After the South African Reserve Bank's Monetary Policy Committee's (MPC) unanimous vote to keep the Repo rate unchanged at 6.50% at its meeting in July, their split vote at the September meeting clearly highlighted the SARB's concerns on inflation. Three of the seven MPC members voted to hike the repo rate by 25 basis points at this meeting. The decision to keep the repo rate unchanged at 6.50% in September was however in line with market consensus. The depreciation in the Rand and higher oil prices led the MPC to believe that the risks to the inflation outlook are to the upside. Inflation forecast for 2019 was thus revised marginally higher to 5.70% from 5.60%, and inflation is expected to peak at 5.90% in the second quarter of 2019.

South Africa slipped into recession in the second quarter of the year, when the gross domestic product (GDP) contracted by 0.70% quarter on quarter on a seasonally and annualized basis following the 2.60% contraction in the first quarter of 2018. The Rand extended its slump, depreciating to its weakest level against the US Dollar in more than two years. The Rand slid to a high of 15.69 against the Dollar as concerns rose around South Africa's risk of a ratings downgrade in June by Moody's following the weak economic growth outlook. The Rand experienced substantial volatility, with a marked depreciation in the third quarter leading to concerns that inflation pressures would build, and lead to an interest rate hike later this year.

The Money Market yield curve steepened and bond yields rose over the quarter as the market moved to discount a probability of a rate hike by the end of the year. The recent disappointing growth data along with the depreciation of the Rand could put further pressure on South Africa's sovereign rating. The forward rate market (FRA curve) has discounted a 60% possibility of a 25 basis point hike in November.

The weighted average duration on the Income Enhancer Fund is kept relatively close to the maximum permitted weighted average duration.

Concerns about a rapidly increasing trade war between China and the United States dampened the global appetite for emerging market assets. A more fiscally expansive United States administration also persuaded investors to take a more cautious stance. Developed markets migration towards more restrictive monetary policy regimes has become the global economic order owing to rising inflationary pressures.

Foreign investors were large sellers of local bonds over the second quarter. Non-resident sales increased around the benchmark area of the yield curve, with the spread between the R186 and shorter R207 marginally increasing from 121 bps to 132 bps. The R186 yield peaked at around 9.2% during the second quarter and ended at 8.8% from an 8.0% low at the end of the first quarter.

The second quarter increase in the demand for cash securities came on the back of rising market volatility levels. The Forward Rate Agreement (FRA) market is currently pricing in at least one rate hike before the end of the year. Should inflation continue surprising to the downside, a hike is more likely to be deferred to the following year.

The price of Brent Crude oil increased by approximately 13% over the second quarter, moving from $70 to $79 per barrel. Combined with a rand depreciation of around 16% we can expect more cost push inflation in the coming quarters. Recent improvements in real wages as well as rising consumer confidence figures are also yet to resuscitate the presently muted demand pull factors.

1st quarter SA GDP figures surprised to the downside at -2.2% QoQ as the agricultural sector gave back some of its previous gains. Private consumption expenditure also continued to moderate as the tailwind from lower food prices waned. Unemployment figures remained stubbornly above 25%.

We currently look towards the H2 MPC policy announcements to provide further policy guidance on the balance of inflationary risks and the outlook for domestic growth.

The All Bond Index increased by 2.2% over the 4th quarter. The respective total returns were: 1-3 year +2.0%, 3-7 year +1.9%, 7-12 year +2.0% and 12+ years 2.3%.

Inflation linked bonds returned 1.0% over the quarter, while cash earned 1.8%.

The Federal Reserve Bank followed through on guidance, hiking the repo rate 25 basis points at Decembers meeting while maintaining the forecast of a further three 25 basis point hikes in 2018. The Fed chair Janet Yellen announced she would be leaving the Federal Reserve Bank after her successor is sworn in. Jerome Powell who will take over in 2018 is expected to largely continue with current policy and guidance. US 10 year bond yields traded in a narrow 2.3% - 2.5% range over the quarter ending the year at 2.4%. The European Central Bank kept its policy rates unchanged at both Q4 monetary policy meetings and confirmed that stimulus through monthly asset purchases would remain until at least September 2018. European growth has been improving however inflation is only expected to return to its target in 2020.

The oil price continued to rise by around $10 per barrel to $66 by year end.

For domestic fixed income markets the October Medium Term Budget Policy Statement (MTBPS) delivered a harsh yet realistic assessment of the domestic economy. With R210bn of revenue shortfalls and a budget deficit of 4.3% of GDP this year, severe steps are required to address the weakness at next year’s budget as gross government debt to GDP is expected to reach 60%. Ratings agencies assessed the budget as a significant departure from the path of fiscal consolidation, causing S&P to downgrade South Africa’s Long term local and foreign currency ratings, now both at sub-investment grade. Moody’s has placed their rating under review and this should be resolved after the February 2018 budget. A downgrade from Moody’s to sub investment grade will result in forced selling of government bonds as South Africa will be removed from the Citibank World Government Bond Index (+/- R100 billion of bond consideration).

The December ANC elective conference concluded a year of extreme South African political volatility in South Africa, with Cyril Ramaphosa elected party president. Domestic fixed income and the currency responded favourably to this outcome.

The MPC met only once over the 4th quarter (November) and unanimously left rates on hold. Interestingly the SARB has enhanced monetary policy guidance to some extent by the more prominent reference to its quarterly projection model (QPM) which is a more rule based economic forecast model and which currently guides to 75 basis points of hikes over the two year forecast period (based on current assumptions). Nersa approved only a 5.23% tariff hike to Eskom against the MPC assumption of 8%.

3rd quarter SA GDP figures surprised, printing 2% growth (against an expectation of 1.5%) QoQ SA annualised.

The Bond fund maintained a tactically defensive position over the quarter given the potential for intense volatility surrounding political, fiscal and ratings risks over the quarter. The fund will continue to adjust its duration and exposure as required over the year ahead.