and for others it only rises if interest rates go up. This leaves investors vulnerable to inflation: 5% may be a good level of income when inflation is low, but it starts to look a lot less attractive if inflation is 6% or higher. Inflation, as measured by the Consumer Price Index, is currently around 7%[1], so most savers will still be losing out as the purchasing power of their savings falls once that’s taken into account. Over one or two years, this might not make a significant difference, but compounded over 10 or 20 years and it becomes a significant drag on the value of any long-term savings.

There are reasons to believe that inflation will remain higher than it has over the past 15 years. A lot of the factors that have kept inflation low over the past 30 years are shifting. Globalisation is reversing, for example, making it less easy to manufacture cheap consumer goods elsewhere. Strong labour markets are pushing up wages, while rebounding energy prices are keeping inflation higher than expected.

Stock markets have historically provided a better defence against inflation. The S&P 500 has gained 10.7% annually since its launch in 1957[2], well ahead of average inflation of 5.2% seen in the UK[3]. While companies will experience higher costs as inflation rises, they often have the ability to pass those price rises onto their customers. This can allow them to maintain their margins during periods of high inflation, which should ultimately feed into share prices. We are currently seeing that companies have been able to pass on higher inflation through higher prices, with limited impact on sales, which has helped boost profitability. But you should remember that investing in the stock market puts your capital at risk and past performance isn’t a reflection on what will happen in the future.

However, it is worth being selective. Companies with undifferentiated products in competitive industries may not have the same pricing power as those with a strong brand or good market share. During periods of inflation, it is important to consider those companies that can raise their prices to absorb rising input costs.

The reason why cash is so vulnerable to inflation is that the capital value stays static over time, while the income generated often lags inflation. That won’t matter very much over a year or two but compounded over 20 or 30 years, it really makes a difference. Over the past 20 years, £1,000 would have had to grow to £2,022 to achieve the same level of purchasing power – an increase of 102%[4].

Cash would not have kept pace. In our opinion, the stock market has the potential to provide that growth over the long term in a way cash does not.

Equally, dividends can also contribute to the total returns. They may start at a lower level but can grow. The dividend yield on the MSCI UK is currently 3.7%[5]- around 1% behind most savings accounts[6].

However, savings rates may rise or fall depending on which way interest rates move. In contrast companies, provided they are doing well, could raise their dividends over time. If the dividend grew at 10%, it would have overtaken the savings account in the 4th year and could still have further growth ahead. Growing dividends can also help drive the share price higher, although this is not guaranteed, providing subsequent boost to returns.

Of course, these possibly higher returns come with a trade-off. The stock market is more volatile and will have periods of weakness, such as that seen in 2022. Diversifying across a range of investments, careful stock selection and strong analysis can help mitigate losses but cannot eliminate the potential for some capital loss.

However, it is always worth looking at the long-term chart of stock market performance. Periods of significant volatility, such as the Global Financial Crisis, the bursting of the Dotcom bubble or the pandemic, whilst they have a significant impact at the time appear as minor blips when put in their historic context. Markets tend to recover their equilibrium relatively quickly after a downturn, although such volatility should serve as a reminder that investing is inherently risky.

Bonds, or fixed income, can offer diversification and provide a useful middle path between stock market investment and cash savings. For government bonds, the income may not grow, but it could be higher and the risks are often no greater than those on cash savings. A potential risk to cash savings is in the event a bank collapses. In that situation, up to £85,000 of your savings (per person, per institution) is compensated by the Financial Services Compensation Scheme, which most banks are covered by. For a UK government bond, the only risk is that the UK Government defaults on its debt. For corporate bonds, investors can get an uplift in their income with bonds issued by large, blue-chip multi-nationals, although with that comes an increase in risk to your capital and usually the higher the yield the higher that risk.

Ultimately, when saving for the long term, investors need their money to outpace inflation. High interest rates are superficially appealing, and cash has an important role to play, but we believe, for those able and willing to take on more risk, a carefully managed stock market portfolio would be better for protecting against inflation over the long term.

[1] https://www.theguardian.com/business/2023/aug/16/uk-inflation-falls-sharply-as-cost-of-living-pressures-ease

[2] https://www.businessinsider.com/personal-finance/average-stock-market-return?r=US&IR=T

[3] https://www.officialdata.org/uk/inflation/1957?amount=1000

[4] https://www.officialdata.org/uk/inflation/2003?amount=1000

[5]  LSEG Datastream / Evelyn Partners

[6] https://savingschampion.co.uk/best-buys/personal/easy-access-accounts

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