Cash is king, long live the king!
While we celebrate the ascension of King Charles to the British throne this week, we are starkly reminded that monarchs come and go, and the expression “The king is dead, long live the king!” comes to mind.
In an almost paradoxical manner, the expression “Cash is king, long live the king!” is also befitting of the time we find ourselves in after a long hiatus with zero interest rate policies in the developed economies that fuelled excess global liquidity.
Interestingly, since the creation of money, cash has been our supreme ruler with its enduring reign as the driver of the global financial system and its powerful influence over people and society.
Yet while money may seem like a permanent force in our society, even the most powerful financial system in the world is subject to upheaval, change and innovation.
The past couple of decades saw central bankers distort the role of cash to provide stability, liquidity and balance in a diversified investment portfolio. This they did by keeping interest rates artificially low through quantitative easing and yield curve control, thus diminishing the attractiveness of cash as a source of return, stability, balance and liquidity.
This prompted investment managers to seek alternative returns in higher-yielding assets, making investment portfolios less diversified and prone to the ebb and flow of equity markets.
Recent events involving the collapse of several US regional banks including Silicon Valley Bank, Signature and First Republic, as well as the rescue purchase of Credit Suisse by UBS Group, proclaim that even the most powerful financial systems are still subject to turmoil and winds of change.
Notwithstanding that, after the global financial crisis of 2008, the banking system was strengthened immensely with capital buffers and stress tests to prevent a similar crisis from happening again, a crisis did happen. The normalisation of interest rates, particularly in the US and in general across the world, exposed the frailties of fractional banking and the vulnerabilities of smaller banks to mismatches in interest rate risk, imbalances in the funding mix, and improper management of surplus funds.
This contrasts with large banks, which enjoy larger deposit bases, which are fairly split between retail and institutional depositors and which are supported by several capital markets programmes to raise short-term and long-term funding to better match assets and to diversify funding sources.
There are 4,700 community and regional banks in the US and only 10 to 20 very large “money centre” banks. The smaller banks will likely lose depositors and the money centre banks will gain these deposits. Large-scale consolidation is likely.
The hiking of short-term interest rates by central bankers to curb inflation and restore premiums for longer investment horizons in the developed economies oversaw the return of cash as a force to be reckoned with. Cash returned to reprise its role as the discriminator between hopeful and prudent investments in the portfolio, it too played its part in the collapse of Silicon Valley Bank and sundry.
The role of cash in a diversified portfolio stretches beyond stability and liquidity. Competitive cash returns raise the required threshold for prudent investments and set a high standard of quality for risky investments to be included in a diversified portfolio.
This is especially so during times when investors are facing increasing uncertainties about the effect of high interest rates on household affordability and credit extension, on deceleration in global growth, and on the potential for a deep recession and increase in unemployment.
All the while, inflation remains sticky and high above central bank targets while some central bankers remain resolute to continue with interest rate hikes to fight high inflation at a risk of a policy error. For now, geopolitical risk factors remain at large, and the coronavirus remains in the periphery of an eye, one mutation at a time.
“Cash is king” if only for when the tide recedes, that we are not found swimming naked. “Long live the king!” if only for a moment’s peace or to catch the next bull on the run.
INFLATION REMAINS STICKY AND HIGH ABOVE CENTRAL BANK TARGETS