The fast view
- Globally, short-term interest rates appear to have peaked and investors are scrambling to accurately forecast the cutting cycles to ensure that they are correctly positioned.
- Historical data suggests that markets often underestimate both the duration and intensity of cutting cycles.
- While investing in call accounts and demand deposits helps investors benefit from high short-term rates, it doesn’t afford the opportunity like money market funds to partially ‘lock in’ and benefit from maintaining higher rates as short rates start to fall.
- South Africa’s steep yield curve has historically offered fixed income investors who are prepared to take more duration risk even better returns through the cutting cycle.
- Investors should understand their cash-flow needs and then segment their investments: invest in cash for their very short-term requirements and for money required at a later stage (from 3 to 12 months and beyond), consider alternative funds that take on marginally more risk to obtain a return above that of traditional money markets.
Globally, short-term interest rates appear to have peaked. While there are questions as to when and how far they will fall, investors everywhere are scrambling to accurately forecast the cutting cycles to ensure that they are correctly positioned to benefit from this. South Africa is no different. Our analysis of over 70 global interest cycles over the past 20+ years has taught us two things: firstly, the markets generally underestimate the hiking cycles, but also importantly, they underestimate the speed and magnitude of the cutting cycle.
As interest rates rise and peak, investors globally migrate into cash and money market funds to take advantage of the higher, lower-risk rates obtained at this point in the cycle. So, for example with Fed Funds in the United States at 5.25% since July last year, flows into money market funds have now exceeded a staggering US$6 trillion after a phenomenal surge of well over US$1 trillion in 2023.
While investing in call accounts and demand deposits helps investors benefit from high short-term rates, it doesn’t afford them the opportunity to partially ‘lock in’ and benefit from maintaining those higher rates as short rates start to fall. While liquidity and capital preservation are key requirements for many investors, the market does offer products that can completely or largely meet those objectives with the added benefit of earning a higher yield for longer.
Figure 1 shows the past two cutting cycles in South Africa, spanning two decades. While call rates move in tandem with the repo rate, money market funds on the other hand, with their ability to extend maturity while still maintaining daily liquidity, offer better yields and higher returns relative to call. For investors that have a slightly longer investment horizon and marginally more appetite for return, a move into STeFI-plus type products opens that yield gap further while still maintaining liquidity. They can also benefit modestly from capital appreciation as short-term yields fall.
Figure 1: Median money market manager yield versus repo rate
Source: Bloomberg, Alexander Forbes MM Survey, Ninety One calculations as at 30 April 2024.
South Africa’s steep yield curve has historically offered fixed income investors who are prepared to take more duration risk even better returns through the cutting cycle, with bond and income funds historically giving investors a healthy excess return over cash, more than compensating for the increased short-term volatility of returns.
Figure 2: All Bond Index performance versus STeFI performance in cutting cycles
Annual returns: 30 June 2003 - 30 April 2024
Cutting cycle 1: The Rise of China (2003-2006)
Cutting cycle 2: The GFC (2008-2022)
Cutting cycle 3: Covid Cuts (2020)
Source: Bloomberg, Ninety One, annual return calculations as at 30 April 2024
Currently, against the backdrop of a cautious Federal Reserve and a hawkish South African Reserve Bank (SARB), the South African market is only pricing in a very modest cutting cycle. Investors that take advantage of this now can help protect the yields that they earn well into a SARB cutting cycle.
So how should investors go about this?
Firstly, it is crucial to understand your cash-flow needs and then segment your investments accordingly. For example, identify how much cash you would need within the next three months, what your cash requirements are over three to 12 months, and finally, over the longer term beyond a year.
Investors are often too conservative, opting to put excess capital in cash, but if segmented appropriately, it could make sense only to invest in cash for their very short-term requirements (capital required within the next three months).
For money that is only required at a later stage (i.e. up to 12 months or beyond), investors could utilise alternative funds that take on marginally more risk in order to obtain a return above that of traditional money markets. These include fixed-income assets from the government, banks, as well as high-quality corporate debt.
Low-risk income funds like the Ninety One STeFI Plus Fund can offer returns up to a percentage point higher per annum than money market funds, while maintaining a focus on capital preservation.
Slightly further up the risk curve are funds like the Ninety One High Income and Diversified Income Funds. These funds aim to provide a higher level of income with greater diversification than traditional money market funds, while employing investment strategies to minimise volatility and risk. They have consistently delivered returns superior to money market funds without sacrificing liquidity.
The obvious benefit of investing in unit trust funds rather than buying the underlying fixed income assets directly is the diversification of assets and counterparties they provide, as well as the added skill of the manager in both asset allocation and credit decisions. The other significant benefit is daily liquidity – if an investor was to buy instruments such as corporate bonds and fixed deposits directly, liquidity would be compromised.
While unit trusts are very liquid and not ‘fixed’ or ‘locked in’ as fixed deposits or many other structured products are, it is important to remember that enhanced-return diversified-income funds, due to their underlying holdings, will display slightly higher levels of volatility than money market funds. Monthly returns would therefore not be as smooth as pure money market investments. While the rewards are there, it is prudent to ensure the investment horizon for the ‘enhanced cash’ portion of your investment is appropriate – typically six months or longer.
In conclusion, as the hiking cycle ends and the market starts to contemplate rate cuts, investors are presented with the ideal opportunity to lock in returns in excess of call rates on their cash.
