South African fixed income markets weakened in September. The All Bond Index fell by 0.07%, after delivering a positive return (0.14%) in the previous month. The shorter-dated bonds performed best, with bonds maturing in one to three years returning 0.64%, followed by medium-term maturities which delivered 0.4% on the month. Long bond performance was poor, outweighting the impact of better performing shorter-dated bonds. Bonds with a maturity of 7 to 12 years were almost flat, and long-dated maturities fell by 0.44% on the month. The combined GOVI index rose just 0.01%, following 0.18% achieved during August. The poorer performance over the month didn't detract meaningfully from the 12-month returns, which were up 6.7%. Inflation-linked bonds underperformed, posting -0.31% on the month, after returning -0.74% the previous month. Cash returned 0.52%. Following an already volatile August, market turmoil intensified as weaker global and domestic growth continued to impact market performance in September. The market focused on a possible normalisation of interest rates at the US Federal Reserve's September meeting, but the Federal Open Market Committee (FOMC) again left rates on hold, for the first time citing the risks posed to US growth from emerging market economic weakness and volatility in global asset markets. The US dollar index (DXY) extended gains, which heightened general concerns about growth and disinflation. Emerging market currencies were hard hit. Following these developments, and persistently mixed US activity data, even in early- October there remains considerable uncertainty about the timing of the first Fed rate hike.

Following the Fed's decision to pause, the South African Reserve Bank (SARB) also held rates steady at the September Monetary Policy Committee (MPC) meeting. The MPC's statement continued to highlight upside risk to its inflation forecast, mostly from the currency. Recent currency weakness resulted in an upward revision to SARB headline and core inflation forecasts for 2016 and 2017, but its short-term outlook for 2015 improved thanks to lower oil prices. The SARB revised its growth forecasts lower over the forecast horizon. In its concluding remarks, the MPC acknowledged that it was mindful to not have an undue negative impact on short-term growth prospects and that this played into the decision to keep rates on hold for the time being.

Economic data released in September continue to paint a picture of weak domestic growth, with few bright spots. Following supply-side data, which revealed a contraction in gross value added in the second quarter, the SARB Quarterly Bulletin provided a breakdown of the expenditure side. Most of the contraction was accounted for by a very large adjustment in inventories, but outside of this, other demand drivers remain weak. Household spending accelerated off a weak base to 4.6% y/y. Household debt levels were a little lower, but the higher interest rate (announced at the July MPC meeting) put a floor under debt service costs, which were unchanged at 9.4% of disposable income. Gross fixed capital formation - notably by the private sector - remained weak at 1.3% y/y. Government spending was up just 0.2% y/y, in line with National Treasury's commitment to keeping expenditure under control. Net exports offered a glimmer of hope, with an improvement that yielded a trade surplus on the current account of the balance of payments. The services balance deteriorated in line with pressure on tourist arrivals, and the non-trade deficit was -3.5% of GDP. Taken together, the deficit on the current account narrowed to -3.1% of GDP from -4.7% in the previous quarter.

Forward-looking data remain discouraging. The PMI print for September was largely unchanged at 49 index points, portraying a manufacturing sector that is performing below trend. Business activity fell again to 46.6 from 48.6, while prices paid ticked up to 77.6 from 76.3, partly offset by rising new orders and an improvement in the employment index. After two months of big cuts in retail fuel prices, October will see a small underrecovery as the currency has weakened beyond the fall in oil prices. This bodes poorly for inflation in coming months. Vehicle sales in September contracted heavily, reflecting continuing weak consumer confidence that - although an improvement on the second quarter of 2015 - remains below trend at -5 index points in the third quarter. It is clear that the MPC remains in a very uncomfortable position.

The global economic backdrop remains unclear. Asia and Europe are firmly in easing mode while the US economy seems mostly on track to start their rate normalisation process before the end of 2015. However, the timing and extent of rate normalisation in the US are still uncertain, and rate hikes are expected to be very subdued and protracted in comparison to previous cycles. Market volatility has increased considerably over the last month and continues to suggest that the premium required to hold risk assets may be higher than is currently being priced into markets over the short term. We see downside risks to domestic growth, with inflation expected to remain around the top end of the target band for the next few quarters. SA government bonds have moved closer to fair value during the month of September and could present a much more attractive entry point.

Portfolio managers
Mark le Roux and Nishan Maharaj

South African fixed interest markets remained under pressure in June. The All Bond Index fell a further -0.2%, following a weak -0.72% return in the prior month. The long end was again hardest hit, albeit less so than in May, with long bonds yielding a return of negative 0.47% on the month. The combined GOVI index fell 0.14%. Despite another month's poor returns, performance over 12 months remains quite strong. Following some weakness in May, inflation-linked bonds (ILBs) once again outperfromed nominal bonds, posting 0.43% on the month. Cash also outperformed with a return of 0.51%

Data published in June continued to show soft growth outcomes, but rising inflation pressure. Both CPI and PPI prints for May surprised to the upside, the former rising 4.6% y/y from 4.5% - driven mainly by food and transport costs. PPI was also higher at 3.6% y/y, from 3.0%, with food and fuel prices as well as machinery prices the main contributors to the acceleration. The weaker currency and moderately higher international oil prices will add to the cost of running transport in the next two months' data, and the July print will be exacerbated by an annual increase in electricity prices of about 13%.

Growth data remain mixed and muted. Aggregate private sector credit growth was 9.5% y/y, but the breakdown showed credit extended to businesses remains strong, whereas household credit extension is languishing at 3.2% y/y. Manufacturing production in April contracted by 2% y/y, while mining production slowed to 7.7% y/y from 19.5% in March. Eskom's load shedding continued while the National Energy Regulator of South Africa (Nersa) considered its application for an additional 12.3% topup tariff for next year to cover costs related to the running of its open cycle gas turbines (OCGTs). The combined weak economic data and deteriorating inflation trend continues to undermine confidence amongst both businesses and consumers. According to survey data from the Bureau for Economic Research (BER), business confidence fell to 43 index points in the second quarter of 2015, implying that 57% of respondents view current conditions as dissatisfactory, and consumer confidence slipped to -4, from 0 - well below the long-term average of 5 index points.

On 29 June Nersa rejected Eskom's application for an additional tariff topup for the 2016/17 fiscal year (an implied municipal increase for July 2016), mostly on technical grounds, but also because Eskom has failed to deliver on past promises. This is not to say that Eskom cannot reapply, or that the overall inflation impact (once clawbacks are included) will be materially below the South African Reserve Bank's (SARB) current forecasts, but the upside risk from this source is perhaps somewhat diminished. That said, a combination of rising retail fuel prices, another recent spike in domestic maize prices and the persistent vulnerability of the currency to interest rate normalisation in the US remain. The gold companies' wage offer - which ranges from 7.8% to 13.0% as a starting offer - is unlikely to be viewed favourably, especially when combined with the latest BER inflation expectations which saw long-term (5 year) expectations jump 0.2ppts and aggregate expectations rise a large 0.6ppts in the second quarter.

This economic environment is extremely challenging for the SARB's Monetary Policy Committee. When they meet again from 21-23 July, they will have a June CPI print, which is likely to be higher than 5% y/y and rising smartly. Despite the 'reprieve' from Nersa, the fact that two members of the committee voted in favour of a hike at the May meeting, coupled with persistent upside inflation risk, makes us believe there is a significant risk that the MPC raises the repo rate by 25bps at this meeting.

There are risks that are starting to threaten the relatively sanguine environment depicted by the local bond market. Liquidity from Europe and Japan will remain a supportive element; however, the soft patch in US data seems to be firmly behind us and markets are readying themselves for a September rate hike by the Federal Open Market Committee. The uncertainty around the current pricing of various asset classes, more especially fixed interest, suggests the volatility and risk premium required to hold these types of risky assets should be higher than is currently being priced into markets. In addition, there is an added risk that the SARB raises interest rates by too much or too soon, and domestic growth slows again. Although this will support the long end of the local bond market, we remain wary of excessive negativity as the hiking cycle recommences locally and in the US.

Portfolio managers
Mark le Roux and Nishan Maharaj

South African fixed income markets remained under pressure in March, continuing to reverse the strong gains achieved in January. The All Bond Index fell a further -0.53% during March, after a weak return of -2.8% in February. While yields across the curve rose, the long end was hardest hit. Long bonds yielded a negative return of -0.87% on the month, and the combined GOVI index -0.53%. Despite another month's poor returns, over the 3-, 6- and 12-month periods performance remains good. Inflation-linked bonds (ILBs) outperformed on the month for the first time this year on deteriorating inflation prospects, posting a positive return of 0.57%, which is slightly above the return of cash (0.51%).

The strong tailwinds that drove bond performance in January continued to unwind in March. Globally oil prices have risen off their January lows, and the effects of this were amplified in the domestic economy by a weaker currency, which translated into a local petrol price hike of Rc162/litre in March following a cut of Rc93/litre in February. A hike in the fuel levy, and an additional allocation to the Road Accident Fund, will also add meaningfully to the retail petrol price in April, extending the pressure on transport running costs.

Food prices, until recently a strong contributor to disinflation, also look less favourable. Food inflation slowed to 6.4% y/y in February, from a recent peak of 9.4% y/y in August 2014. But the Crop Estimates Committee forecast for the current maize harvest was cut to its smallest since 2007, due to severe drought in the North West and Free State. Maize is an important component in the food basket, not only as a cereal, but also because it affects meat and dairy prices. The current forecasts is for a harvest 32% smaller than in 2013/14, with white maize - a staple food for many South Africans - down 40%, and yellow maize (which is used mostly in feed), 24% lower. The impact on headline inflation will likely only become evident from mid-year, but the rise in these prices will contribute to the less favourable inflation trajectory in coming months.

The Monetary Policy Committee left the repo rate unchanged at 5.75% following its March 26 meeting, but the issued statement highlighted a deterioration in the inflation outlook. The MPC revised its forecast for inflation from 3.8% to 4.8% in the current year, and to 5.9% in the next two years. Core inflation is expected to remain well above 5% this year and next. Compared to the context in which the January meeting took place, when the committee concluded that the lower oil price would allow them a pause in the cycle of rate normalisation, the March meeting conceded that the room to pause had narrowed. The committee's risk assessment is also pitched to the upside, mostly on concerns that a change in US monetary policy may put renewed pressure on the exchange rate.

Growth prospects, however, remain poor. Despite the weaker currency, manufacturing and mining sector output has been weak year-to-date. Forward-looking Purchasing Managers' Index (PMI) data for March showed almost no change to the headline at 47.6, still below the break-even level of 50, and reflecting weak growth momentum in manufacturing. A little more positively, PMI expectations remain positive, indicating that prospects are expected to improve.

At this stage, the weak growth outcome coupled with Eskom's supply constraint offer some muting effect to price pressures, which still mostly reflect cost-push factors, rather than demand-related increases. The MPC nonetheless rang a cautionary note that it would continue to normalise policy rates in coming meetings.

Despite the weaker start to the year, the outlook for the bond market in 2015 remains constructive, and year to date the ALBI has outperformed other fixed income asset classes. Continuing liquidity from the developed world, coupled with weak domestic growth and still relatively muted inflation remain supportive elements. In our assessment, the risks to growth continue to be considerable and in the event the SARB raises rates too soon, or too aggressively, this will be exacerbated, and longer-dated bonds will benefit.

Portfolio managers
Mark le Roux and Nishan Maharaj

2014 closed on a positive note for the South African bond market, as the continued fall in energy prices - combined with expectations over further monetary policy easing in the developed world (specifically Japan and Europe) - contributed to a compression in global and local bond yields, which supported other fixed income assets. This was despite some negative local news as the power supplier Eskom's inability to keep the lights on in South Africa added to mounting concerns over the entity's financial sustainability, and the broader implications for domestic economic growth. However, falling inflation expectations proved to be the stronger driver of local bond performance. Nominal bonds managed to outperform both cash (1.5%) and inflation-linked bonds (2.2%) for the quarter, registering an impressive 4.2% for the final quarter of 2014. However, for the year, inflation-linked bonds (11.1%) still outperformed nominal bonds (10.1%), albeit marginally.

The positive quarterly performance masked some of the volatility during the period, both in fixed income and in the currency market. Local bonds traded in almost a straight line from a high yield of 8.35% at the start of the fourth quarter, down to an intraday low of 7.50%, before an abrupt turnaround in December which saw yields ending the year around the 8%-level. This was despite a further 2.5% weakening (in Q4) in USDZAR spot levels, as the dollar strengthened against almost all developed and emerging market currencies. Sentiment around the strength and vigour of the US economic recovery remains quite buoyant, which should support the dollar for the better part of 2015. Economic data releases and rhetoric from the Federal Open Market Committee (FOMC) continue to suggest marked improvements in underlying economic fundamentals and that the rate hiking cycle should start towards the middle of 2015. Still, the breadth of this cycle remains a topic of much debate.

Emerging market currencies, the rand included, continued to weaken in sympathy with rate hike expectations. This in contrast with bond markets, which benefited from expectations of a new leg of quantitative easing by the European Central Bank amid subdued inflation and growth on the continent. This compressed both developed market and periphery country yields in the EU, while providing an anchor for developed market bond yields. Adding more fuel to the fixed income rally was the slump in oil prices, which almost halved in 2014 and dampened inflation expectations. SA bond yields remain relatively low, pricing in a very benign inflation and growth outlook, supported by low yields in developed markets (particularly the EU and US) and a much-improved inflation outlook on the back of oil prices.

2015 will be an important year for South Africa, as markets (and rating agencies in particular) will be looking for some indication that the twin deficits are being rehabilitated. The trade balance continues to weigh on the current account, but exports should find support as mining and manufacturing are now almost back to full production and wage settlements have been concluded for at least the next two years. However, Eskom's ability to ensure a constant electricity supply remains the major risk that could derail export recovery expectations. The Medium Term Budget Policy Statement (MTBPS) in October showcased the new finance minister's commitment to fiscal consolidation. Adherance to the nominal expenditure ceiling, monetary support for government agencies (mainly Eskom) from deficit neutral sources (the sale of non-strategic state assets), and a possible increase in taxes were the main takeaways from the mini budget, which bolstered sentiment in Q4. In order for this to be maintained into 2015, the budget in February would have to show a continuation of these actions. In particular, the municipal wage negotations will be closely watched, as unions have already indicated demands of wage increases of up to 15%.

Despite the positive outcome from the MTBPS, the bond market registered close to R20bn in outflows in Q4. This brings the total outflows for 2014 to R57bn, following inflows of R38bn, R87bn and R500m for 2011, 2012 and 2013 respectively. Last year's outflows came even as US government bonds gradually rallied back close to 2% over the course of 2014, providing an anchor for global yields. This trend has not been specific to South Africa; most emerging market bond markets saw outflows, indicating a gradual decrease in risk appetite for high yielding assets. However, the lack of recovery in South Africa's twin deficits combined with the renewed negativity around Eskom intensified the outflows from the domestic market, and market positioning remains quite negative and underweight in South Africa going into 2015. On the flipside, this provides an interesting backdrop going into 2015, as it suggests that any positive surprises resulting from a recovery on the twin deficits, Eskom, inflation and/or risk sentiment might result in a scramble for duration assets.