The fixed interest market has reversed its losing streak of the previous few months in September, and recorded its first positive month since May of this year. The All Bond Index (ALBI) rose 3.90% in September, beating cash (+0.43%) and inflation-linked bonds (+2.91%). Long-dated bonds were the better performing area of the curve, running well ahead of the short end. Vanilla bonds were the superior performers for the quarter, returning 1.9%, compared to cash (+1.3%) and inflation linkers (+1.2%). This latest uptick improved the longer-term performance of vanilla bonds; however, the ALBI is still lagging inflation linkers and cash over a 12-month period. In line with the trend of the past few months, the local bond market took its cue from developments around quantitative easing (QE) in the US, and its expected scaling back in the near future. After much talk of QE tapering since May, the market had largely expected that it would be announced at the September meeting of the US Federal Reserve (Fed). However, the Fed's decision to not start tapering prompted a rally in US Treasuries as well as in emerging market currencies and bond markets (including South Africa). Compared to the levels of US Treasuries before the Fed's initial tapering announcement in May, the US bond market still sold off aggressively; QE may not have been scaled back at the September meeting, but its reduction is still expected at some point down the road. Further to the delay in action by the Fed, gridlock in Washington DC returned as a focal point in the markets. The US government has (at the time of writing) gone into shutdown, as Republicans and Democrats failed to find common ground to pass a budget for the upcoming fiscal year. Implications for US growth stemming from this development risks having QE remain in place for some time still, possibly delaying the normalisation in yields across global bond markets. Against this backdrop, the rand rallied against the US dollar during the month, gaining about 25 cents to end September at R10.03/$. However, the currency still weakened overall from the end of the second quarter (R9.87/$). Foreign buyers returned to the local bond market, buying almost R12 billion worth of South African bonds during September. Net foreign buying amounted to R14.8 billion in the third quarter - a recovery from the net selling in the second quarter during which R5.8 billion worth of bonds were sold. While the market has gyrated amidst the fanfare surrounding the prospects of QE tapering and its subsequent non-delivery at the September meeting, local fundamentals have either remained stuck in poor territory or worsened. The current account print for the second quarter registered 6.5% of GDP (from 5.8% in the first quarter). Furthermore, the trade deficit remained wide in the first two months of the third quarter; making prospects for the third quarter current account number look bleak. This should continue to keep the rand under pressure, especially as South Africa has one of the widest current account deficits among emerging markets. Meanwhile, GDP is poised to remain soft this year and does not bode well for fiscal revenues. Against fiscal expenditure that remains sticky, prospects for the fiscal deficit are not promising. The latest monthly prints for the fiscal balance remain worrying. The upcoming Medium Term Budget Policy Statement (MTBPS) in October will likely reveal some deterioration in the fiscal metrics, implying that National Treasury's funding requirement will continue to be under pressure. Amidst the deterioration in the twin deficits, consumer inflation (CPI) rose during the third quarter. In July, CPI breached the upper end of the South African Reserve Bank's (SARB) target band, printing 6.3% year-on-year, and rose further to 6.4% in August. The SARB expects this inflation breach to be limited to the third quarter, but has increasingly struck a hawkish tone in response to inflation expectations lying at the upper end of the target band. The SARB has emphasised that it sees inflation risks biased to the upside and will react appropriately should the inflation outlook deteriorate further. We expect CPI to be around or over 6% for much of the next year and agree that risks remain tilted to the upside. With inflation ticking higher (leading to lower real interest rates), and with the generally weaker rand, the SARB's monetary policy stance is becoming more accommodative. While the market is pricing in some normalisation in policy - about 150 basis points of interest rate hikes are reflected in the FRA curve to the end of 2014 - the start of this policy normalisation is difficult to anticipate, especially in an environment where QE might still be in place for longer than expected. However, the SARB's recent statements provide some comfort that monetary policy will react appropriately if inflation outcomes increasingly print above 6%. In this muddied environment, with uncertainty around the end of QE (or the return of sustainable US growth), global factors are likely to continue to drive market direction. However, the market is not oblivious to the state of local fundamentals in emerging markets, as was highlighted by the August sell-off in emerging market currencies and bond markets with worrisome fiscal and/or balance of payments metrics (the 'fragile five'). Given that South Africa is part of this grouping, we remain cautious of a further sell-off, though the scale will likely not be as extreme as the rout seen in the second quarter. After lying in expensive territory for some time, local bonds have weakened aggressively in the second and third quarters of 2013. While current bond yields are closer to fair value than at the beginning of the year, there is probably room for further weakness. Fundamentals are still poor, and the market remains vulnerable to global risk sentiment. What is more certain is that the eye-watering bond market returns of the cheap money era are behind us. The rising liquidity tide is no longer lifting all boats and South Africa's poor fundamentals in an emerging market context leave our bond market among the more exposed.

Bonds continued to sell off during June, which resulted in negative returns for both the month and quarter. The All Bond Index (ALBI) lost 1.5% in June and 2.3% over the quarter, while inflation-linked bonds (ILBs) were more negatively affected because of their high duration and lost 5.47% in June and 4.9% for the quarter. Cash returned 0.43% in June and 1.3% for the quarter. The further bond sell-off in June took place despite some stabilisation in the rand over the month (around the R/$ 10 level). The bond market weakness came against the background of a rise in global bond yields. US 10-year treasury yields rose sharply from 2.17% to 2.49% over the month as the market's concern over the potential withdrawal of support from the US Federal Reserve (the Fed) became clear. The anxiety extended to emerging markets, which saw some significant redemptions by foreigners. This was also the case in South Africa, where foreign sales in June totalled R10.6 billion (following a R3.7 billion net outflow in May). This resulted in the first quarterly net outflow being recorded since the first quarter of 2011. ILBs were particularly hard hit during June. With the rand remaining weak (albeit stabilising) in June and the South African Reserve Bank (SARB) stating late in the month that it would not act pre-emptively against inflation, it is hard to fathom that complacency about South Africa's inflation was the primary reason behind the poor performance in domestic ILBs. Rather, we think a significant part of the move was due to the global back-up in real yields, and the chart below shows how South African real yields have recently moved in tandem with US real yields. With breakeven inflation being below 6% in the belly of the curve, implying that the market is too optimistic on inflation compared to our expectations, we think that ILBs continue to offer value and thus would not be sellers at current levels. We'd note that despite the sharp fall in June leading to its underperformance year to date (as per the table above), ILBs still show significant outperformance on a 12-month basis versus both nominal bonds and cash. It's worth delving a bit deeper into SARB governor Gill Marcus's speech of 26 June. Specifically, we note the comments that indicate that the bank is already more tolerant of inflation at the upper end of the target range because of the growth background, and that there are increasingly strong upside risks to the inflation outlook (because of the rand). But more importantly, we would highlight the comments that current inflation (and the SARB's forecast) constrain accommodation but do not 'automatically' imply a tightening of the monetary stance, and that the SARB will not be 'unnecessarily pre-emptive' - the latter comment coming after the speech notes "there is of course always the danger that we are 'behind the curve'". While we can sympathise with the SARB's unwillingness to tighten policy against the growth background, we think there are a few points that need to be made. The first is that as inflation rises, policy is already becoming more accommodative as real interest rates fall - in other words, if the SARB leaves the policy rate unchanged against rising inflation, it is in fact easing (not maintaining) policy. Secondly, inflation expectations (as per the Bureau for Economic Research survey) are nudging up, now between 6% - 6.1% for the next few years. If history is anything to go by, these will rise as inflation itself does. Thirdly, and possibly most importantly, is the clear implication that the SARB is more willing to make a policy error that results in higher inflation than one that results in lower growth (even though interest rates are not the factor inhibiting growth at present). Again, while we have sympathy with the SARB's dilemma and understand that it does not want to jeopardise a fragile growth situation, it would be remiss of a bond investor to ignore the implications of the central bank not doing anything to pre-empt inflationary pressures. So apart from the underlying pressures on inflation from the currency and wages, we also have a central bank stance that will (at least initially) underpin rather than offset such pressures. Against this background, and with the added factor of break-evens showing value even at current levels, we strongly believe an overweight in ILBs remains the correct positioning. Needless to say, the depreciation in the rand has underscored our expectation that inflation will breach the SARB's target this year, and the risks remain clearly skewed to the upside - how much will depend on where the rand settles of course, but the inflation picture remains murky with a weaker rand and pressure on wages the main concerns. We do not see inflation falling comfortably within the target until the fourth quarter of 2014 at the earliest. The nominal bond curve underwent a large degree of 'bear flattening' during the months of May and June. This was in large part led by a repricing of rate expectations in the front end of the curve. Market expectations moved from expecting an interest rate cut to expecting two interest hikes by the fourth quarter of this year before stabilising around expectations of a single hike by the end of 2013. The discount required to hold longer dated bonds given South Africa's deteriorating fiscal backdrop has been considerably reduced. This suggests to us that the longer end of the bond curve remains vulnerable to further weakening in coming months as the effects of higher global rates and the prospects of a withdrawal of stimulus from the US Fed continues to reverberate through global markets. We have been cautioning for some time that global bond markets were overvalued and that the rand was vulnerable, being buoyed by liquidity related flows in the face of weak domestic fundamentals (including the twin deficits and the socio-political situation). While markets never move in a straight line, we believe that interest rates probably have further to sell off. The timing of this will probably be related to that of further weakness in global (especially US) bonds, and to local inflation data confirming that a higher-for-longer trend is likely. Sentiment may well keep the currency relatively weak, especially against a backdrop where the current account deficit remains wide and general sentiment towards emerging markets and commodity currencies appears to have turned. Under the combination of current domestic and global factors, we certainly expect the rand to remain relatively volatile. We remain defensively positioned in our bond funds.
Portfolio manager
Mark le Roux

The All Bond Index (ALBI) eked out a 0.24% return in March, bringing its return for the first quarter of 2013 to 1%. Inflationlinked bonds (ILBs) produced a better return of 1.57% in March and 1.84% for the quarter. While ILB returns were ahead of cash for the quarter, the ALBI lagged the cash return of 1.3% over this period. Over longer time periods, ILBs remain the best performer in the South African fixed interest universe . South African bonds were quite resilient in a quarter that was filled with mostly bad news for the bond market. As will be discussed later in this commentary, the market has been supported by continued foreign inflows. Local fundamentals, on the other hand, presented a background of overall negative news flow. The rand had a significantly weaker tone over the quarter. It ended the 2012 calendar year at R/$ 8.40, and weakened to a worst level of around R/$ 9.32 during March 2013 before recovering slightly to close the quarter at R/$ 9.23. It also fared poorly on a trade-weighted basis, depreciating by 5.7% over the quarter, although somewhat better than against the US dollar; only because of the weaker euro. A trend of a stronger dollar/weaker euro in the first quarter of 2013 (partly as eurozone fears were revived when Cyprus faced a bailout crisis) did not help the currency. The main reason for rand weakness, however, must lie with the trade/current account deficit. The current account deficit was 6.3% of GDP in 2012, having reached a level of 6.8% and 6.5% in the third and fourth quarter of the calendar year respectively. The slight narrowing of the gap is not very comforting considering the size of the deficit. Trade data releases early in 2013 continued to show sizeable deficits, with January recording a record monthly trade deficit in both rand and US dollar terms, and February recording the largest deficit on record for that particular month. While the current account may be past its worst, we do not expect to see a significant narrowing in 2013 compared to 2012; the wide deficit will continue to leave the rand vulnerable to any deterioration in foreign sentiment and thus capital inflows. The rand was the worst performer of the major emerging market currencies this past quarter, a period that was marked by some significant divergence in currency performance and an indication that fundamentals (rather than global risk appetite) are becoming more important. Even before one could really expect to see any impact from the first quarter's currency weakening, CPI has risen to just under the upper end of the target range at 5.9% in February. Part of this is naturally due to some passthrough from the rand depreciation in 2012, and notably this rise in the overall CPI number has occurred despite recent softer to stable food and energy inflation - by contrast, core inflation has been rising. We maintain our view that CPI will breach the upper end of the target in the next month or two, and we expect it to remain above target for most of the rest of 2013 and into early 2014. The 2013 budget speech was delivered on 27 February, and the wider deficits budgeted for necessitated upward revisions to the bond market funding requirement, which put some pressure on bond yields, especially at the longer end. Weekly bond auctions (starting April) for the new fiscal year have been increased as a result of the higher funding requirement. Concern remains about the slow pace of fiscal consolidation in South Africa, especially compared to the progress that many other emerging markets have made on this front in the few years since the crisis-induced budget deterioration. All the above notwithstanding, foreigners continued to buy South African bonds, in line with continued global flows into the emerging market bond asset class. Net purchases of South African bonds in March totalled R1.6 billion, bringing the quarterly number to R8.5 billion. This was slightly below that of the final quarter of 2012, but was also the lowest quarterly net inflow into domestic bonds since the third quarter of 2011. The pace of foreign inflows has showed a clear deceleration since our inclusion in the Citigroup World Government Bond Index in October but, for now, they remain inflows. We continue to believe that the South African bond market, like most bond markets around the world, is stretched in terms of fundamental valuation at present and that the risks are skewed towards a weakening. Global bond markets are being supported by the current 'ultra easy monetary policy', including quantitative easing, and the flush of liquidity that results from this is buoying emerging markets too. However, when liquidity is the principal factor supporting markets then they are always vulnerable. A number of factors will be key for the domestic market. These include US bonds, global risk appetite, the rand, the fiscus and inflation. Added to these factors is heightened political risk, shown more recently by labour market unrest (which in turn harms exports and renders the rand more vulnerable as a result too). We thus believe that the balance of risks is skewed towards higher yields. This may however continue to be mitigated in the shorter term by a continuing dovish stance by the South African Reserve Bank (which remains very concerned about growth) and foreign flows.

Portfolio manager
Mark le Roux

The All Bond Index (ALBI) gained 2.3% in December, bringing its return for the year to 16.0%. This impressive performance was still outdone by inflation-linked bonds, which returned 3% in December and 19.4% for the year. Cash has lagged significantly, with an annual return of 5.6%. Against this backdrop, the fund returned 16.49% for the 12- month period.s The bond market return for the year is particularly good if one considers the less than impressive domestic fundamental backdrop: inflation averaging in the higher end of the target range; wider than initially budgeted fiscal deficits and an increase in the funding requirement as a result; credit rating downgrades; and the significantly weaker rand in the final quarter of the year. However, the global environment came to the rescue in 2012. Despite the bouts of risk aversion, the global search for yield - also underpinned by South Africa's inclusion in the Citigroup World Government Bond Index in October 2012 - saw large flows into the local bond market. For the year net foreign purchases of South African bonds totalled a record R85 billion. And as elsewhere, the market benefited from accommodative monetary policy, which anchored the short end of the yield curve and incentivised investors to move out along the curve (which remains steep) to pick up yield. The outperformance of inflation-linked bonds seemed to stem both from understandable inflation concerns (given accommodative policy and the weaker rand later in the year), as well as a positive global environment for inflation-linked bonds (the chart below shows real yields in South Africa closely shadowing trends in the US). In a world where real cash rates are negative, guaranteed real returns are prized to such an extent that, in South Africa, the two shortest-dated inflation-linked bonds were both trading at negative real yields by year-end. Looking ahead, the crystal ball is as murky as ever. We are fairly confident that the domestic fundamentals for South African bonds are not positive. The funding requirement remains large: a net R136 billion (gross R157 billion) for the 2013/2014 fiscal year, with only a small moderation forecast in the following two years. The inflation outlook is not encouraging either - although there are indications that the current food price cycle will peak in the first half of this year, pass through from rand weakness will pressure CPI and we expect a net upward effect from the rebasing and reweighting exercise. All in all, we expect to see CPI breaching the upper end of the target range again this year. Underlying vulnerability is likely to remain in the currency as well, given that the massive trade deficit is likely to take some time to reverse and we expect another large current account deficit in 2013. Finally, as expected, Fitch has followed S&P and Moody's by downgrading their credit rating for South Africa from BBB+ to BBB, and we would not exclude the possibility of a further downgrade by Moody's later in the year. We do not see much scope for another rate cut in 2013, as inflation concerns offset any lingering concerns about growth, especially while policy remains accommodative. Portfolio manager Mark le Roux