Potential effects of COVID-19 on money market funds

Currently, Covid-19 has spread to over 104 countries with major economies such as Italy, Japan, South Korea, France, Spain, Australia, and the US reporting thousands of cases of the virus within their borders, and deaths. The first case of infection within Kenya’s borders was reported on the 13th of March 2019. 

The impact felt in the local financial market mirrors what has equally been witnessed in the global setting. The uncertainty brought about by the disease, more so with World Health Organization (WHO) declaring it a pandemic, has seen investors selling-off risky assets such as equities in favor of safe havens such as gold and US Treasuries.

What are the possible effects the pandemic might have on Money Market Funds especially on Kenya’s macroeconomic environment and fixed income market?

Kenya’s macroeconomy

Kenya’s 2020 GDP growth was projected to come within the range of 5.6% – 5.8% supported by expected improvements in private sector growth, anticipation for stable growth of the agricultural sector and public infrastructural investments to be driven by budgetary allocations in infrastructural projects. 

However, since the outbreak of the virus coupled with the invasion of locust in the country, key sectors such as the Agricultural sector have already taken a bad hit, and has resulted in severe implications for macroeconomic indicators in the country as highlighted below:

Fixed money income

Fixed Income markets are markets where securities such as certificates of deposits, corporate & government bonds and other money market instruments are traded. In light of the pandemic, what is its current situation? 

Interest rates; Around the globe, we have seen several central banks ease monetary policies to support the economy amid the negative macroeconomic effects. The table below shows how Central Banks of major global economies have moved to cut interest so far; 

Similar to the actions of other Central Banks, we expect the MPC to reduce the Central Bank Rate (CBR) by up to 100 basis points to 7.25% from 8.25% in a bid to boost the economy amid the uncertainty and supply chain shortages caused by the Coronavirus. 

However, we do not expect this to pass on to bank rates. The enactment of the Banking (Amendment) Act 2015 in September 2016, introducing interest rate controls, reduced the effectiveness of the monetary policy and made it difficult for the CBK to adjust the monetary policy rates in response to economic developments. Following the repeal of Section 33B of the Banking Act, the implementation of expansionary monetary policy continues to be difficult because with the tough and uncertain economic environment, banks find it even more difficult to price for risk at lower interest rates. In such an event, banks will also not increase their deposit rates. 

On this premise, we believe that a big part of the solution to broken supply chains, and the sharp fall in demand in industries acutely affected by the virus, is fiscal, and as such monetary policy might not be effective in injecting the requisite liquidity to the economy, owing to the fact that Banks are expected to take a cautious stance in lending due to the heightened likelihood of defaults and as such we do not foresee a decline in lending interest rates, and also do not expect an increase in deposit rates at banks.

We believe this is the main reason that has driven the Kenyan Government to take a rather unconventional type of quantitative easing by transferring Sh7.4b obtained from the demonetization exercise of the older series Sh1,000 notes from its General Reserve Fund to the Government Consolidated Fund in a bid to inject new money into the money supply,

Bond Yields; Over the last two weeks, the bond market recorded reduced activity with bonds worth Sh30.1b transacted, 13.8% lower compared to Sh34.9b registered in the previous two weeks before the first case of Coronavirus was recorded in the country. We attribute dampened activity to large players such as commercial banks preferring to hold excess liquidity in the current uncertain environment. This week, only the 1-year, 5-Year and 11-Year yields recorded price gains as their yields decline with the other bonds recording price losses as yields rose across the board. 

We expect the yields on government securities to remain stable despite the expected cut on the CBR, with a bias to an upward readjustment in the yield curve. We believe that in the absence of credit risk, the main feature associated with Government-issued securities, the value of the cash flows accrued to such investors becomes a function of their required return based on inflation expectations, which presents a risk of effectively eroding the purchasing power of such securities future cash flows. With the expectations of heightened inflationary pressures, we believe that investors will continue demanding higher yields to compensate for the inflation risk, which will possibly lead to higher yields. 

Bank Deposits;Despite the corona pandemic, liquidity in the money market has remained relatively favorable with the interbank rate averaging 4.2%, below the 4.3% average for the entire year so far. We believe favorable liquidity conditions will persist in the money markets, following the drive by the Government as well as the industry players to discourage cash transactions in the economy in favor of mobile money transactions, card payments, and internet banking to reduce the risk of transmission of Covid-19 via hard currency. This directive has also seen financial industry players waive costs associated with the transfer of money between their mobile wallets and bank accounts. However, given the prevailing environment and movement of funds away from the equities market, towards investor perceived safe havens such as bank deposits, government instruments and gold, we do not expect any changes in deposit rates, given that supplyof funds towards the banking sector will not be affected.

Impact of Covid-19 on asset classes of the Money Market Funds 

Money Market Funds are conservative funds designed to serve the needs of investors whose primary goal is capital preservation, and who are willing to accept a modest return on their investment portfolio in return for safety and liquidity. Therefore, to achieve this objective, Money Market Funds primarily invest in securities with short maturities and pose minimal investment risks such as fixed deposits, Government-issued securities, and commercial paper. As at December31 2019, the Money Market industry’s exposure to Cash and Fixed Deposit and Securities issued by the Government of Kenya stood at 31.2% and 55.7%, respectively, bringing the combined exposure to 86.8%. The table below highlights the Capital Markets Authority’s provisions for the above-mentioned asset classes, their investment limits, actual exposure as at December31 2019 and our expectations on the effects potent to them from the ongoing pandemic:

Based on the above-mentioned factors, we expect the yields on Money Market Funds to remain stable, with a likelihood of going higher. The table below highlights the yields of Money Market Funds in the market as published on 21st March 2020;

Money Market industry’s exposure to Securities issued by the Government of Kenya continues to be the highest coming in at 55.6%, as at the end of 2019. The expectations of stability in yields on government securities will provide an adequate buffer on the Money Market Funds effective annual yields. In the event that interest rates from Cash, Demand Deposits and Fixed Deposits decline, we expect to see a readjustment in the Money Market Funds portfolios to skew towards increased exposure in Government securities to abate any reinvestment risks (the possibility that an investor will be unable to reinvest cash flows at a rate comparable to their current rate of return).

Lastly, we believe that for Money Market Funds will remain stable with a bias to a slight increase upwards should rates on government securities increase, and, they will remain the most liquid of all mutual funds providing a short-term parking bay that earns higher income yields compared to deposits and savings accounts.

Further, with increased digitization and automation, liquidity is enhanced and an investor should receive their funds within 3 to 5 working days if they are withdrawing to their bank accounts, and immediate access to funds when withdrawing via M-Pesa.  

Also, as investors are fleeing to the Fixed Income market in light of current economic conditions, we believe that due to economies of scale, small investors are unable to do so. Money Market Funds allow such investors to re-align their investments with their risk appetites by pooling money together and investing in safe havens.  Also noting that historically markets have shown an ability to bounce back from events that sparked volatility, we are of the view that the coronavirus pandemic will be no exception. Thus, it is important that investors remain calm even in the face of uncertainty.  

-Cytonn Investment

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