Portfolio Pointers: How low can SA interest rates go, and what can investors do about it?
By David Crosoer and Professor Prieur du Plessis
JOHANNESBURG - The South African Reserve Bank (SARB) has almost halved the repo rate to 3.5percent this year.
This matters to savers, because investors seeking cash-like returns effectively lend money to banks and other entities in anticipation of a return linked to the expected path of the repo rate.
Consequently, investors in money-market unit trusts have seen their expected return almost halve.
Should such investors now assume the worst is over, and short-term interest rates will soon return to levels they previously were used to? Or is this the new normal and are further interest rate cuts still possible?
Until quite recently, South Africans experienced cash returns well in excess of local inflation as the SARB tried to entrench its inflation-beating credentials to reduce the overall cost of government funding. For example, according to Morningstar, last year investors in money market unit trusts, on average, received interest from their investments well in excess of 7percent for the calendar year in comparison to an annual inflation rate of about 4percent.
Today, however, interest rates are as low as they were in the mid-1960s, and investors are now finding cash returns offer scant compensation for inflation. At the same time, the cost of government borrowing, especially at longer maturities, remains elevated, given investor concern about the sustainability of government debt and the lack of meaningful reforms.
How extreme things have become is illustrated in the accompanying chart that shows changes in the inflation rate and repo rate over the past five years, plus the cost of government borrowing over a 30-year term.
Clearly, neither the previous interest rate policy of the SARB, nor the subsequent slashing of short-term interest rates has impacted positively on the cost of longer-term government funding, where investors are potentially receiving considerable compensation for inflation risk, if they are willing to lend money to the government over an extended time period.
In contrast, today there is almost no difference between the short-term interest rate and the inflation rate, and investors in shorter-dated fixed instruments are unlikely to receive compensation much above existing inflation.
According to the most recent statistics from the Association for Savings and Investment South Africa, close to two-thirds of investments in interest-bearing funds, which account for 30percent of all investments in collective investment schemes were invested in cash-like instruments with a maturity of one year or less as at the end of June.
Similarly, with some notable exceptions, close to half of all investment in collective investment schemes were with managers with more flexible asset allocation mandates that in aggregate remain relatively cautious in purchasing fixed-interest instruments of longer maturity funded by the government, despite the return on offer. Likewise, many of these managers remain underweight inflation-linked bonds given their expectation that South African inflation is unlikely to surprise on the upside anytime soon.
Market expectations today are that short-term interest rates will remain unchanged for the next year. If the market is right, investors should expect an annualised return of about 4percent from money-market investments. In the light on this, should investors not look to take advantage of the steep yield curve on offer, and the lack of market conviction that South Africa’s longer-term funding costs will in fact fall?
Such decisions may best be left to a portfolio manager that is given a mandate with sufficient discretion to implement such a view. In assessing this decision, though, it is worth pointing out that South Africa is relatively early on this journey of lower interest rates, and it has not yet positively impacted on the price of most other South Africa assets that continue to be dogged by poor investor sentiment.
In contrast, in many other countries, exceptionally low short-term interest rates have already remained for multiple years, and (more importantly) are expected to remain so for the considerably future. This means these countries face abnormally low borrowing costs across all maturities and not just at the shorter end, as well as inflated prices across multiple asset classes.
No-one yet knows whether South Africa will resolve its funding issues, or the global economy its abnormally low interest rates and extensive indebtedness. The SARB might be forced to raise short-term interest rates should confidence in South Africa deteriorate further. But globally there is clearly the intention to keep interest rates abnormally low for as long as necessary to generate some unexpected inflation and some persistent economic recovery.
In a sense, South African cash investors are forewarned. Global investors who remained in cash over the past decade have had a difficult time as interest rates have been deliberately suppressed. Is something similar happening here?
In the light of this, it may well be worth considering the extent to which your unit trust portfolio can tolerate an extended period of abnormally lower interest rates, and possibly higher inflation, should you currently be invested in predominately money-market instruments.
The collective investment scheme industry offers various options that may be more appropriate, depending on the kind of risks investors are trying to manage. Investors in single strategies, even conservative ones, are sometimes far less diversified than they realised, and exposed to risks they may not understand.
David Crosoer and Professor Prieur du Plessis are the chief investment officer of PPS Investments and the chairperson of PPS Multi-Managers, respectively. Email [email protected]