The global credit crisis and the failure and bailout of international household names have not only rocked financial markets, but have also shaken the confidence of the man in the street. This was vividly displayed at the end of the month when the US federal government felt the need to put forward a $700 billion package to bail out the ailing banking sector. At the first vote on the package, it was thrown out on the basis that the tax payer should not be bailing out Wall Street. During lobbying and changes to the package it was highlighted that if an amended package was not passed, the ramifications were so wide that it would be the man in the street that would be paying the price in not being able to run his business without credit lines from the banks, with the resultant loss of jobs. As we are all now aware, the amended package was passed by the US House of Representatives on Friday, 3 October.
At the heart of the problem is a massive crisis of confidence. There is huge uncertainty as to who the holders of the so called "toxic" sub- prime loans are. As a consequence, banks are not prepared to lend to each other and this has led to a liquidity crisis. To ease this situation, major central banks have made huge amounts of liquidity available to the financial system. Even this has not been enough and that is why the US has come up with this bailout plan. In essence the US government will be setting up an entity that will buy these "toxic" loans from the banks - the Troubled Asset Relief Program (TARP).

Local events were largely relegated to the sidelines, even though on the political front we were going through the most volatile period since 1994. We saw the recalling of President Mbeki and the appointment of President Motlanthe. The market did have a bit of a wobble when news of the resignation of Finance Minister Manuel broke. However, once he was re-appointed into the same position by the new President this blew over.

On the inflation front CPIX reached 13.6%, up from the previous month's 13% and higher than the expected 13.3%. PPI came out at 19.1%, marginally lower than the expected 19.2% but up from the previous month's 18.9%. Private sector credit extension growth came down from 19.8% to 18.6%, indicating that it was fast responding to the tighter monetary policy. Money supply growth (M3) also came down sharply over the month from 18.5% to 15.4%.

The Rand has borne the brunt of this market turmoil, depreciating from R$7.74 to R$8.28 over the month. Our sovereign risk spread has also taken a beating, widening from 244 basis points (bps) to 364 bps over the same period. Ironically, the US dollar has been the currency that has benefitted from the global uncertainty, appreciating from $1.46 to $1.41 to the Euro. The only bit of good news has been the decline in the oil price from $114.4 to $98.5 over the month, as expectations of a meaningful slowdown in global growth build.

Notwithstanding the rapid decline in the Rand, our bond market has remained very strong. Money market rates also showed strength over the month. The three-month NCD rate remained unchanged at 12%, and the 12-month NCD rate declined by 15 bps to 12.50%.

With inflation generally believed to have peaked, there is the expectation that we have seen the last of the interest rate hikes. The next move in the official interest rates is expected to be down, and this is forecast to happen some time during the 2nd quarter of 2009. The market tends to anticipate the official interest rates so we can expect rates to continue declining over the next few months. We therefore intend to continue investing in the higher longer term rates in as much as we can within the maximum maturity constraints of the portfolio mandate.

Much to the surprise of the majority of the market, the South African Reserve Bank (SARB) increased the repo rate at the June meeting of their Monetary Policy Committee (MPC) by only 50 basis points (bps), rather than the expected 100 bps. While inflation concerns were still very much in evidence, in mitigation the MPC for the first time made mention of the slowing economy, reflecting the impact of the interest rate hikes over the previous two years. The SARB made the point that the risks for inflation remained on the upside, particularly with the then pending NERSA decision on the electricity price increase still outstanding. As it transpired, the eventual outcome was that Eskom was given approval for a 27.5% increase this year and increases of between 20% and 25% over the next three years. The other area of major concern was the size of the current account deficit. This puts the Rand at risk, which could result in further inflationary pressures.

The inflation numbers that came out during the month once again surprised on the upside. While the CPIX was only marginally higher than expected, coming out at 10.9% versus the expected 10.8%, it was up from the previous month's 10.4%. The real shocker was the PPI number that came out at 16.4%, much higher than the expected 12.3% and up from the previous month's 12.4%. The main culprits remained the food and oil prices (the oil price increased from US$126.2 to US$141.4 over the month), but there is a general broadening and intensification of inflation pressures. The much spoken about and feared second round effects are now coming to the fore. CPIX is currently at a five and a half year high and our research suggests a peak of above 13% some time over the next few months and a subsequent decline to within the target band only by late 2010 or early 2011!

The impact of the hike in the repo rate and ongoing concerns of ever higher inflation had a very negative impact on the bond market. The R153 government bond maturing in 2010 rose by 22 bps to 11.75%, the R157 maturing in 2015 rose by 71 bps to 10.71% and the R186 maturing in 2026 rose by 56 bps to 10.48%. In contrast, money market rates actually declined over the month. This was as a result of the market having expected the SARB to hike the repo rate by 100 bps and only did so by 50 bps. As a consequence the three-month NCD rate declined by 20 bps to 12.30%, and the 12-month NCD rate declined by 10 bps to 13.80%.

Money market rates are still pricing in at least one further hike in the repo rate at the next MPC meeting due in August, and we would tend to agree with this outlook. While the inflation risks still remain on the upside, the consumer is being squeezed by not only the higher food and fuel prices, but also by interest rates. This is likely to dampen the SARB's enthusiasm for hikes in the repo rate beyond the August meeting. Going forward we are likely to be cautiously increasing the duration of the fund to start taking advantage of the higher rates of the longer term assets in the money market.

The US sub-prime crisis has continued to weigh very heavily, not only on the US but also on global markets. The uncertainty over the ultimate ownership of the sub-prime investments has led to a liquidity crunch, which has resulted in the US Federal Reserve (Fed) dropping their discount rate and broadening the range of assets that can be discounted with them. With housing prices in the US continuing to fall even in nominal terms, the growth prospects for that economy have continued to deteriorate. As a result, the Fed reduced their Fed funds rate by a further 25 bps during the month.

On the local front the environment has also continued to deteriorate. The Rand and oil price, and therefore the petrol price, have continued to put upward pressure on inflation. Eskom has added further fuel to this fire by requesting a 60% increase in its tariff. The Rand declined from R$7.94 to R$8.14 over the month. Since the beginning of the year the Rand has now fallen by 18.4%. Against the Euro the Rand has depreciated by 26.9% over the same period. This past month the oil price increased from US$100.52 to US$104.84. Since the beginning of the year the oil price has risen by 9.6%.

Inflation has continued to deteriorate, with the February CPIX number coming out at 9.4%, which was up from the previous month's 8.8%. It was, however, in line with market expectations. While inflation is expected to peak over the next month, the ongoing hikes in the petrol price and likelihood of substantial increases in the electricity price are going to keep inflation higher than may previously have been expected.

Over the month interest rates rose across the yield curve. The R153 government bond maturing in 2010 rose by 14 bps to 9.72%, the R157 maturing in 2015 rose by 24.5 bps to 9.23% and the R186 maturing 2026 rose by 30 bps to 9.095%. Money market rates also rose, with the threemonth NCD rate increasing by 5 bps to 11.30%, and the 12-month NCD rate by 15 bps to 12.25%.

With the current inflation rate so meaningfully above the Reserve Bank's inflation target, the risk of further hikes in the repo rate would normally be very high. Counterbalancing these inflationary forces, however, is a consumer sector that is under a lot of pressure from the 4% interest rate hikes that have been experienced over the past 17 months. Household debt as a percentage of disposable income is at historically high levels. The previous peak back in 1996 was at 61% and it is currently standing at 78%. Banks have been experiencing increasing levels of bad debts and further hikes in interest rates would only exacerbate the problem. We therefore remain of the view that the Reserve Bank will leave the repo rate unchanged at their next Monetary Policy Committee meeting.

As there is still a level of uncertainty over the next move on interest rates we have been accumulating cash over the past few weeks. Once the decision has been made we will move to increase the average term of the fund.

The global environment continued to dominate our markets over the past month. With the view that there was more bad news to come on the subprime front, the US Federal Reserve Bank surprised the market by cutting the US Fed Funds rate by 50bps, rather than the expected 25bps. This caused reverberations across world markets: equity markets soared (including South Africa) but developed market bond rates rose slightly on concerns of higher inflation on the back of the growth stimulus from the cut in the Fed Funds rate. The US 10-year government bond rate rose by 5bps over the month from 4.53% to 4.58%.

On the local front, the Rand strengthened from R$7.17 to R$6.90 over the month on the back of stronger commodity prices that rose as a result of the improved global growth outlook. Part of the Rand strength was as a result of US Dollar weakness, as it fell from Euro$1.36 to Euro$1.43 over the month. The Rand appreciated relative to the Pound but it did lose ground to the Euro, falling from REuro9.77 to REuro9.83.

Over the month, emerging market bond spreads narrowed from 2.23% to 2.01%, as did the South African sovereign spread, which narrowed from 1.30% to 1.15%. The local bond market also benefited from the stronger Rand, with the benchmark South African government bond rate, as represented by the R157 maturing in 2015, declining from 8.61% to 8.26%. The bond market was also supported by better than expected inflation numbers that came out during the month. The CPIX numbers came out very much in line with expectations at 6.3%, compared to the expected 6.2% and down from the previous month's 6.5%. The PPI numbers were quite a bit better than expected, coming out at 9.4% versus the expected 9.7% and down from the previous month's 10.3%. For the time being the market seems to have ignored the higher oil price, which rose from US$72.06 to US$81.09 over the month.

While there is some talk of credit extension slowing down on the back of the 300bps of interest rate hikes we have had in the lending rates and the impact of the National Credit Act, private sector credit extension still remains at very high levels. Money supply growth (M3) actually accelerated over the month from already very high levels.

Money market rates were a bit mixed over the month. The three- and sixmonth NCD rates increased from 10.10% to 10.13%, and 10.35% to 10.50%, respectively. The 12-month rate, on the other hand, has declined by 5 bps from 10.90% to 10.85%, which is more in line with the bond market.

Looking forward to the October Reserve Bank Monetary Policy meeting, we see an interesting debate coming up with the Reserve Bank officials having to weigh up the fact that inflation is likely to remain above the inflation target range for some time, as well as still very high levels of credit extension - although they do appear to be slowing - against a global backdrop where major central banks have already started cutting interest rates or have slowed down or stopped their increasing cycle. On balance we believe there is a slightly more than 50% probability that there will be a 50bp hike in the Repo rate. Our view would also be that that this is likely to be the last hike in the interest rate cycle. Some commentators are even beginning to talk about cuts in the rate during the second half of next year.

From a portfolio action point of view, the longer end of the money market curve is still compensating one for the risk of another hike in the Repo rate. We will therefore continue investing in that area of the curve.

In line with expectations, the South African Reserve Bank (SARB) hiked the official repo rate by 50 bps at the December meeting of their Monetary Policy Committee. This was as a result of the short-term outlook for inflation having deteriorated since their previous meeting and their concern that the balance of risks to their inflation outlook remained on the upside. They are also concerned about the outlook on the global economy, in particular the potential fall-out from the US sub-prime problems.

The local inflation numbers that came out during December were somewhat mixed. CPIX came out slightly higher than the expected 7.8%, at 7.9%, meaningfully up from the previous month's 7.3%. This was as a result of petrol price hikes and higher food prices. PPI, on the other hand, came out at 9.1%, much lower than the expected 9.7% and down from the previous month's 9.5%. What is concerning is that the oil price continued rising over December, from US$88.93 to US$95.70, after briefly touching US$100, which does not auger well for the petrol price going forward.

On the credit front, while anecdotal feedback would seem to indicate that credit demand has slowed down, the official credit extension numbers still remain very high, at a year-on-year growth rate of 22.6%. Money supply growth, as represented by M3, also remains high at 23.2%.

The global concerns mentioned above have resulted in fairly dramatic actions being taken by, in particular, the US Federal Reserve. They cut their Fed Funds rate by a further 25 bps during December. Since September they have now cut interest rates by a full 1%. With fears of a recession beginning to loom large there is pressure mounting for further extensive cuts going forward. While the Emerging Market Bond Index spread declined from 246 to 239 bps over the month, the South African sovereign spread increased from 149 to 164 bps. The US 10 year government bond yield also increased by 10 basis points to 4.03%.

The local bond market saw some normalisation of the yield curve as the shorter dated R153, maturing in 2010, declined by 12 bps to 9.37%, while the R157 bond, maturing in 2015, declined by only 1 bp to 8.50%. The long dated R186 bond, maturing in 2026, in fact increased by 2 bps to 8.11%.

On the back of the hike in the repo rate, money market rates rose across the curve. The three-month NCD rate increased by 20 bps to 11.20% and the 12- month NCD rate rose by 17 bps to 11.90%.

Looking forward, notwithstanding further upward pressure on inflation from the petrol price, we are of the view that we are likely to have seen the end of the interest rate hiking cycle. The combined impact of the National Credit Act, together with a total of a 4% increase in interest rates over the past 18 months, is certain to have had the effect of slowing the economy down. There is no expectation, however, in the short term that we are likely to see interest rates start declining, this is likely to emerge toward the end of the year.

Within the fund we are planning to take advantage of the higher long-term rates to the extent that we can, in anticipation of rates declining over the forthcoming year. As such we will extend the duration of the fund to the maximum allowable in the mandate over the next few months as investments mature.