Hold cash to beat the recession

Posted on 03 May 2008 with no comments from readers

The old investment adage that cash is king in a recession still rings true. Cash might indeed be the emperor in such times.

  

Global stock markets were down 10 per cent in the first quarter of 2008 and even hedge funds managed to loose an average of four per cent. Real estate is also on a downtrend now in many countries, except in places like the oil rich UAE.

 

Cash might look a poor investment with low interest rates, dollar devaluation and rising consumer price inflation. But in a world characterized by asset price deflation then cash is still rising in value relative to everything else, except perhaps food and energy.

 

Another way to look at this is to say: now that prices of houses or shares have fallen my cash will buy more of them. But it is hardly any wonder that even professional investors are confused about which way to jump at the moment, with the dollar rally catching many out last week.

 

The biggest economy in the world is in trouble, with falling house prices now compounded by falling share prices and a financial crisis with a grid-locked credit market. Most economists now finally accept that the US is in a recession, though 0.6 per cent growth in Q1 was not technically a recession just yet.

 

Yet the jury is still out on whether this will be a shallow recession, or something that drags on much longer and causes more damage. Optimists are just about keeping their heads above water at the moment, yet they are struggling.

 

The root cause to the current malaise is that US house prices are coming down, and the banks that lent the money to finance this boom are in trouble as their customers increasingly find it hard or impossible to pay their mortgages. The IMF has come to the shocking conclusion that this might cost the banks a total of $1 trillion in sub-prime write-offs, even if the Bank of England disagrees and says it is exaggerating the problem.

 

It would be nice to think that $1 trillion could somehow be brushed under the carpet and forgotten but this sum will leave the banks short of capital. In fact it leaves them in a major financial crisis, and some like Bear Stearns will not survive, let alone continue lending at a reduced rate. We have not seen the end of it yet.

 

But financial crises do always come to an end. The Great Depression of the 1930s was finally brought to an end by the huge economic stimulus of the Second World War. The 1973-5 Oil Shock took a decade to work through the system.

 

All the same to expect a sudden and miraculous recovery in the US economy looks rather over-optimistic. Far more likely is surely a spreading of the economic downturn to other parts of the world via the mechanism of reduced trade flows and US dollar depreciation.

 

That would mean a downturn in Europe and Japan as well as the emerging markets like China and India, and a fall off in demand for industrial commodities like steel and oil.

 

The IMF recently said there was a 25 per cent chance of a global recession, and how long ago was it that economists were giving a similar chance of a US recession? In such circumstances investors should include a high cash element in their portfolios, along with defensive stocks and precious metals.

 

If nothing else the value of cash will rise in terms of hard assets that fall in price, and the liquidity of cash is unequalled in a recession when it can be very hard to sell things and the best time to buy.