The Alternatives in the Space of Cash and Cash Equivalents Continued

Interest rates in SA to be Cut Shortly

Over the past few months, our SA inflation has been drifting lower. We can all see this in our lower food and fuel prices, which are expected to drop even further next month.

For us in SA, we are due interest rate cuts, yet we have been waiting for the US to lower theirs first, as the risk is that if we are too early to do so, it could weaken the Rand, causing more inflation again.

Similarly, given the size of the US economy, many other countries worldwide have felt the same. Yet, delaying interest rate cuts too much can damage economies, and many other countries have recently come out believing they cannot wait any longer.

For example, the UK saw the Bank of England cut its interest rate by 0,25% for the first time in over 5 years a fortnight ago. And just yesterday Namibia cut theirs too by 0,25%.      

Old Mutual’s chief economist Johann Els on Monday commented;

“Interest rates: The relatively fast easing in headline inflation that I expect over the next few months could result in a 50bp rate cut at one of the two remaining MPC meetings this year.”

While my forecast—for now—remains a 25bp rate cut at both the September and November meetings (given the Reserve Bank's conservative and hawkish stance), the decline in inflation may be more pronounced than the Bank’s forecasts. This could potentially trigger a debate within the Reserve Bank about front-loading rate cuts.

My revised outlook on Fed rate cuts could serve as an additional catalyst, possibly leading the Reserve Bank to cut rates by 75 basis points total during the remainder of this year. While my forecast does not yet reflect a faster cutting cycle, the risks have started shifting in that direction.”

US CPI inflation This Week Lower in Line with Expectations

This week's latest US inflation data was largely in line with estimates and marginally below consensus, up 0,2% month-on-month. Or 2,9% year-on-year vs 3,2% consensus expectation, confirming the inflation rate in the US is decreasing. Core US inflation (CPI less food and energy) came in at 3,2%, in line with expectations;

Ninety One View on Interest Rate Cuts in SA

In turn, Ninety One released their forward view on interest rates in SA on Monday, which is largely in line with Old Mutual’s Johann Els, too;

What Noise to Expect in Coming Months | “Possible US Recession”

Lower inflation and Interest rate cuts are good for markets, both locally and abroad.

Interest rates, especially in the US and UK, have been very high for quite some time, and today, they remain at elevated levels.

Higher interest rates are designed to curb inflation, slowing down the economy.

This is with the proviso, though, that it is not overdone, as economies can then be forced into recession.   

Therefore, this raises the question of recession possibilities in the US or UK and after that in SA (?)  

According to Johann Els, “I do not believe that the US economy is heading toward a recession any time soon, but I do expect that the economy will experience substantially slower growth in the second half of 2024 and into 2025 compared to the robust growth during the first six months of this year.

I believe the Fed will not cut rates between meetings (i.e. before the scheduled September meeting), as that would likely be seen as a ‘panic’ move. But I expect the Fed to cut rates by 50 basis points in September, compared to previous expectations of 25 basis points. I expect a similar-sized rate cut in November, followed by 25 basis points in December. This would equal a total cut of 125 basis points for the remainder of the year.

In SA, available second-quarter economic data points to positive GDP growth, up from the -0.1% quarter-on-quarter decline in the first quarter. My initial forecast is a +0.4% growth for the second quarter. However, a substantial amount of data for June has not yet been released, and some sectors where high-frequency data is unavailable.

In addition to the likely positive growth for the April to June period, there is an increasing chance that first-quarter GDP growth data could be revised into positive territory. Revisions in mining and manufacturing production data have shown somewhat better growth in these sectors than previously reported”.

Planner Comment | “As Long as Recessions are Avoided, Lower Inflation and Interest rates are Good for Markets”

My comments here are, firstly, that “markets are gonna market.” Don't let periods of calm fool you; short-term volatility is a part of equity investing. However, if you take a longer-term view, you need to squint to see these episodes on a chart. Time is your friend.
 
Secondly, the big question remains whether the US economy will have a soft landing or a hard landing. The latter turns corrections into bear markets. I don't think there will be a hard landing, nor does our chief economist, but if there is, it won't be because financial conditions have tightened. They have eased.
 
Thirdly, interest rate cuts are coming. The US Fed may not necessarily ease as much as it is currently priced, but it remains a significant turning point. The global risk-free rate is about to fall, reducing pressure in all corners of the world.

Over the coming months, one can expect many press articles questioning a recession in the US as it slows. From our side, the US is growing 3% in the 2nd quarter this year and expecting 1,4% in the 3rd quarter - it’s an incredibly long way from here to get to negative (recessionary) growth.   

From our side, “in the final analysis, as long as recessions are avoided, which certainly appears intact - lower inflation and interest rates are good for markets”.

Lower US and SA inflation Gives Rise to a Stronger Rand

All other things being equal, lower SA inflation also means a stronger Rand, and Emerging Market currencies in general.

If you think back in the past, whenever inflation and SA interest rates have been higher, a stronger Rand has usually accompanied this, and vice versa.

Historically, lower inflation and interest rates mean a stronger Rand (and vice versa), and so yesterday, we saw the Rand break through the R18 to the $US level again.  

Income Funds as a Cash Solution

Maintaining a healthy cash reserve remains a key financial planning pillar.   

Where money market rates are just under 9% per annum at present, which has been attractive after last year’s interest rate hikes, however, we can all see that the current interest rate is going to drift lower shortly.  

Therefore, where excess cash is held, the investor should consider more equity (share) exposures (both locally and abroad).

However, most investors, including retired persons, will not have a fully equity-based portfolio. That bit of cash you always have access to in the form of a cash reserve remains a key financial planning pillar.   

For investors who wish to keep some cash and cash equivalents for a certain part of their portfolio, Income Funds remain a good, solid, reputable option with a strong track record.

The minimum investment size is usually very low, and liquidity is simply a few days being the time to sell and pay out the funds (usually 2-3 working days).    

What Do Income Funds Invest In?

These invest in money market and deposit accounts, together with short-term bonds, with an overall duration of no longer than 2 years (meaning far lower risk than a bond fund).   

Reasonable Return Expectations from Income Funds

Investors looking at Income Funds as a solution need to be prepared to accept some short-term volatility in seeking to achieve returns of 1%—2% per annum more than the traditional money market over rolling periods.   

It is acknowledged that more value will be added during a decreasing interest rate cycle than during an increasing one.

From the income fund specifically, in a soft increasing or flat interest rate cycle, an expectation is for the outperformance of closer to up to 1% per annum over and above money market rates is realistic.

In a decreasing interest rate cycle, this ought to be around 2% per annum. In the past this has been up to 3% more, depending on how far interest rates fall.    

2023 Return from Income Funds

Last year, the average money market return was 8,4% for the 2023 calendar year, where interest rates increased during the year.

Although Income Funds usually do not perform as well during interest rate hike cycles, most returned between 9,4% and 9,6% for the last calendar year, which is very pleasing in an interest rate hike cycle.  

By virtue of the longer duration in the shorter-term bond holdings, more outperformance to the traditional money market can be expected during interest rate decreasing cycles.   

Recent Past Results from Income Funds

I summarise the results of the leading Income Funds to the end of June:

*returns for the 3 years are annualised (per annum) returns.

The Prescient SA Income Provider Fund has the highest returns over 1 and 3 years because its bonds have a longer duration.

Each of these funds gained over 1% in July (after June).

Ninety One Diversified Income Fund Manager Video

Per this video link below, lead fund manager Malcolm Charles of the Ninety One Diversified Income Fund succinctly shares how his Fund has protected capital and achieved cash + inflation returns despite local and geopolitical volatility.

Our latest Portfolio Manager insights | Ninety One | South Africa

In the interview, Malcolm confirms that the yields on the assets held within the fund are 10,4% per annum.  

The fund manager's view, which we agree with, is that these funds are expected to deliver double-digit percentage returns for 2024 and 2025. The current yield of the fund’s assets supports this.  

Income Funds Are Not a Homogeneous Grouping

Importantly, Income Funds are not a homogenous grouping. Some Income Funds carry far more risk than others.

The Old Mutual Income Fund, for example, is the most conservative, and the latest fund fact sheet is in the 1st attachment here

https://drive.google.com/file/d/1tQeFBEYyElBKyXtDgM72yURC4p8ixoB7/view?usp=drive_link

I include the Prescient and Ninety One fund fact sheets per the 2^nd and 3^rd attachment, for the rounded view.   prescient-income-provider-fund-a2-january-2025-pipfa2.pdf and https://drive.google.com/file/d/1A2MMtefx4OlJ4Lz1lo6QkIZq6_Yo5ft5/view?usp=drive_link 

Stanlib, Prescient and Nedgroup are more “middle of the road” in terms of their risk rating within the Income Funds space. I have excluded the more risky options from my comparison.  

For investors who like this option (within the space of cash and cash equivalents) but wish to see a greater risk/reward relationship, the duration in pure Bond Funds is considerably higher (longer) but still conservative enough for longer-term holdings, in Living Annuities, for example.

These are the leading options for the investor who wants cash and cash equivalents but is open to a longer timeframe to manage any potential short-term downside risk from the bond content.

This week, Allan Gray who was previously always limited in this space, is launching two new funds to their fixed income offering – the Allan Gray Interest Fund and the Allan Gray Income Fund, which will be available for investment from 20 August 2024.

PWM Extra Interest Fund

In turn, at PWM, we launched our own Income Fund offering in October last year, designed to be a more defensive and secure Income Fund, where the main characteristics are:

Since its inception, we have neatly outperformed the Money Market with a fairly defensive Income Fund holding structure, that is our aim (to outperform the Money Market with the least possible investment risk) with this fund.

Past Performance Following Crises Events When Interest Rates are Cut

This graph, independently prepared by Marriott, shows how short SA bond blow-outs traditionally have been, that usually only last a few months before subsiding again, with good investment results that then follow;   

Of course, these extra high returns shouldn’t be seen as an expectation but rather as an indication of the upside potential that does exist. We have large events that are then followed by a cycle of interest rate cuts.

Prudential on SA Bonds | Are SA Bonds Still Attractive after the Recent Rally? 

After the good run from the bond market the past few months on our lower inflation data coming out in conjunction with our GNU following our election, and where most Income Funds have now returned over 10% the last year - the natural question is what are the prospects going forward from here?

Per the last attachment, the Mail and Guardian (previously called Prudential) share their views on why they remain bullish for local bonds;

“Equally, history suggests that the SA bond market typically delivered a return of around 13% p.a. over the next three years from a starting valuation such as this.

Even though it is possible for things to turn out very differently this time, judging by history alone, the valuation remains compelling”.

We share a rounded independent view from M&G, which is much in line with our thoughts, too, and where the Income Funds share in the Bond Market on the shorter side.

All these reputable solutions with solid track records are available via ourselves either directly or on the leading investment platforms for investors wanting some protection on their cash funds where interest rates are set to decline soon.

Peregrine High Growth vs 12 and 60-month fixed deposits

Another thing to keep in mind is that all these income funds, money markets and fixed deposits all attract income tax. The interest you earn here is taxed on your marginal tax rate which could be as high as 45%.

Alternatively, if you move up the risk scale ever so lightly and invest in the Peregrine Pure Hedge Fund more than 80% of your returns are capital of nature. This means that you only effectively pay 18% at the maximum tax rate vs 45%.

The Peregrine Pure Hedge has never had a negative return calendar year since its inception almost 30 years ago, so you are not taking much market risk for a great risk-adjusted return which is taxed favourably.

EG: if you invest R30 million in the best 12-month fixed deposit now at 9.57% and is on the 40% tax bracket you will get R1,589,760 growth on your money in one year after tax.

If you invested the same money in the best 60-month fixed deposit now at 11,14% and you’re in the 40% tax bracket you will get R11,489,950 growth after tax.

The Pure Hedge fund delivered 10,78% over the last 5 years. So keeping in mind that here you would only pay 16% capital gains tax on the growth of your money if you are on the 40% tax bracket, you would have received R834,127 more in a year after tax than in a 12-month fixed deposit (2,78% more in one year)

You would have received R3,430,082 more over 5 years after tax even though the growth rate was less than the fixed deposit purely because of the tax saving. The difference there is 11,43% over the 60 months.

If you have some cash lying around attracting too much tax let me know and I will take you through this scenario planning, more info here:

Friday Food for Thought