RYK VAN NIEKERK: From the mid to late 2000s and again from early 2015 to date, money market funds offered good real returns of around 2% at minimal capital risk. This was a good yield in light of the poor performance of other asset classes such as equity and property.
Paul Hutchinson, a sales manager at Ninety One, is on the line. Paul, thank you so much for joining me. We have seen four interest rate cuts this year in South Africa. The prime rate started the year at 10% but was cut by two-and-three-quarter percentage points to 7.25% and this is a drop of around 30% of the interest rate – which is significant. We haven’t seen many such aggressive cuts since the 1970s and most certainly not over the past three decades. How did this affect money market rates?
PAUL HUTCHINSON: Thanks Ryk. It’s a fascinating question and what we’ve tried to do to understand the ramifications of these interest rate cuts is to look at South African inflation. The repo rate, which is really the rate at which the Reserve Bank lends to the commercial banks in South Africa, and money market unit trust fund returns as a proxy for cash investments. And we’ve tried to understand what this means for conservative cash-like investors. And we observed three things.
The first is not that significant in that it’s clear that as inflation goes up, or is expected to rise, so the Reserve Bank acts by increasing the repo rates. And similarly if inflation falls, or is expected to fall, so the Reserve Bank acts by cutting the repo rate. So that’s not that insightful.
What’s potentially a little bit more insightful is that money market fund investments follow the repo rate. So if the repo rate is going up, so the returns that you can expect from your money market fund investments go up, but there is a lag effect. So for investors, the path of the repo rate gives them a good indication of where money market fund investment returns are likely to go.
And I guess the third and most important observation is that the money market fund investment returns peak where the repo rate peaks and they bottom where the repo rate bottoms. So what we have now, as you pointed out in the introduction, is we’ve had 2.75% cuts in the repo rate, where the repo rate now is at a low level of 3.75%.
So investors can expect in the coming months for their returns from money market fund investments and other cash-type investments to fall to as low as 3.75%.
And this is significantly concerning given that a year ago, less than a year ago, they were earning north of 7% from their money market fund investments. So a real dilemma for savers. And while cuts in the repo rate are fantastic for borrowers – anyone with the bond will now have more money in their pocket – unfortunately anyone that has been saving in cash-like investments will have less money in their pocket as a result of the cuts in the interest rate.
RYK VAN NIEKERK: Yes. And a significant amount less because the cuts have been so aggressive. What has been the experience in the past? For example, after the 2008 and 2009 Global Financial Crisis, we also saw a significant cut in interest rates. How did the cycle follow this? Did we see interest rates recover shortly after such aggressive cuts?
Unfortunately, interest rates didn’t recover all that quickly. So analysing the central bank response to the global financial crisis is fascinating and [especially] considering that central bankers are following the same response now. So after the global financial crisis, central bankers around the world – and the South African Reserve Bank (Sarb) was no exception – cut interest rates to record low levels to stimulate the economy and not worrying really about the possibility of inflation, which actually didn’t materialise post the Global Financial Crisis. Central bankers in response to the economic effects of Covid-19 are responding in a similar manner, aggressively cutting interest rates as we’ve seen in South Africa. And what’s interesting is that post the Global Financial Crisis money market fund returns in South Africa delivered negative real returns for five years from 2010 to 2015.
What that means is that investors and the purchasing power of their money actually went backwards over this period, so they could buy less in 2015 than they could in 2010, and that’s what we are experiencing today. We’ve seen a massive and rapid cut in interest rates in South Africa. It is likely, that for the foreseeable future, money market fund investments will deliver negative real returns to investors over the coming months and years.
RYK VAN NIEKERK: What would your advice be to individuals who own fixed income- or money market products currently. In the recent past, the advice to investors holding equities was to sit on your hands and just ride out the cycle, but what advice would you have for people who are dependent on income and own fixed income and money market products?
PAUL HUTCHINSON: I think they face a real dilemma, because for the past five years they have been earning attractive real returns from their money market and cash investments and this in a period where growth assets, equities, property have delivered disappointing returns at best. So being in cash has been a great place for investors to be and unfortunately, that’s unlikely to be the case going forward. So I would start by saying conservative investors that have heavy exposure to cash should consult with skilled and experienced financial advisors to assist them with this decision.
And certainly where they can start looking is at multi-asset income funds where the portfolio manager has a broader range of underlying assets that he or she can invest in, across the yield-enhancing spectrum.
And this should allow those types of funds to deliver returns 1% to 1.5% above cash, while remaining fairly conservative in that they’re unlikely to deliver negative returns over rolling three- or six-month periods. So unfortunately for conservative investors, they’re going to have to consider how important security of capital is to them and they’re also going to have to take a slightly longer time horizon in terms of how long they view their investments to be.
RYK VAN NIEKERK: Yes, but that will come with more risk obviously. Are we in a situation where investors are now being forced to take on a little bit more risk?
PAUL HUTCHINSON: I think that’s true, so I think investors are going to have to accept slightly higher volatility because returns from cash, as I indicated earlier, are likely to fall to as low as 3.75%, and that’s actually not taking into account any potential further interest rate cuts that the Sarb might offer us in the months to come.
So short answer: unfortunately, investors are going to have to consider slightly more aggressive investment vehicles to deliver slightly higher returns than [those] which they can get from the money market.
RYK VAN NIEKERK: It’s always interesting in discussions like this, because it forces the investor to take another look at asset classes and asset allocation within his or her portfolio. Whose responsibility is it to look at asset allocation? Is it the investor him- or herself? Is it the investor’s financial advisor or should you leave those decisions to the fund manager?
PAUL HUTCHINSON: I think the starting point is to properly understand your personal circumstances or the investor’s personal circumstances: what are their requirements? So together with an experienced financial advisor to complete a financial needs assessment as well as a tolerance for risk, and that should guide the client into a type of investment that they require.
I would then suggest that they consider multi-asset funds where the portfolio manager makes the asset allocation decision between which asset classes to be invested in at a particular point in time. So starting with a financial advisor, understand your requirements, understand the return goals that you have and the time horizon that you have to achieve those return goals and then decide on a multi-asset fund that can help you get to that specific goal.
RYK VAN NIEKERK: Multi-asset funds are interesting. In many fund categories, you see very homogenous approaches from different asset managers, but when it comes to multi-asset funds, they can be very, very diverse. How should you look at a multi-asset fund to decide whether the risk profile matches the investor’s needs?
PAUL HUTCHINSON: Very difficult question to answer I think. But I would suggest the starting point is to look at the risk-return characteristics of that multi-asset fund relative to its peer group and relative to its ability to deliver on its investment objectives over time. And that’s again where a skilled financial advisor can assist the client. That advisor would have done work on a universe of funds that he or she supports over time and should be able to direct the client to the most appropriate fund to meet that client’s specific goals.
RYK VAN NIEKERK: Yes, it’s not always easy, but how do you see the current interest rate cycle or put differently, what do you think needs to happen for interest rates to start rising again?
PAUL HUTCHINSON: I think we need growth. I think you’ve heard that from almost every commentator on your show. We need … strong economic growth to come back for the cycle to regenerate.
RYK VAN NIEKERK: Yes. Growth is most definitely the key. But let’s look back at history and the other crises we have seen. And looking back, it’s clear that things work in cycles and sometimes people are too conservative to adapt strategies quickly when cycles change, because they’re just too afraid of what’s going to happen in the future.
PAUL HUTCHINSON: I think quite often what happens is at times of risk, people are fearful and they de-risk their portfolios and the challenge then is when to reinvest into growth assets. More often than not, staying the course, remaining invested, is the best possible decision and if you have put in place a detailed financial plan and you are on course to meeting your financial goals, there should be no real reason to change through time, unless there is some kind of revolutionary change that needs to be factored in.
But as you pointed out, things act in cycles and looking through the cycle and staying committed to your investment plan, is more often than not, the best decision that one can make.
RYK VAN NIEKERK: If I understand you correctly, you say go sit with your financial advisor, look at your current plan. Understand how the changes in markets and the economic environment will affect your plan and look at how you can tweak your plan to increase the yield with only a minimal increase in risk?
PAUL HUTCHINSON: Correct. And that’s specifically because of how low interest rates have fallen in South Africa and the likelihood that they remain at these low levels for a period of time. And the risk is that investors earn negative real returns for an extended period of time if they remain invested in money market type assets for the duration. So really for those investors that have high exposure to money market-type assets, for them to consider whether that is still suitable and will still assist them in meeting their long-term financial goals.
RYK VAN NIEKERK: Thank you, Paul. That was Paul Hutchinson. He is a sales manager at asset management group Ninety One.
Brought to you by Ninety One.