March was a much better month for domestic markets and the bond market more than recovered its February losses. The All Bond Index (ALBI) rose 2.63% in March, with longer-dated maturities delivering the best performance. Bonds with a maturity of 12 years or more gained 3.02%, compared to those with maturities of 1 to 3 years that returned 1.28%. Inflation-linked bonds underperformed with a return of 1.05%, while the cash return was 0.58%.

Global market volatility started moderating in February and improved even further in March, as most risk assets rebounded in the month after a torrid start to the year. On balance, global growth data showed some stabilisation and oil prices rose, extending the reprieve for emerging asset prices. In the US, decent employment data and a small improvement in the detail of the ISM Manufacturing index data offset some of the earlier concerns for growth. European data were mixed, amid increasing concerns about deflation. Deflationary conditions in France and Germany contributed to European inflation moving into negative territory in February. The European Central Bank cut the deposit rate and announced a large extension in its quantitative easing programme, extending asset purchases to include non-financial corporate bonds. Politics also started to heat up, with the US presidential election gaining momentum in what looks to be a closely contested race in coming months. A heavy schedule of European elections are also in the pipeline. The UK Brexit referendum has been set for 23 June.

In South Africa, March saw the release of the SARB quarterly bulletin, presenting national accounts statistics for the fourth quarter of 2015 and for calendar 2015. The biggest disappointment was a marked deterioration in the current account deficit, which expanded to -5.1% of GDP in the fourth quarter of 2015, reflecting a sharp deterioration in the trade deficit during the quarter. The shortfall in services, income and current transfers also widened at the end of last year, but the deterioration was marginal, with services benefiting from improved tourism flows, while the income deficit widened. For the year as a whole, however, the deficit narrowed to -4.4% of GDP, from -5.4% in 2014. The breakdown of the GDP statistics was more mixed. Annual and quarterly GDP growth statistics from the supply side were already known, but the demand side detail showed an improvement in growth contribution from households and fixed investment last year relative to 2014. Net exports were steady, in line with the improvement in the current account deficit. Inventories and a large residual remain growth detractors. Domestic high frequency data have also been more mixed. The PMI print for March was better than expected with seasonally adjusted headline PMI at 50.5 - the first print above 50 since July 2015. Trade data surprised on the upside, in part reflecting seasonally strong exports, but also relatively larger export growth than in the previous year. Import value rose slightly, showing import demand remains resilient. Fiscal data were strong at the end of February: the budget balance was up R16.4bn on the month, with the cumulative deficit for the eleven months to February at -R151.7bn. This puts government well on track to meeting its -3.9% fiscal deficit target for the year. Mining and manufacturing, however, were much weaker than expected, with mining output falling -4.9% y/y in January and manufacturing contracting -2.5% y/y. Inflation data (again) surprised to the upside in March, as base effects and food prices pushed the headline CPI reading to 7.0% from 6.2% y/y the month before. Warnings of impending price increases from food producers and retailers suggest that food inflation may rise steadily from here, and a large early-April petrol price hike will add significantly to inflation momentum. PPI inflation showed another surge in food prices on the month, a harbinger of more price pressure for the consumer basket.

The SARB MPC raised the repo rate another 25bps in March, bringing cumulative hiking in this cycle to 200bps, and the repo rate to 7.0%. The decision was split, with three members voting for 25bps and three for no change. At the heart of the decision remains the view that inflation risk is still to the upside of the current forecast. A concerning rise in core inflation suggests that in addition to food inflation and energy price risk, there are signs that pass through is becoming more evident. The deterioration in the political context poses a risk to the currency and with the higher oil price and upside CPI surprise in March, is likely to contribute further to the MPC's inflation risk assessment. We think more rate hikes are in the pipeline this year.

As an aside, it's worth understanding what investment grade rating SA is in danger of losing, and also what this would mean for SA government bonds. Each country has two types of credit ratings, a local currency rating (a measure of your riskiness as an issuer in the local currency, rand in the case of SA) and a foreign currency rating (which measures your riskiness as an issuer in a foreign currency such as pounds, euro, US dollar etc.). SA's foreign currency rating, as illustrated in the following table, is at the greatest risk of being downgraded to 'sub-investment grade'. At this point, our local currency rating maintains a sufficient margin of safety not to lose its investment grade status. The local currency rating is more important for our continued inclusion in the various global bond indices. SA will be kicked out of the key Citi World Government Bond Index if the country is downgraded to sub-investment grade by at least two ratings agencies. This will trigger a large mandated selling of SA government bonds. SA's foreign debt component is relatively small (only 10% of SA's debt, approximately $10bn, is issued in foreign currency). Accordingly, losing its foreign currency's investment grade will have a minor impact on the pricing. Looking at the following graph which depicts SA's sovereign spread, one can see that we are sitting at levels that are already consistent with a much lower credit rating.

Although a downgrade will probably increase volatility, the majority of the bad news seems to be already pretty much in the price. As indicated in the following graph, the market already rates SA not only at sub-investment grade, but also about two notches below. While a downgrade to sub-investment is very likely, downgrades of multiple notches are not warranted against our current fundamental backdrop.

There continue to be considerable downside risks to South African growth, with inflation expected to persist above the top end of the target band for most of this year and into 2017. Against the backdrop of further expected fiscal disappointments and the current flux in the political landscape, we remain concerned about the risk to South Africa's ratings in the year ahead. At this time, we believe the negative fundamental backdrop outweighs the cheap valuation of South African long bonds.

Portfolio managers
Mark le Roux and Nishan Maharaj

The All Bond Index (ALBI) suffered a torrid end to 2015 as it lost 6.67% in December, which dragged down returns for the fourth quarter and the year to -6.43% and -3.93%, respectively. There was no safe place to hide on the bond curve as yields widened across the curve by approximately 125 basis points (bps) during the quarter (and some 175bps over the year). The worst-hit area of the curve was bonds with maturities of 12 years and longer; month-to-date and year-to-date returns were -8.55% and -7.04% respectively. The one-to-three year area of the curve outperformed, delivering 4.1%. The index itself experienced significant changes during the course of the year as its weighting of bonds with maturities of longer than 12 years increased from 36% to 51%. As one would expect, the riskiness of the index (as measured by the modified duration) increased from 6.54 (at the start of the year) to a peak of 7.17. However, following the sell-off in the final months of the year, this has now settled at 6.52. Still, the fortunes of the index will continue to remain largely a function of longer maturity (of more than twelve years) bond performance.

2015 was a difficult year for emerging markets (EM), and specifically for South Africa. The global environment was plagued with concerns of a more pronounced slowdown in China, a European economy that was struggling to lift itself out of recession and the effects of the first interest rate hike in the US following the financial crisis of 2008. The commodity slump added to pressure on many EM countries. These factors, combined with high levels of uncertainty (as reflected by the increase in asset price volatility) left EM currencies battered. South Africa, unfortunately, did very little to differentiate itself in a positive way from its peer group. Its deteriorating growth outlook, along with concerns around government finances and an increase in both socioeconomic unease and political uncertainty, contributed to a slump of 33.7% in the rand over the course of 2015. This weighed on local government bonds, and intensified negative sentiment during the last quarter of 2015, resulting in a significant widening of these yields.

The outlook for local bonds during the course of 2016 will be dictated by three major factors: the outlook for global bond yields; the outlook for local inflation (which could see further deterioration given the persistent drought in most of the country and the significant rand decline); and the risk premium that needs to be priced into local assets given the political landscape.

To assess the current investment case for local bonds, the end of the third quarter of 2015 is a useful point of reference. In our assessment of the fair value of bonds, we use the 10-year US bond yield as a proxy for global bond yields, the difference between inflation expectations in the US and SA as measure for the inflation premium and the SA sovereign spread as proxy for SA's risk measure. At the end of September 2015, these were 2.04 (10-year US bond yield), 287bps (SA sovereign spread) and 4% (expected one-year inflation differential between the US and SA), which together indicated that the fair value for the 10-year SA government bond was around 8.9%, compared to its actual level at the time of 8.6%. This suggested that local government bonds, although not cheap, were relatively close to fair value. Consequently, as we stated then, any widening in yields would warrant an increased allocation to local bonds. However, given the events of the last quarter of 2015, some of the valuation metrics have seen such significant change that an adjustment to our expectations of fair value, and hence our view on SA government bonds, is warranted.

The first major factor to take into account is the US rate-hiking cycle, where the focus has shifted to the breadth of the cycle following the first increase. The US Federal Reserve (Fed) has indicated that rates will only increase by some 75bps during the course of 2016, which is in line with current market pricing. The recent further decline in energy prices, a strong dollar and new indications of a further economic slowdown in China are bound to keep the Fed relatively cautious during the year. Inflation remains well below the Fed's 2%-target, however the economy is approaching full employment with growth expectations close to 2.5% for 2016. This implies that the current 10-year US bond yield of 2.3% may be a bit optimistic. Clearly, a level of conservatism should be incorporated into expectations. Also, a slightly higher risk premium should be priced in since much of the lower commodity prices are already baked into baseline readings and expectations. Consequently, a fair value range for the US 10-year bond yields of between 2.5 and 3% seems more appropriate.

SA inflation has been relatively well-behaved over the last year. Falling oil prices and limited pass-through from the weakening rand have helped keep both actual and expected inflation fairly contained. The SA Reserve Bank (SARB) expects inflation to breach the target band in the first quarter of 2016, averaging just over 6% for the year. These expectations were based on assumptions of an electricity price increase of 12%, an oil price of $56, slightly lower world food prices and a weakening in the real effective exchange rate of 4% (as at the November meeting of the monetary policy committee). Since then, the rand price of oil has moved lower by 5%, the rand is 11% weaker, white maize prices increased by a whopping 50% and the outlook for the secondround effects of higher food prices has deteriorated. The food component of CPI represents just under 15% of the basket, implying that the risks to current inflation expectations are firmly to the upside and that the expected inflation average of 6% for 2016 is too benign. A more prudent and realistic expectation would be an inflation average of 6.3% to 6.5% for 2016. Growth and its underlying components have and will continue to remain weak, hampering the ability to pass through price increases to the consumer. Furthermore, the lower growth prospects will continue to restrict the SARB from acting as aggressively as it would like to limit the second rounds effects of a persistent breach of the inflation-targeting band.

Current market levels suggest that the repo rate will rise close to 200bps (bringing the repo rate to 8.25%) during the course of 2016 as the SARB will be forced to act on its hawkish rhetoric. While this would seem like a fair expectation in any other cycle, it is very difficult to see such rate hikes over the next year given the poor growth backdrop. We expect a repo rate of between 7.25 and 7.5% (hikes of between 100 and 125bps) will be more palatable for the ailing local economy.

Lastly, SA's risk profile has been significantly elevated relative to its peers following the dismissal of the minister of finance. Although the reappointment of Pravin Gordhan, a former finance minister, did offer some calm to the markets, it is highly unlikely to expect the risk premium to decrease in the runup to the February budget. All eyes will be on the new finance minister, and how willing and able he is to take on fiscal consolidation.

Furthermore, concerns surrounding the approval of the nuclear programme do leave a very dark cloud hanging over SA's fiscal future. In the following graph, it is clear how SA's sovereign spread jumped higher during the December period, highlighting the market's increased skepticism over the political will to get the economy on a better footing. Going forward, a reduction in the country's risk premium is highly unlikely and a level of 325 to 350bps seems appropriate given the current political and socioeconomic climate.

When the drivers of the various valuation metrics are adjusted to reflect the new realities - resulting in a 2.5% to 3% 10-year US bond yield, a 6.3% to 6.5% SA inflation average for 2016 (against an unchanged 2% inflation outlook for the US) and a 325-350bps SA sovereign risk premium - the fair value range for the SA 10-year bond benchmark shifts to the 10.25-10.5% range. This compares unfavourably to the current market levels of around 9.75% and suggests a definite degree of caution is warranted when it comes to local government bonds. In addition, with government issuing bonds that are focused on the longer end of the curve, and with growth continuing to deteriorate, it is very likely that a further risk premium will have to be priced in for longer-end bonds, relative to the short-end and belly of the curve.

Unfortunately, given the current local backdrop, SA is setting itself apart from its peers in all the wrong ways. Until we see a strong shift towards sustainable economic growth and a definite political commitment to making the necessary hard decisions, the appeal of the asset class will only be enhanced if yields widen more to reflect the necessary risk premium.

Portfolio managers
Mark le Roux and Nishan Maharaj