I'm sure many savers heading towards retirement in the next decade will, at some point over the last ten years, have wished their bank interest rate was something a little more like what they dimly remember they received when they were young.
On the surface, this autumn's fixed-term deposit offerings appear to have granted those wishes.
This, coupled with high levels of investment-market volatility, has made it tempting for many to make a switch from stocks to term deposits offering rates that were unthinkable even a few short months ago. However, those doing so in the belief they are reducing their risk may be in for a shock.
The insidious impact of inflation could well deliver a permanent loss of buying power.
In the years following the global financial crisis and leading up to the Covid-19 pandemic we became accustomed to cash deposits paying very little interest. However, one consolation was that for most of the period inflation was muted, and, overall, not too far from the Bank of England's (BoE) 2% target.1
This environment meant that the value of deposits was slowly eroded year by year - a form of financial repression designed to encourage us to invest rather than hold cash. Of course, the inflationary backdrop has changed rapidly over the last 18 months as we emerged from the pandemic and faced fresh geopolitical challenges. Inflation rose and became entrenched, with central banks raising rates in an attempt to control it.
As a result, we cannot know for certain what inflation will be over the next 24 months, but we can get an idea of the risks involved in term deposits by looking at the situation today versus a year ago.
The bank with the top interest rate today offered only 0.6% per annum on its two-year fixed deposit two years ago.2 Had you locked into that rate at the time, you would have just received £101.20 when you regained access to the money.
However, UK consumer price inflation (CPI) over the two years to September 2022 was 13.5%, so the purchasing power of your investment would have been eroded by over 12% in real terms, i.e. a painful and much more rapid erosion of real capital than experienced in the previous decade.
So term deposits may not be volatile but can still serve up large real-terms losses.
A year ago, the bank was offering only 1% per annum on a two-year fixed deposit, and the expected outcome over two years was a real-terms loss. Depositors accepted this expected negative real return only because at that time other assets looked to them to be unattractively pricey following their rapid post-Covid-19 recovery.
Today, most investments are priced very differently and potentially rather more attractively. Why? Because persistent post-Covid inflation was stoked by the Russian invasion of Ukraine and meant rapid rate rises from central banks leading to a repricing of risk assets like equities.
As a result, US large-cap equities have suffered a peak-to-trough fall of almost -24% within the last 12 months.3 UK large-cap equities have also seen a fall (of -11%),4 and this has been flattered by sterling's rapid depreciation and the substantial overseas earnings of the firms in the index.
Of course, buying equities at lower prices does not guarantee strong long-term returns as markets can always sell off further. It does, however, bias the outcome more in your favour and, over the long run, developed-market equities have historically beaten inflation over most periods in excess of five years.
The performance of high-growth US technology stocks - the so-called ‘FAANG' stocks - was stellar during the Covid-19 pandemic as we all worked and shopped virtually. Likewise, their decline has been equally precipitous over the last 12 months. Perhaps these look temptingly cheap? Beware, however, that the regulatory landscape is changing for these behemoths, and some face stiff competition. Their advertising and subscriber-driven revenues are also likely to be lower in a slowing economy.
What we expect to see in future is far greater disparity in the prospects for different stocks; we are no longer in an environment where cheap money creates a rising tide that can lift all boats. Also, if history tells us anything, it is that in the aftermath of recessions, the new winners are not the same as those that came before. In these challenging market conditions, DC schemes will need to think how they can deliver the best outcomes for members, and we believe this means that careful, active management can be particularly valuable, and that teams like ours, taking a research-intensive approach that incorporates consideration of long-term themes, have an opportunity to add material value.
Christopher Nichols is head of client solutions at Newton Investment Management
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Notes:
1. Over 12 years from the end of 2008 to the end of 2021 UK CPI was 1.96% per annum.
2. Tesco Bank, October 2020
3. S&P500 Total Return Index was 9,986.7 at close on 27 December 2021 versus 7602.99 at 10 October 2022
4. FTSE100 was 7672.4 on 10 February 2022 then 6826.2 on 12 October 2022
Important information
This is a financial promotion. These opinions should not be construed as investment or other advice and are subject to change. This material is for information purposes only. This material is for professional investors only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors.
Issued by Newton Investment Management Ltd. ‘Newton' and/or ‘Newton Investment Management' is a corporate brand which refers to the following group of affiliated companies: Newton Investment Management Limited (NIM) and Newton Investment Management North America LLC (NIMNA). NIMNA was established in 2021 and is comprised of the equity and multi-asset teams from an affiliate, Mellon Investments Corporation. In the United Kingdom, NIM is authorised and regulated by the Financial Conduct Authority (‘FCA'), 12 Endeavour Square, London, E20 1JN, in the conduct of investment business. Registered in England no. 1371973. NIM and NIMNA are both registered as investment advisors with the Securities & Exchange Commission (‘SEC') to offer investment advisory services in the United States. NIM's investment business in the United States is described in Form ADV, Part 1 and 2, which can be obtained from the SEC.gov website or obtained upon request. Both firms are indirect subsidiaries of The Bank of New York Mellon Corporation (‘BNY Mellon').
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