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How to protect your capital in times of financial repression

You can’t afford to be underinvested – particularly amid lasting low interest rates. Investment in cash, after inflation and taxes, is a guaranteed loss. In times of financial repression, even the most conservative portfolios beat cash the overwhelming majority of the time. This #CIOViews article explains what to look out for.

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The era of financial repression
We are living in a world of financial repression. In the last decade, confronted with pedestrian gross domestic product growth, anaemic inflation, and soaring public debt, governments in developed markets have resorted to keeping interest rates very close to zero – or even negative.

Although markets expect some rate normalisation in the coming years, if a meaningful increase in interest rates is even possible (given the world economy’s over-reliance on debt), we expect it to happen closer to the end of the decade. This is only when – and if – Western governments manage to structurally reflate their economies with the use of fiscal policies. 

The danger of cash
In the meantime, investors who put their money into cash deposits are confronted with the certainty of a loss, in particular once inflation is accounted for.

Real rates are negative across the board in developed countries, including in the US, but the situation is most dire in Europe, where German 10-year real rates have been in sub-zero territory since the height of the European debt crisis in 2011. And we should not forget that taxes are still due on top.

Such losses might seem negligible over the short term, but the cumulative impact over a decade or more is devastating. So how can investors protect themselves against such financial repression?

Lessons from Japan
To shed light on this situation, we can look to Japan – which has experienced near zero to negative interest rates for the last 25 years. This provides us with some interesting insights into the consequences of financial repression on a typical investment portfolio consisting of domestic bonds and domestic equities.

Such a portfolio carries no currency risk, which avoids the additional issue of currency-induced drawdowns that need to be accounted for in internationally diversified portfolios.

The chart below shows the five-year rolling returns of Japanese portfolios consisting of 75% bonds/25% equities (75/25) and 50% bonds/50% equities (50/50) in the past 20 years, as well as the rolling return of cash over the same period.

The chart clearly illustrates that, even compared with a very prudent portfolio allocation such as the Japanese 75/25, cash is very rarely king.

  • Even during the worst five-year rolling window (May 2012), a Japanese 75/25 portfolio did not perform much worse than cash, yielding an annualised -1.7%, while cash returned +0.4%.
  • During the most favourable five-year rolling window (October 2017), this same 75/25 portfolio produced +6.8% performance on an annualised basis, while cash yielded a negative return.
  • Overall, the conservative portfolio beat cash 87% of the time. Taking a longer time horizon of ten years, this statistic increases to 100% (this figure is based on monthly ten-year rolling returns of a portfolio comprising 75% Japanese government bonds/25% Japanese equities and of cash from May 2006 to November 2021 – the maximum available time period).

The cycle of poor returns 
The chart below, showing the same data for the European Economic and Monetary Union (EMU), makes it clear that the situation is repeating itself, in an even more pronounced way, on the ‘Old Continent’. Notable is the fact that even during the pandemic crisis, cash’s medium-term returns could not protect investors from the market drawdown.

Cumulative performances, as illustrated in the chart below, show the true long-term cost of being underinvested. It showcases the returns of Japanese and EMU multi-asset portfolios and cash. Over a long enough time horizon, diversified portfolios beat cash. This is all-the-more-true as interest rates are stuck at low levels.

In conclusion, wealth owners are confronted with an obvious choice between the certainty of a net loss on cash deposits, and the high probability of a gain over several years using a prudent mix of credit and equities. 

How should you position your portfolio in the view of Julius Baer's experts?

> Contact us to find out

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