The Money Market Fund returned 1.9% to the three months ending June, exceeding the Stefi 3-month benchmark which returned 1.76% over the same period. The annual return for the fund was 7.98%, compared to the 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 (3.74%), 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 Christine Fourie
as at 30 June 2017

The fund returned 1.9% for the quarter, exceeding the STeFI 3-month benchmark which returned 1.7% over the same period. The annual return for the fund was 7.9%, also ahead of the 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 the year ended with growth falling by 0.3% quarter-on-quarter (seasonally adjusted and annualised) from 0.4% in the prior quarter. 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.

The fund remains cautiously positioned given the current volatile environment and will only invest in instruments that offer an appropriate return for the underlying risk.

The fund generated a return of 1.97% for the quarter and 7.69% over a rolling 12-month period, which is ahead of the 3-month STeFI benchmark return of 7.05%.

The domestic bond market rallied in December after a weak performance in November. The All Bond Index (ALBI) almost fully reversed the prior month’s losses of 1.83% by rising 1.57% in December. Longer-dated maturities performed best. Bonds with a maturity of 12 years or longer were up 1.76% after losing 2.48% in the prior month, and compared to those with maturities of one to three years rising 0.78%. Inflation-linked bonds were down 0.51% (-1.09% in November), while the return on cash (0.58%) was in line with the prior month.

In the month after the US election, most global financial markets rallied on better than expected macro data, anticipation of stronger growth outcomes in the US and, consequently, on improved global growth prospects in 2017. US economic data have also been positive, backing the run in markets. After expanding at a rate of 3.2% in the third quarter of 2016, fourth-quarter GDP is tracking between 2.3% and 2.5%. Data published in December were broadly positive: December payrolls showed an increase of 156 000 on the month, unemployment came in at 4.7% and average hourly earnings rose by 0.4% compared to the prior month. Auto sales were up 3.1% in December - a new cyclical high - and construction spending rose 0.9% month-on-month (m/m). The US manufacturing ISM rose 1.5 points to 54.7, and the Markit PMI was up at 54.3 - a 21-month high. US inflation also ticked up, and US Treasury yields ended December about 5 basis points (bps) higher than where they started at 2.43%.

Reflecting a more buoyant economic environment - and improved prospects in 2017 - as well as rising inflation, the Federal Reserve (Fed) raised the funds rate another 25bps to a range of between 0.5% - 0.75% in mid-December. The accompanying statement concluded that the ''near-term risks to the economic outlook appear roughly balanced.'' Fed officials' forecasted pace of rate hikes from their ‘dot plot’ evolved higher in December, with the median dot for 2017 increased by one 25bp rate hike, to an expected three hikes in 2017. The 2018 and 2019 forecasts also moved higher, and point towards three rate hikes per year.

In Europe, politics remained the main focus of markets with the Italian referendum vote rejecting prime minister Matteo Renzi’s proposed Senate reform, which lead to his resignation in early December. The next big political event is the Dutch election in mid-March, and thereafter a number of key national elections in the major economies in Europe. On the European data front, December ended on a strong note with composite PMIs revised higher to 54.4pts, a five and a half year high consistent with GDP growth of over 2%. In line with the pickup in PMIs, the European Commission’s economic sentiment survey also rose to a multiyear high of 107.8 (from 106.6), with solid gains in manufacturing, construction, retail and services. Consumer confidence in Europe improved too. Despite these positive underpins, retail sales fell 0.4% m/m in November, after jumping 1.4% m/m in October. Euro area inflation jumped 0.5% m/m to 1.1% y/y in December as a result of higher food and energy prices. In line with the rise in US Treasuries, German Bund yields rose between November and December and remained broadly unchanged at the end of December at 0.2%. In early December, the European Central Bank (ECB) announced that it will scale back its monthly asset purchases from €80bn at present to €60bn as of April 2017 until December 2017. At first sight, this would have seemed to be a hawkish move, but ECB President Mario Draghi managed to package this decision with dovish commentary, by stressing that the ECB stands ready to increase/extend quantitative easing if needed and that tapering was not discussed and is "not in sight".

SA politics were markedly quieter in December than in November, and both the currency and local bonds strengthened. Activity data remained relatively weak, with retail sales contracting in October by 0.2% year-on-year (y/y), the weakest print in more than two years. October wholesale trade sales also fell 0.3% y/y and data on formal employment showed that government remains the only source of job creation in Q3-16. CPI inflation data for November showed headline CPI at 6.6% y/y, and core inflation at 5.7% - both in line with expectations, and at the peak in my forecast. CPI should moderate quite quickly in 2017, although retail fuel price hikes and annual medical tariff increases in February could see inflation rise briefly, and pose the risk of a stickier profile to CPI in coming months.

The MPC’s final meeting of 2016 took place in November, at which they left the repo rate unchanged at 7%. The tone of the statement - given global and local developments since their September meeting - was more hawkish and the governor pledged vigilance to the risk of rising inflation. We expect the repo rate to remain on hold in 2017, but inflation deceleration in the second half of the year could open the door for easing late in 2017.

Increased optimism about US growth and inflation has spurred a rise in core bond yields, dragging emerging market assets and currencies lower again in December. Valuations in many emerging markets, including SA, are as cheap (if not cheaper) than they were at the height of the 2013 taper tantrum crisis. The combination of cheap local valuations and expectations of lower inflation, sub-trend growth, unchanged monetary policy settings and a narrower current account deficit provides sufficient reason to be optimistic about SA bonds. While political uncertainty has forced a more tempered approach in the near term, we remain more positive and constructive on medium to longer-term outcomes.