The past quarter can only be termed as the bad news quarter, which came through in big waves, bringing with it higher price volatility and ever decreasing confidence. Compared to a year ago, there is not much to be happy about. But knowing that markets work in cycles and always bounce back, the current market presents a great buying opportunity for long-term investors.

We saw the repo rate being raised by a further 1% over the period (0.5% in April and June), taking it to 12%. Short term interest rates have more than doubled since the beginning of this interest rate cycle, with deposit rates now at 14% compared to 7% in 2006.

Eskom's price increase for this year of 27.5% was confirmed in June. When factored into inflation, the CPIX forecast peaks at over 12% - clearly a worrying figure. Once again, inflation is a cycle and the ten interest rate hikes to-date are designed to bring down inflation. Economists furthermore expect the decline in inflation to be aided by the 5-yearly re-weighting of the CPIX basket in January 2009.

The rand price of oil is up more than 100% from a year ago. The direct contribution to inflation from oil has been huge, which is quite clearly visible in the petrol price. But the indirect impact of higher oil prices is also notable, take for example the price of maize. Two important inputs into maize production are diesel and fertiliser, both oil by-products which are now causing a renewed surge in the maize price. It would appear that inflation and interest rates will deteriorate further before declining.

Money market rates have topped out but the FRA curve continues to price in a further 1% hike in interest rates (reflected in the 1 year NCD rate of 14%). The Coronation Money Market Fund has a small holding in the attractively priced 12 month NCD, but 23% exposure to floating rate investments which reset every 3 months and provide up to 0.5% additional yield over the reference rate, JIBAR. These act as an interest rate hedge. The fund has built up a holding in high yielding, short dated corporate paper issued by blue chip companies such as Anglo American, Toyota, SAB, Transnet and Aspen Pharmacare; companies which have recently started to tap short term funding in the domestic money market.

The Coronation Money Market Fund returned 2.8% for the second quarter and 10.70% for the last 12 months. The short duration of the portfolio (currently 80 days) has protected investors from the negative mark to market effect that rising interest rates have had on the bond market (All Bond Index lost 4.9% for the quarter) affording investors a level of capital protection not available from any other asset class.

Tania Miglietta
Portfolio Manager

There has been much turmoil in international money markets in the last few months. Worryingly, large banks and brokers have been under severe liquidity stress. Northern Rock - a UK mortgage lender went into liquidation and Bear Sterns - a well established large US broker was bailed out by JP Morgan. Both were casualties of the sub-prime fallout and the global credit crunch.

In this instance, SA banks are not exposed to the same credit woes as their international counterparts, largely because SA banks do not hold CDOs which were originated out of the subprime mortgage sector. However, SA banks are feeling the squeeze that higher domestic interest rates are putting on economic conditions and consumer demand. In recent months banks have been lending more to corporates than to the man in the street, but these loans still need to be funded. Liquidity is drying up - which is what happens when interest rates rise - and so the banking environment is getting tougher.

Money market rates are holding up in a market where ongoing repo rate hikes are still on the cards according to some economists. 3-month NCDs are at 11.30% and 12-month NCDs are at 12.20% - both very attractive yields. FRAs - which give investors a good idea of what the market is expecting for short term interest rates, are pricing in an 80% chance of another interest rate hike in April 2008. We are of the view that there is no need to further hike the repo rate as the past eight interest rate hikes are already working well. The fund has been accumulating money market investments at these very attractive yields for some time and we have been increasing duration to just over 80 days.

Looking forward, our analysis shows that we are very close to the peak in inflation, and hence in interest rates. Investors are reminded that inflation is a measure of rate of growth of prices, which means that existing high prices does not translate into ever higher inflation. Food prices appear to be topping out (the supply response domestically has been significant) although these are not yet falling. Oil remains an enigma and prices are likely to remain high as long as geopolitical tensions persist in the Middle East. However, electricity price increases are the real wildcard. If the regulator grants the latest increase requested by Eskom, we could see the inflation rate peaking in double digits to around 10.50% by July of this year. Evidence in the real economy suggests that a slowdown is underway. Retail sales and vehicle sales are coming under severe pressure and are expected to continue downwards as monetary policy changes take 12 to 18 months to have a full effect. The last four interest rate hikes in 2007 have yet to fully filter through and already the excessive consumer demand in the economy has shown signs of abating. It is acknowledged that the inflation target is currently in breach, but this is due to contributors which are not interest rate sensitive, such as oil and food. So would a further interest rate hike help to bring inflation down under these circumstances?

The interest rate hikes coupled with ongoing turmoil in global credit markets have resulted in severe strain being placed on the local securitization markets. Significant spread widening and lack of liquidity has prevailed. The Asset Backed Commercial Paper (ABCP) market is in an oversupplied position since a large unit trust fund, outside of its mandate, was forced to withdraw its holdings. Spreads have since widened to around JIBAR + 40 basis points - a level never seen before, and in our opinion attractive for a good quality, transparent AAA-rated ABCP instrument of up to 3-months to maturity. We have been investing in the ABACAS and Blue Titanium ABCP issues at these spreads for the Coronation Money Market Fund. Under these conditions, the time to pick up bargains is now as the point of maximum stress is reached.

Commercial paper (CP) issuance picked up this past quarter. Typical borrowers in this short term money market space are Sasol, SA Beer, Airports Co of SA, Development Bank of SA and more recently Netcare - all issued at an attractive spread over JIBAR.

The Coronation Money Market Fund had an effective annual yield of 11.26% at the end of the quarter. With call rates at 10.7%, this implies a significant yield pick-up with added diversification for the money market investor.

Tania Miglietta
Portfolio Manager

The SA bond market returned 0.9% for the quarter. This lacklustre performance should be seen in the light of more negative surprises on CPIX inflation; two interest rate hikes, an intensification of the credit crunch overseas, and a widening in emerging market spreads. Against that backdrop, the fact that bonds managed a positive return is actually not bad at all! The only really supportive factor was a decline in US bond yields, though that was largely a combination of flight-to-quality bids and fears about US growth, neither of which is particularly healthy for SA. The rand moved largely sideways over the quarter, with a brief spurt of strength in late October/early November proving unsustainable. The all-bond index underperformed both cash and inflation-linked bonds for the quarter and the year.

Each of the three CPIX inflation releases during the final quarter of the year surprised market forecasts on the upside, and the end result was that CPIX had moved up sharply from 6.3% in August to 7.9% in November. This is well above the upper limit of the SA Reserve Bank's (SARB) 3% - 6% target range. The December figure, to be released at the end of January, will almost certainly be well north of 8%. The fact that the driving factors behind the inflation rise remained food and energy added to the SARB's concerns about second-round effects, and the data most probably sealed the decision to raise the repo rate 50 basis points at each of the October and December MPC meetings. The repo rate has now increased by a total of 400 basis points in this cycle.

However, the news was not all bad from an inflation perspective, and indeed from a forward-looking standpoint there are clear signs of improvement. The rand has generally remained stable (not just over the quarter but throughout 2007) and the lagged effect of this will help dampen CPIX beyond the first quarter of 2008. Indeed, the stable rand has already had something of a positive impact on PPI, and unlike CPIX that has tended to surprise on the downside. PPI is a leading indicator of CPIX trends. Meanwhile, the SARB's other stated concern - consumer spending - has shown signs of a sharp slowdown in recent data, and it can only be a matter of time before this is reflected to an acceptable extent in the credit data.

The SARB continues to find itself in a tight spot, with no sign of pressure easing on food and fuel prices, but yet with all indications that more than enough pressure has been brought to bear on consumers. There must be a limit to the extent to which exogenous factors (and here we would include Eskom tariff increases) can drive monetary policy in the face of slumping consumer spending. It may be an opportune time to stick our necks out and say that it is likely time that the SARB will pause at the January MPC to see the effects of previous rate hikes - particularly if it is forward-looking.

The international backdrop will continue to be crucial. There are heightened concerns about growth in certain developed markets, particularly in the US. This could keep US bond yields low. However, if the credit crunch continues, risk aversion may stay relatively high and risky assets may stay under pressure. Capital flows into SA have been a key factor supporting the rand in the face of the wide current account deficit, and the rand could become vulnerable if sentiment towards emerging markets in general turns negative. This will remain a key risk this year. A positive side effect may be that concerns about growth should help alleviate some of the pressure recently seen on oil prices.

From a domestic perspective, the outlook is cloudier in the shorter term than the medium term. CPIX is expected to remain elevated in Q1, but should begin declining meaningfully from Q2 and should slip back inside the target range by Q3. Coupled with what we expect to be continued evidence of a consumer slowdown, this should provide space for interest rate reductions in the second half of this year. This more positive outlook for interest rates is again predicated on the assumption that any depreciation in the currency will be moderate, and is again held hostage to developments in oil and food prices. While the medium term outlook is basically positive, therefore, it remains fraught with risks and the SARB is likely to remain cautious.

The fund is positioned for the top of the interest rate cycle via a maximum holding in fixed rate NCDs, which we have continued to accumulate at attractive yields of between 10 and 11.4% p.a. We have actively participated in the growing commercial paper market introducing names such as Sasol, SAB, Development Bank of SA and ACSA into the portfolio. Credit spreads have widened considerably on the back of lower demand for credit (non bank) investments and liquidity drying up from higher interest rates. The credit spreads of 20 to 30 basis points over JIBAR for short dated investments now achievable, offer far better value, and correctly reflect current liquidity and credit risks, unlike 6 months ago.

Tania Miglietta
Portfolio Manager