A natural reaction of late, especially since the strong falls on share markets across the world through October, has been a flight to safety namely cash. The Australian government guarantee of cash deposits has solidified at least one area of the market. This looks pretty attractive when most other asset values, even residential property based on data out today, are falling or have already fallen significantly.
Unfortunately, interest rates on these cash deposits are also falling. Central banks around the world (whole heartedly supported by their respective governments) have cut interest rates in what has been viewed as a coordinated response to the looming downturn in the global economy. (Some would say slashed but I think emotive language such as this coming out of the media has been less than helpful and is in a small degree responsible for the scale of the falls on markets. I'll get off my soap box now.)
The economic theory behind these moves is that through reducing interest rates, access to credit becomes more accessible and at the same time fewer resources are needed to pay back outstanding debt. This in turn leads to more money being freed up by and for consumers and companies to spend in the real economy. This in turn leads to higher levels of economic growth. The economic term to explain this policy move is loosening monetary policy. The sooner this is done the better as economic theory suggests the time lag between a cut in interest rates and for this to lead to a stimulation of the economy can be up to 18 months in duration. Let's hope the impacts are felt sooner rather than later!!
These reductions in interest rates flow on to the rates paid by institutions for customers to loan them money by depositing their money with the bank or other financial institution. These rates paid by banks and the like in Australia are still comparatively high compared to other developed parts of the world, thinking particularly of Japan and the USA, but are starting to fall.
As rates fall it makes the decision to hold cash that touch more difficult. In a Eureka Report article published early in October - Yields the new king? - Scott Francis pointed out that the yields (or income) on Australian shares and listed property trusts are making these asset classes look a whole lot more attractive compared to cash deposit interest rates, especially when taking into consideration franking credit benefits.
Nicole Pedersen-McKinnon provided a similar angle in her article published in the Sydney Morning Herald and dated the 26th of October - Cash is safe but it isn't king - where she in particular referred to the dividend yields of 8% or more being offered by the big four banks. The big assumption here is that company dividend payments will at least remain steady. There is some doubt as to this but so far the big banks, the part of the market which has suffered the most from the credit crisis so far, have at worst maintained dividends (ANZ) or in other cases continued to increase. What this is telling investors is that if you buy shares in the banks now and held them like holding a term deposit, the income returns - the money coming into your bank account - would be 8% compared to what could soon be 6% or even in the 5% range for cash deposits after a few more RBA cuts.
Now of course the growth side of owning shares, taking the big 4 banks as an example, have been anything but stellar over the past 12 months. If you might need to access the capital contained in a bank account or a share investments there is real risk in buying shares as the underlying investment may still fall in value. But if you have a buy and hold strategy, for the long term, you would have to think that asset prices are pretty compelling at present levels.
A third piece of commentary on the problem with holding cash over the long terms is that inflation is a killer and eats into the returns from cash. Warren Buffett makes this case in his article - Buy American. I am. - which I have referred to in a previous blog posting. Growth assets, such as shares, also have a growth component and their income tends to grow over time, both providing a hedge against the impact of inflation.
As Nicole Pedersen-McKinnon suggests in the conclusion to her article - buying bank shares (or any shares) is not for the faint hearted but dipping the toes in and taking a conservative, measured approach through techniques such as dollar cost averaging might make some sense. However in my view this should only be contemplated by buy and hold long term investors in consultation with their financial advisor and in relations to their current portfolio allocations, as the share market might just keep falling in value and/or dividends might not hold up over the coming year.