Published November 22, 2008

Cash: Is it really king?


WHEN there is extreme uncertainty and volatility in financial markets, investors become unsure about where to park their funds. So holding cash may seem the safest option. But is cash really as safe an option as it seems - even now when a global recession is looming and asset prices are falling? The answer depends, among other things, on your risk appetite and investment horizon.

Before we delve into the topic, it is important to highlight that holding cash is not a risk-free option, especially when inflation runs ahead of interest rates.

In Singapore, for example, the annualised inflation rate in September was 6.7 per cent - substantially higher than fixed- deposit rates, which range from less than 0.5 per cent to less than 2 per cent, depending on the tenor.

Even at next year's officially projected inflation rate of 2.5 to 3.5 per cent, real interest rates - that is, the difference between deposit rates and the inflation rate - would still be negative. So those holding cash will still suffer wealth erosion.

So are you be better off investing your cash, given that equity markets seem more attractive after the recent huge correction? Our take is that investors should not let their guard down just yet - the outlook is still fraught with uncertainty.

Obviously, equity markets have come off very sharply. The MSCI World Index, for example, has sunk more than 40 per cent this year. In Asia, the correction in some markets has been even more pronounced, with bourses like China having declined more 60 per cent this year.

The sell-off has made markets less pricey, with forward price/earnings multiples now in the low teens or even at single-digit levels. Consequently, investors may find it tempting to go head-long into equities. However, this may not be the best strategy - and there are good reasons to stay cautious right now.

True, fears of the global banking system collapsing have eased and credit markets have shown signs of improvement. However, the situation is far from normal and it could take several months if not years before 'order' is restored.

Banks will need time to recover substantial losses and recapitalise their balance sheets. Hence, they are likely to stay cautious and may not resume normal lending any time soon.

We are already starting to see signs of forced selling and de-leveraging in the US$2 trillion global hedge fund industry. As funds' returns suffer, investors are pulling out money, while banks and prime brokers are cutting their leverage and demanding more collateral. As a result, hedge funds are forced to sell off assets to cover redemptions and meet margin calls.

In the US, the housing slump is hardly over. Home prices there are still falling and the rate of mortgage foreclosure is expected to rise in the coming months, especially when adjustable-rate mortgages are reset. Over the next two years, ratings agency Fitch has estimated that a sizeable US$96 billion of adjustable-rate mortgages will be reset higher.

Companies will also continue to unwind their debt holdings and investments, bought with the help of borrowed money, which will further drag down the market prices of many assets, including equities, causing yet more losses for investors.

Even if the central bank rescue efforts help calm conditions in credit markets and the nerves of jittery investors, this may not be enough to prevent a drawn-out global recession. Also, the write-downs may not be over. Global financial institutions may need to make more provisions as the value of assets on their balance sheets could diminish further and losses will be realised if these assets are sold at current market value. Given the risk of a deep and protracted recession, corporate earnings forecasts for next year, which appear to be too optimistic, may miss the mark in coming quarters, and this is another factor that could weigh on equity markets as profit estimates are cut. Given the risk of further downside, those who are looking to bargain-hunt at this time must have a strong risk appetite and a long-term investment horizon, as equity markets are likely to remain volatile and full recovery may not take place for several months at least.

Anyone looking to buy now should also spread their investments out over the next few months, instead of trying to time the markets. Time diversification aside, investors should also stay diversified across asset classes to protect against downside. It is especially important at this time not to get carried away with specific themes - no matter how appealing they may seem - and over-invest in them.

Despite the current turbulence, equities are still a good long-term bet and markets in Asia and emerging regions should resume their uptrend once the dust settles. However, this does not mean you should plough all your investments into equities. Instead, work out a suitable asset allocation strategy based on your risk appetite and long-term goals. If you're not sure how to do this, seek the help of a qualified financial adviser.

Staying largely in cash for now may seem like a good option if you are convinced that markets have not bottomed. But buying at the bottom is also near to impossible - so if you are afraid of missing the boat, then go ahead and nibble.

Investments are necessary to grow your wealth. Staying in cash for too long is clearly not a long-term option, because the negative real return will erode your wealth and leave you worse off in your golden years. Investments are still a good way to growing your wealth and the current turmoil in markets will throw up attractive opportunities for those with the risk appetite and the foresight to look beyond the current crisis.

Vasu Menon is vice-president, group wealth management, OCBC Bank