Cash trending towards trash

The Reserve Bank cut the repo rate by 2.75% in 2020, to a long-term low of 3.5%. As a result, money market returns will be materially lower than investors have previously experienced. Investors seeking positive real returns can consider the Ninety One Diversified Income Fund.

Jan 27, 2021

5 minutes

Paul Hutchinson
The Reserve Bank cut the repo rate by 2.75% in 2020, to a long-term low of 3.5%. As a result, money market returns will be materially lower than investors have previously experienced. Investors seeking positive real returns can consider the Ninety One Diversified Income Fund.

During the mid to late 2000’s and then more recently from January 2015 to date, South African investors could invest in the money market and earn an attractive real return with little risk to their capital, as evidenced in the following chart. The more recent period of positive real money market returns coincided with a period of disappointing returns from growth assets (equities and property), with the result that more and more investors switched their growth asset exposure to cash. This action accelerated post the equity market collapse in March 2020.

Figure 1: South African inflation, interest rates and money market returns

South African inflation, interest rates and money market returns

Source: Ninety One Benchmark database.

Some observations:

  • It is evident that the SA repurchase (“repo”) rate is the key monetary policy tool used by the South African Reserve Bank (SARB) to control inflation.
    • As inflation rises (or is predicted to), so the SARB responds by increasing the repo rate, and as inflation falls (again, or is predicted to) so the SARB responds by cutting the repo rate.
  • As the repo rate rises, so returns from money market investments also rise, and vice versa. Note that the average money market fund return lags that of the repo rate.
    • Importantly, the cuts totaling 300 basis points in the repo rate are yet to fully reflect in the performance of the average money market fund. This means that money market returns will continue to fall from here.
  • The average money market fund return peaks where the repo rate peaks and bottoms where the repo rate bottoms.
    • We can therefore expect annualized money market fund returns to trend down towards the current repo rate of 3.5%.
  • Over the full period for which the SARB has implemented inflation targeting, the money market has delivered an average real return of 1.9%.

It is instructive to consider what happened in the period post the Global Financial Crisis (GFC), which introduced a lengthy period (approximately 5 years) of negative real returns for money market fund investors. Could it serve as a warning for the likely path of real money market fund returns? We think so.

Central bank action post the GFC and now again post COVID-19

To re-stimulate economies post the GFC, central banks around the world, including the SARB, anchored interest rates at record low levels. In the subsequent years, money market returns fell to levels where investors were guaranteed negative real returns, encompassing the first half of the last decade. This was because policy makers were more concerned about stimulating economic growth at the expense of wanting to contain inflation, which interestingly never materialised.

And now history is repeating itself. In response to the devastating consequences of COVID-19, Central banks around the world have once again responded by cutting interest rates to record lows (in some countries interest rates are at zero or negative). The Monetary Policy Committee (MPC) of the South African Reserve Bank has acted similarly, by announcing two 100 basis points cuts, a 50-basis point cut and a further 25-basis point cut in the repo rate in 2020. These actions have reduced the repo rate to 3.5%. They were also the first moves of more than 25 basis points by the MPC in many years, illustrating the seriousness with which they viewed this crisis.

Given what we have observed above, we can therefore expect the average money market fund return to trend towards 3.5%.

Deciding what matters most

This will mean that financial advisors and investors will need to look beyond the perceived safety of money market funds to deliver attractive real returns. I say “perceived safety” because cash will increasingly prove to be a poor investment in preserving the purchasing power of your money over the longer term. You will note from the chart below that over the last 10 years many components of inflation (electricity, health costs, education and petrol) have increased by more than the return achieved by the average money market fund. So, anyone invested in the average money market fund would have been spending a greater portion of their income on these necessities, which they would have had to subsidise from other sources (if possible) as their money market fund investment has not kept pace with these increases.

Figure 2: Hiding in cash does not protect you from inflation over the longer term

Hiding in cash does not protect you from inflation over the longer term

Source: Bloomberg, Morningstar to 31.12.20.

However, conservative investors will face a dilemma, as higher real returns will come at a price, including capital security and recommended investment term. Investors must therefore satisfy themselves that the trade-off is worthwhile.

The Ninety One Diversified Income Fund

Conservative investors with an investment time horizon of greater than one year need look no further than the Ninety One Diversified Income Fund (“the Fund”), where the portfolio managers have a far broader investment universe from which to choose, and so can diversify risk while potentially earning returns in excess of money market rates. Essentially the Fund seeks to generate real returns (participate) while managing downside risk (protect). To date the Fund has:

  • Provided a consistent total return in excess of cash/inflation over time, with some correlation to the bond market when the bond market outperforms cash, and little to negative correlation to the bond market when it underperforms. Since the Fund’s inception in 2008 it has outperformed the average money market fund by approximately 2% per annum
  • Avoided quarterly drawdowns and eliminated 6-monthly drawdowns completely. In what proved to be the most difficult quarter in many years, the Ninety One Diversified Income Fund was one of the very few flexible fixed income funds that delivered a positive return over the first quarter of 2020, further validating the Fund’s unique “participate and protect” structure

These characteristics of generating real returns while managing downside risk are illustrated in the following chart.

Figure 3: Defining what the Ninety One Diversified Income Fund is trying to do

Defining what the Ninety One Diversified Income Fund is trying to do

Source: Ninety One.

While our portfolio construction methodology treats risk and return equally, with market valuations where they are and the income on offer going forward, we anticipate that the fund will continue to deliver attractive returns relative to cash in 2021. In conclusion, the Fund’s defensive yield of around 6.25% with the potential for some capital uplift is attractive compared to cash rates of 3.5%, which will be no place to hide!

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Authored by

Paul Hutchinson
Sales Manager

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