The fund generated a return of 2.04% for the quarter and 8.45% over a rolling 12-month period, which is ahead of the 3-month STeFI benchmark return of 7.21%. The fund continues to produce strong returns against its benchmark over the long term.

The All Bond Index gained 1.11% in September. This strong performance showed gains across the curve, with longer-dated bonds of 12+ years performing best (+1.38%), followed by the belly of the curve (7 to 12 years) which performed almost as well (+0.79%). Short-dated bonds (1-3 years) were up 0.58%, and bonds maturing over 3- 7years gained 0.51%. Inflation-linkers (+1.07%) rose after a small gain in August. Cash returned 0.54%.

Political surprises, low inflation and central banks’ balance sheets dominated news flow this month. In Europe, Germany’s election -which was widely expected to yield an overwhelming victory for Angela Merkel and see a coalition between the CDU and SPD - saw a surprise increase in support for the populist right-wing party AfD. SPD withdrew as CDU coalition partner, and due to diminished support Ms Merkel now needs to form a new coalition. This is likely to take time. In Japan, Prime Minister Abe called snap elections for 22 October. His popularity has risen meaningfully in recent opinion polls, and he is running on a platform of increased spending on education, constitutional reform and a stronger leadership position in the face of ongoing missile threats from North Korea. An emerging opposition coalition could increase uncertainty, and bears watching.

Global economic data continue to suggest decent underlying momentum across developed and emerging economies, but inflation has remained lower than activity data might suggest. Indices tracking global GDP, like JP Morgan’s global manufacturing tracker, suggests global growth will be about 3.6% this year. In the US, GDP estimates for the second quarter were revised up slightly from 3.0% to 3.1%. Underlying data show emerging growth in capital expenditure on equipment, decent accumulation of inventories too, and an improved trade performance. Income and consumption data were a bit weaker, with nominal income growth at 0.1% month-onmonth (m/m) in August, and real growth falling as a result of rising inflation. The August payrolls report showed growth of 156K from 189K the month before, and the unemployment rate ticked up to 4.4% from 4.3% in July. The September hurricanes are expected to temporarily drag third-quarter GDP and employment numbers weaker, with the GDP figure currently tracking about 2.0%.

Inflation is still well below the Federal Reserve’s (Fed) target - although there are some tentative signs of an acceleration at headline level. Core personal consumption expenditures undershot consensus forecasts in August, rising just 0.1% m/m and moderating to 1.3% year-on-year (y/y) from 1.4% y/y. However, headline CPI was up 0.4% m/m, and 1.9% y/y, ahead of the consensus forecast, driven mostly by rising gasoline prices. Core inflation was a little higher on the month as some transitory disinflation (communication and medical costs) has moved out of the data. In September, the Fed announced the start of its balance sheet normalisation in October (somewhat earlier than the market expected), and signalled that it is still broadly on track to raise rates again in December.

Eurozone growth remains resilient, although a stronger euro could detract in the longer term. Gains in the Purchasing Managers Index (PMI) were healthy in September, after some weaker prints in July and August. With PMI levels now almost as high as the record peaks registered in April and May of this year, the outlook for euro area manufacturing is still good, and export-oriented new orders showed particular strength in September, despite the recently stronger currency. Importantly, the PMI data suggest tightening capacity, with backlogs lengthening, and signs of pipeline production prices rising. Elsewhere, euro area economic sentiment jumped to a 10- year high in September, reflecting good manufacturing sentiment as well as strong consumer sentiment with both current and future purchase intentions up, and employment intentions high across all sectors. Euro area unemployment was steady at 9.1% in August. The impact of the German election may dampen sentiment in coming months, but overall underlying growth momentum supports above-trend GDP growth for the region of about 2% in 2017.

Here again, inflation remains subdued. Flash estimates for headline inflation was 1.5% y/y in September - flat compared to the August print. Despite this, the European Central Bank (ECB) signalled in September that it expected to provide more detail about its plans to taper the current quantitative easing programme from the beginning of 2018 at their October meeting.

In Japan, following the very strong second-quarter GDP data of 4.0% quarter-onquarter (seasonally adjusted and annualised), business conditions remain good. The Tankan survey , Japan’s broadest business survey, showed that aggregate business conditions for the third quarter of this year were at their strongest levels since 1991, with strong external demand visibly boosting conditions for machinery and chemicals. The labour market is also showing signs of tightness, especially small and medium enterprise employment, but large firm hiring has lagged. This is holding back wage inflation which is still very low. Core CPI continues to deliver a sustained undershoot of its 2% target, but accelerated to 0.7% y/y in August.

Amongst its peers, the UK continues to fare poorly. Rising inflation is weighing on real income growth, and employment has stagnated. Ongoing concerns about the economic impact of Brexit and ongoing political uncertainty are likely to weigh on growth. A tricky combination of stubborn inflation pressure and weak growth has prompted the Bank of England to be much more hawkish, and the market expects the Monetary Policy Committee (MPC) to raise the base rate by 25bps in November.

In South Africa, uncertainty surrounding political outcomes at the ANC December electoral conference and the implications for policy going forward continue to dominate news flow. This, coupled with clear evidence of a meaningful deterioration in government finances is keeping confidence weak. Activity indicators so far in the third quarter of this year have been mixed - the PMI for September posted a modest recovery to 44.9 - still well below the breakeven level of 50 and bringing the thirdquarter average to 43.9 - well below the 47.6 achieved in the second quarter. Surprisingly, vehicle sales were strong again in September, up 7.0% y/y after a gain of 7.6% y/y in August. Trade data for August showed another solid surplus of R5.9bn, and ongoing support for the currency, while credit extension to the private sector was slightly stronger at 6.0% y/y (from 5.7%) as corporate lending picked up.

The good news was largely limited to inflation, which, despite rising fuel prices, remains broadly on a moderating course. August CPI rose to 4.8% y/y from 4.6%, owing to higher petrol prices, but the underlying data - including food inflation - were softer, and core inflation was just 4.3% y/y. Despite this, and contrary to consensus expectations, the SA Reserve Bank decided to leave the repo rate unchanged at 6.75% at the September MPC meeting.

In recent months, external influences have overwhelmingly benefited South African fixed-income assets - and also the rand - along with other emerging markets. Developments that destabilise these supportive influences could potentially leave South African bonds in a precarious position, given the weak domestic fundamentals. As such, a defensive stance and an emphasis on relative value propositions within fixed income portfolios remain appropriate.

Portfolio managers
Nishan Maharaj, Mauro Longano and Sinovuyo Ndaleni

The fund generated a return of 2.1% for the quarter ended June 2017 and 8.4% over a rolling 12-month period, which is ahead of the 3-month STeFI benchmark return of 7.25%.

The SA bond market enjoyed a relatively decent quarter as the All-Bond Index gained 1.5% for the three months to June 2017, slightly behind cash (1.9%) but well ahead of inflation-linked bonds (1%). In the year to date, bonds remain the star performer in the fixed income asset class, returning 4%, well ahead of cash (3.7%), inflation-linked bonds (0.4%) and even preference shares (2.3%), which have been the stand-out performer over the last 18 to 24 months. The strength in local bonds was in large part a function of the strong performance of emerging markets, with the JP Morgan EMBI Global Diversified composite (a proxy for emerging market bond performance in dollars) returning 2.2% in the second quarter, and 6.2% year to date. This has supported inflows into the local bond market of approximately R40 billion so far this year (R21.3 billion in the second quarter), which helped keep local bond yields relatively well-contained despite a deteriorating fundamental backdrop.

Over the last quarter, there have been some key developments on the local front. Firstly, inflation has continued to fall and the SARB has started to shift towards monetary easing as growth collapsed, and pushed SA into a technical recession. Much-needed policy reform remains hamstrung by accusations of endemic corruption at the core of government and stateowned companies, leaving policymakers in an even deeper state of paralysis. Confidence in the economy and in the ability of policymakers to make the right decisions has continued to decline, as seen in recent business and consumer confidence numbers. This creates a vicious cycle: there is no new private or corporate investment, further adding to the downside risks and dragging on the momentum in growth over the next year (and more importantly, over the longer term). The net effect is an economy with no buffer or ability to withstand any further bad news or deterioration in global risk sentiment. Credit worthiness will worsen due to deteriorating debt and fiscal metrics and, without serious policy action, the economy looks set for further downgrades into sub-investment grade over the next 12 months. This will not only be felt in the bond market, where index exclusion will trigger large outflows, but inevitably by the man on the street, who will be impacted by higher borrowing costs and possibly higher inflation over the longer term. Accordingly, local economic prospects remain quite dim. When we faced such poor prospects in the past, investors could take comfort in the fact that local asset prices were reflecting the same (if not a greater level) of pessimism. Being able to buy assets at a decent risk-adjusted discount could at least compensate for feelings of personal misery. Unfortunately, this is currently not the case, especially not in the local bond market, were yields have managed to remain quite stable at relatively expensive levels (an average of 8.65% average the last quarter, reaching a low point of 8.38%). The primary support for local yields is a reawakening in the global hunt for yield.

Given the local macro-economic backdrop, we remain cautious. We expect low growth and policy inaction to contribute to a worsening in SA’s fiscal and debt metrics, inevitably leading to further moves into sub-investment grade territory and index exclusion if we see no immediate policy reaction. The hunt for yield in emerging markets has diverted attention away from the deterioration in local fundamentals. But low global real rates may not last forever, and when the easy money stops flowing into the country, SA’s harsh reality will be exposed. The outlook for local credit markets remains equally precarious. As such, we continue to only invest in instruments which deliver an appropriate return for the underlying risk taken, while also considering the liquidity constraints of the fund.

Portfolio managers
Mark le Roux and Mauro Longano as at 30 June 2017

The fund generated a return of 2.0% for the quarter and 8.2% over a rolling 12-month period, which is ahead of the 3-month STeFI benchmark return of 7.2%.

The domestic bond market saw a moderate rally in March after a decent rise in February. The All Bond Index (ALBI) added 0.4% in March to the prior month's gains of 0.71%.
Mid-dated maturities performed best. Bonds with maturities of 3-7 years were up 0.8%, while those maturing in 1-3 years gained 0.7%. Longer-dated maturities of 12 years or longer were up 0.3% (after gaining 0.5% in the prior month).

Inflation-linked bonds fell 2.2%, after a flat February, while the return on cash (0.6%) was broadly in line with the prior month. Domestic economic indicators published during March were mixed. GDP data for the fourth quarter of 2016 showed that growth fell by 0.3% quarter on- quarter (seasonally adjusted and annualised) from 0.4%, but was up 0.3% y/y. For the year as a whole, the economy grew a paltry 0.3%. More positively, the SA Reserve Bank's (SARB) March Quarterly Bulletin showed a meaningful improvement in domestic terms of trade in the fourth quarter of 2016, which helped reduce the current account deficit to just 1.7% of GDP and to -3.3% of GDP for the calendar year. High-frequency activity data (including mining and manufacturing) and retail sales numbers for January were weaker than suggested by the forward-looking PMI prints. March PMI was 52.2, following a strong average for January and February of 51.7, seasonally adjusted. Despite this, manufacturing production grew just 0.8% year-on-year (y/y) in January, while mining output was up 1.3% y/y. Retail sales weakened sharply, contracting by 2.3% y/y. Inflation continued to moderate with headline CPI at 6.3% y/y in February, from 6.6% the month before, and core inflation surprising to the downside at 5.2% y/y off a high base. The SARB MPC met at the end of March and signaled that they 'may' be at the end of the hiking cycle. While the repo rate was left unchanged at 7%, one of the six-member MPC voted in favour of a rate cut.

Developed market macroeconomic data maintained strong momentum in March. Europe continues to be the best-performing region, the March European Commission economic sentiment survey came in at a six-year high, and the German Ifo Business Climate Index jumped this month. The aforementioned echoes the strong flash PMI readings and support upward revisions to the 2017 growth outlook for Europe, broadly at 2.5%. Given the positive growth dynamics, tightening labour markets and strong gains in headline inflation, the European Central Bank will be watching closely for signs of pressure on core inflation. March's core inflation surprised to the downside, but a sustained pace of activity could see it rise in coming months.

Activity data in the US were a little less robust. While first-quarter GDP data for the 2017 calendar year is tracking around 1% real growth (3.2% annualised) ? supported by 0.4% growth in consumption and better trade data - growth momentum is being dampened by a drag from inventories. High frequency data saw a moderation in vehicle sales in March, while housing data was broadly stronger. Consumer confidence however jumped 9.5 points to 125.6 - the highest level since the end of 2000. The March ISM Manufacturing Index remained strong, albeit slightly weaker than in February. At a level of 57.2, the data are consistent with further acceleration in factory output. The Federal Reserve raised the federal funds rate by 25bps to 50bps, as widely expected. The market interpreted the statement as leaning to dovish because the 'dot plot' remained unchanged, showing a central tendency for another two rate hikes this year and three in 2018. Politically, President Donald Trump's proposed revision to the healthcare bill was withdrawn after it failed to receive support from within the Republican Party. Government also risks a shutdown by the end of April if they fail to pass a new continuing resolution to adjust the debt ceiling, when the current one expires.
In the UK Prime Minister Theresa May triggered Article 50 on 29 March, officially starting the two-year negotiation period for the country to leave the European Union (EU). The remainder of the EU is expected to agree on a common position at a summit on April 29. The two sides are expected to begin formal negotiations in mid-May after the French election. Economic data from the UK remains solid, with a more expansionary Budget tabled in March, allowing for an increase in fiscal spending.

The stand-out event for domestic investors was the recall of finance minister Pravin Gordhan and his deputy, Mcebisi Jonas, from an investor road show in London on 27 March. This triggered a series of events which culminated in a Cabinet reshuffle by President Jacob Zuma on 30 March. As part of the reshuffle, the president replaced ten ministers, and ten deputy ministers, including Gordhan and Jonas. On 3 April, ratings agency Standard & Poor's downgraded South Africa's foreign currency rating from BBB- to BB+, below the investment grate limit, and retaining its negative outlook. Moody's Investor Services followed with a notification of its intention to downgrade pending further information. The political environment remains very fluid, with clear evidence of discontent both within the ANC, its alliance partners, and parts of society at large. That said, there is little evidence of impending change or an obvious path for recourse. The current stalemate may continue for some time, coupled with nervous and volatile markets.

Volatility and uncertainty in the markets continue to weigh-in on credit as an asset class. As such, we remain cautious and will only invest in instruments that offer an appropriate return for the underlying risk. The fund remains well-positioned in the current environment.

The fund generated a return of 2.06% for the quarter and 7.92% over a rolling 12- month period, which is ahead of the 3-month STeFI benchmark return of 7.05%.

The political earthquakes of 2016 have caused shock waves that will continue to reverberate across financial markets for much of the new year. Brexit and the election of Donald Trump as the new US president reflected a deep disdain and discontentment with the status quo among voters, who expressed their unhappiness with current regimes and policies. It was a stark reminder that eight years since the great financial crises, growth in many countries remained undesirably low, while income inequality has seen a marked increase. Locally, although the shock of Nenegate was behind us, the political landscape remained volatile.

Despite the volatile local and global backdrop, SA bonds managed to perform much better in 2016. This was primarily due to bonds starting the year at quite elevated yields. After starting at 9.71%, the local 10-year benchmark bond traded in a range of 9.83 to 8.40%, settling at 8.92% at year-end. The All Bond Index (ALBI) delivered a total return of 15.5% for 2016, far ahead of cash at 7.05% (Short- Term Fixed Interest Composite Index) and inflation-linked bonds at 6.05%. As one would expect, with 60% of the ALBI weighted towards the 12-year and longer range of the local bond curve, these bonds delivered the biggest contribution to overall performance with 17.5% compared to 10.1% for bonds over 1 to 3 years; 13.4% (3 to 7 years) and 15.4% (7 to 12 years). Key to note here was that despite the substantial capital appreciation of bonds from their low starting point at the start of the year, the bulk of returns still came from the yield they provided. The ALBI's return of 15.5% was composed of a 5.85% capital return (return due to an appreciation in bond prices) and a 9.65% interest return (return due to yield earned from the underlying bonds).

Over the medium to longer term, domestic inflation will continue to direct local bond yields, as will the pricing of country-specific risks and developments in the global yield environment. The performance of local bonds will therefore depend on whether current yields provide a sufficient margin of safety against adverse developments in any of these or other unforeseen events.

The outlook for local inflation has improved, primarily due to the deceleration in food inflation. Using a base case scenario, which includes an assumption of average food inflation of 3.4% for 2017 and 4% for 2018. Even if we shock our inflation forecasts by including a move in oil to $65 per barrel and a rand slump (to R15.5/$ in the first quarter of 2017), it is still difficult to see a sustained breach of the top end of the Reserve Bank's inflation band. In fact, inflation over 2017/2018 under our stressed scenario only averages 5.75%, compared to 5.45% under our base scenario.

The bottom line is that it is very hard, without a sustained shock to food inflation, to see the consumer price index (CPI) persistently above target over 2017/2018, with the risk very much skewed to the downside (indicated by the orange line in the graph). This is due to the abundant rainfall over much of SA during October to December 2016, as well as early indications that planning could increase by 15% in 2017 (measured even before the rainy period), providing a favourable environment for local bonds. Following on from this, it is very likely that we have seen the end of the interest rate hiking cycle in SA, with real policy rates expected to drift up to above 2% as inflation comes down next year. This will limit the SA Reserve Bank's ability to increase policy rates further and, if anything, shift expectations towards the start of a cutting cycle in late 2017 or 2018.

The local risk premium can be represented by two key measures: the SA credit default swap (CDS) spread, which measures the sovereign's riskiness as an issuer, and the spread between SA's 10-year bond yield and the US 10-year bond yield.

SA's current credit default swap (CDS) spread sits at a level of 209bps, which already prices it below investment grade. Our local budget deficit, although still wide, is projected to contract meaningfully over the next three years (by approximately 1.5%), which should reduce financing needs and costs. In addition, the weaker rand and the stable mining and manufacturing environment should also continue to promote a strong trade recovery, which should reduce our current account deficit back towards -3%. The reduction in budget and current account deficits indicates that our twin deficit problem will become more manageable over time. Our expectations of a favourable inflation outlook further implies an increase in household disposable income, thereby suggesting stronger local consumption and a more stable underpin for growth. These improvements, although by themselves not sufficient to avoid a downgrade to below investment grade, do suggest that the risks are definitely tilting towards a more positive outcome on the rating front, implying our CDS spread is somewhat too aggressively priced.

The spread between the SA 10-year government bond and the US 10-year government bond is representative of two factors, namely, the inflation differential between the two countries and the SA-specific risk premium: (SA 10- year bond yield - US 10-year bond yield) = (SA inflation expectations - US inflation expectations) + SA risk premium

Currently, the spread sits at 645bps, well above the long-term average of 525bps. But more important is its implication for SA's risk premium. The implied breakeven inflation rate for the US 10-year bond is 2%, in line with the US Federal Reserve's (Fed) target. Our expectation of average SA inflation over the next two years is 5.5%. Using these values and the formula above, the implied SA risk premium is 295bps, compared to current market pricing of 209bps. This suggests that the implied risk premium between the SA 10-year and the US 10-year bonds provides a decent buffer in terms of risk premium expectations, making local bonds particularly attractive on this basis.

One could argue that the elevated SA-specific risk premium is due to the volatile local political landscape. However, the major local events of 2016 such as the reappointment of Pravin Gordhan as finance minister, the public prosecutor's report on state capture, the ruling of the constitutional court against President Zuma, and the results of the local government elections suggest that political volatility is starting to near its end and the perceived risk premium is too high.

Global bond yields pushed higher after the shock result of the US election in November last year. However, to call this the start of a global bond bear market seems extreme. The prospects for European Union (EU) inflation and growth have improved, but the need for monetary policy accommodation will remain for some time as indicated by the extension of the EU quantitative easing programme. Even after the end of the programme, it will be a long time before base rates move materially above the zero level again, keeping bond yields anchored. German bond yields rose by 40bps from their lows last year but remain at 0.2% ? hardly a level that strikes fear into the heart of a SA government bondholder, who earns 9%! The Fed has a target on core inflation of 2% and on keeping unemployment below 6.5%. As history has shown, it is not likely that the Fed will allow inflation to spiral out of control, causing an inflation-driven yield sell-off. In addition, with steadily decreasing levels of productivity and effective floor in the unemployment rate due to gains in technology, US real rates will be required to remain relatively low when compared to history, around the 1% to 1.5% level. This puts the medium-term nominal rate on a US 10-year bond at around 3% to 3.5% (assuming the 2% inflation target is met and maintained). We have long argued that yields below 2% for the US long bond were too expensive and fair value was somewhere around 2.5% to 3.5% over the medium term. As such, we do not believe that this is the start of a multi-decade sell-off in US bonds but merely a move towards levels that are more reflective of the underlying fundamentals and risks.

The combination of a more favourable inflation outlook in SA (with risks to the downside), flat local policy rates, a SA risk premium that prices in a good deal of conservatism and a global bond environment that should remain relatively stable, suggests a more encouraging environment for SA government bonds. SA's 10- year and 20-year government bonds trade close to 9% and 9.6% respectively, which when taken against an inflation expectation of 5.5 to 6%, suggest a range of real returns of 2.8% to 3.9%. This is a very attractive level both from a historical and absolute perspective, enhancing the attractiveness of SA government bonds. The main risk to this outlook remains a resurgence in local political volatility that negatively influences the country's ability to implement policy effectively. While political uncertainty has forced a more tempered approach over the previous year as well as the very near term, we maintain a more positive and constructive view on medium to longer-term outcomes