Finance: Investment

The signals from world equity markets in early August were loud and clear: risks are being rapidly and radically re-priced, and with good reason. Economic growth is slowing quite sharply in the developed world; recession may be on the way for some. Whether or not it arrives, the prospect of slow or no growth combined with vast government borrowing and uncertain political leadership is toxic for markets. Banks and their shareholders look horribly exposed.

Small businesses, the backbone of the British economy, have been showing caution for some time. They are reducing their exposure to risks from the banking system by repaying debt at an increasing rate. Their cash holdings (£58.2bn on the latest figures) are growing at more than 10 per cent a year and many are only investing to stand still—replacing old equipment but not expanding. The deleveraging of the corporate sector is underway. Combine that with fearful and debt-stuffed consumers, and it’s hard to imagine anything other than muted growth at best. And if growth falls short, Britain’s ratio of government debt to GDP could get a lot worse before it gets better.

As with companies facing uncertain times, so with investors. As the outlook has darkened, the attractions of cash as a haven asset class have reasserted themselves. Funds have been pouring out of equities and junk bonds—the riskier plays on corporate performance—and into money market funds at an extraordinary rate. Almost $50bn made the switch in the week to 10th August, the FT reported, a higher volume than that after Lehman Brothers collapsed. Faced with the wild volatility we have seen recently, this makes complete sense.

A relatively short while ago, retail investors were being urged to find ways to earn an above-inflation return on their money, which meant moving out of cash and into riskier assets exactly as the architects of quantitative easing might have hoped. But after the market action of the past few weeks, holding cash, even at negative real interest rates, still looks a less bad option than most of the alternatives. Cash gives you the greatest possible choice in how to direct your investments when opportunity arises, and in the meantime it is probably the best tool for controlling the level of risk in your portfolio and protecting against huge losses. Look on negative real interest rates as a sort of insurance premium, the price of security if you like. Until the price gets too high, the cautious will keep paying.

But most of all, the question of whether it makes sense to hold cash depends on whether you believe the developed world is heading for inflation or deflation. If you come down on the side of deflation, which seems entirely possible, then cash is a sensible asset to hold, as are high-quality bonds. Big unresolved questions still hang over the equity markets, particularly from the eurozone’s troubles, and therefore it is not clear to me that shares are cheap. But it is clear that the penalties for risky decisions that go wrong—paid in cash—are potentially high.

So much for cash. But what of the other great financial pillar of the British private investor—property? Even several years into the worst banking crisis since the 1930s and a sharp slowdown in mortgage lending, British house prices have refused to crash in spite of many dire warnings. Indeed, buy-to-let mortgage volumes are growing again—investors scent attractive returns in a market where stubbornly high prices in some areas are turning would-be buyers into persistent tenants. Renting may be entering a long-term growth phase.

Certainly, house prices remain high relative to incomes, which points to the need either for prices to fall or for incomes to rise. Given that we are in the midst of the longest fall in real incomes (after adjusting for inflation) since the depression, it appears that falling prices will have to pull affordability back into line with its long-run average. The question is how this might happen.

It seems possible to me that instead of a crash, we might witness a long period of house prices grinding gradually down. As the supply of mortgage credit has drained away, the number of transactions has dived. People who might have moved if they were feeling more confident about the economy stay put. Those who can’t borrow stop looking. Banks, meanwhile, are allowing overstretched borrowers to move on to interest-only arrangements that keep them in their homes but make it much harder for them to move, which further clogs up the market. And faced with such muted demand from buyers, housebuilders are going slow—the number of units completed last year was the lowest since the 1920s—so there’s no sign so far of supply overwhelming demand and driving prices lower.

The big risk in property (leaving aside, of course, the buoyant, prime areas of London and the southeast) seems to me that it is the polar opposite of cash—even in good times it is about the most illiquid asset you can find. Recently, its illiquidity has reached an extreme. It doesn’t take a crash to make housing an unattractive investment.