The fund returned 0.77% in September, bringing its total return for the 12-month period to 8.60%. This is well ahead of the returns delivered by both cash (7.21%) and its benchmark (7.95%) over the same one-year period.

This past quarter saw the All Bond Index (ALBI) gain 3.7%. Its returns for the year to date (YTD) and over a rolling one-year period, at 7.8% and 8.2% respectively, are both well above cash. While the yield of the long-term section (12 years and longer) of the ALBI is well above 9.5%, it has been the 3- to 7-year area of the bond curve that provided the best performance YTD and over 12 months. The shorter end of the bond curve has been anchored by expectations of a lower repo rate, which was eventually cut in July. In addition, strong emerging market (EM) bonds have buoyed local bonds. Over the previous quarter, the ALBI’s performance in US dollar (-0.63%) was behind that of the JP Morgan EM Bond Index (+2.41%). Still, the ALBI’s performance YTD (+8.74%) is in line with EMs (+8.76%). Over a rolling one-year period, the ALBI (+9.07%) is far ahead of the EM index (+4.18%). South Africa’s high yield relative to its EM peers has helped attract foreign capital and prevented any material widening in yields (capital loss), thus far.

At the end of August, shorter-dated negotiable certificates of deposit (NCD) traded at 8.04% (three-year) and 8.62% (five-year) respectively, close to their highest levels for the quarter. The main reason for this was the SA Reserve Bank’s decision to leave the repo rate unchanged at 6.75% at the September MPC meeting, contrary to consensus expectation. Inflation moderation remains on course despite rising fuel prices. August CPI rose to 4.8% y/y from 4.6%, owing to higher petrol prices, but the underlying data - including food inflation - were softer, and core inflation was just 4.3% y/y. NCD spreads relative to cash compressed aggressively over the quarter due to a combination of a compression in credit spreads and the outlook for interest rates. NCDs continue to hold appeal due to the inherent protection offered by their yields, however the hunt for yield in the local market has started to push bank credit spreads into expensive territory (less than 100bps in the 3-year area and 130bps in the 5-year area). The fund continues to hold decent exposure to these instruments (both floating and fixed), but will be cautious and selective when increasing exposure. NCDs have the added benefit of being liquid, thus aligning the liquidity of the fund with the needs of its investors.

Global economic data continue to suggest decent underlying momentum across developed and emerging economies, but inflation has remained lower than activity data might suggest. Indices tracking global GDP, like JP Morgan’s global manufacturing tracker, suggests global growth will be about 3.6% this year. In the US, GDP estimates for the second quarter were revised up slightly from 3.0% to 3.1%. Underlying data show emerging growth in capital expenditure on equipment, decent accumulation of inventories too, and an improved trade performance. Income and consumption data were a bit weaker, with nominal income growth at 0.1% month-onmonth (m/m) in August, and real growth falling as a result of rising inflation. The August payrolls report showed growth of 156K from 189K the month before, and the unemployment rate ticked up to 4.4% from 4.3% in July. The September hurricanes are expected to temporarily drag third-quarter GDP and employment numbers weaker, with the GDP figure currently tracking about 2.0%.

SA is currently benefiting from a flow of capital towards EM bonds. The market expects that global inflation will undershoot targets in the shorter term, that the unwind of quantitative easing won’t have much of an impact and that developed-market bonds will remain well-behaved. Unfortunately, all of these assumptions are based on shorterterm outcomes that can dissipate quickly. Market expectations for US rate hikes are still materially below what the Fed is guiding; to such an extent that the current market pricing of the long-term Fed target rate is 1% below the Fed’s own guidance (1.75% versus 2.75%). Investors are buying EM (and SA) bonds because they offer much higher yields, but the underlying assumptions about US yields are either very stretched or at risk of being too optimistic.

The rand (-1.9%) was weaker over the quarter, ending the month at R13.55/$. This performance was pretty much in line with the EM peer group despite global flows into EM being quite strong. The fund maintains a healthy exposure to offshore assets, and when valuations are stretched, it will hedge portions of its exposure back into rands by selling JSE-traded currency futures (both in US dollar and UK pound). These instruments are used to adjust the fund’s exposure synthetically, allowing it to maintain its core holdings in offshore assets. (It has the added benefit of enhancing the fund’s yield.)

The SA 10-year benchmark bond started the quarter just above 8.8%, touched a low point of 8.38%, but spent the majority of the quarter treading time between 8.5% and 8.6%. Despite the elevated levels of uncertainty, bond yields have not been volatile. Over the last year, the benchmark bond’s trading range (difference between the highest and lowest traded yield) has narrowed steadily to below 100bps - the lowest level in the last 20 years. This hardly seems to reflect a high level of uncertainty. There are a few interlinked reasons that explain these low levels of volatility in the local bond market. First, it is important to distinguish between volatility and uncertainty. Volatility occurs when uncertainty suddenly materialises in definitive actions that impact asset prices. Since the Nenegate crisis, there has been an increase in uncertainty, but not an increase in definitive policy actions that have had an actual impact on underlying asset prices. Also, the market holds very different views on the implications of possible policy actions, providing very little guidance as to how asset prices should/could behave.

To us, the major concern is that the prolonged lack of definitive policy actions will further undermine the lacklustre economy, eventually triggering a stark reaction from the market. At the moment, the current subdued volatility is feeding an underlying complacency about possible market outcomes. Over the last year, low levels of volatility have allowed investors to safely earn the yields offered by local bonds. But stability begets instability. That is, investors extrapolate current stability and expect that things will always remain okay. The slightest unexpected negative event may then trigger an overreaction, and the ultimate outcome may be much more dangerous. There is only one way to protect our investors against this risk: by only investing if the underlying assets are cheap enough to withstand any short-term deterioration in fundamentals and/or volatility.

SA government bonds are somewhere between fair value and expensive. In the short term, the global backdrop remains supportive with growth pushing higher, inflation heating up (but contained) and global yields remaining well behaved. However, local valuations do not offer any margin of safety against bad news. The underlying mix of factors driving the current level of yields in the SA bond market is concerning. Low volatility has increased complacency, supported by aggressive short-term inflows into the bond market. This has created an eerie feeling of stability despite a steadily deteriorating local backdrop. Meanwhile, the international environment is becoming less friendly for carry trades. Yet investors continue to revel in delusions fuelled by the accommodative global monetary policies of yesteryear. It is therefore, difficult to justify a long duration position in the SA 10-year bond yields. Only when bond yields are cheaper than fair value, and offer an adequate buffer against expected adverse volatility, will we look to meaningfully deploy capital into the asset class. The fund will look for opportunities to incrementally add selective exposure to the longer area of the bond curve (12y+) at levels of around 10%, given its attractive return prospects relative to cash over the longer term. We will remain more cautious on shorter-dated bonds.

The SA listed-property sector gained 5.74% over the quarter, bringing its return for the year to 8.18%. From our recent interactions with many of the listed property companies, it is clear that poor economic conditions have started to affect the local property market. Still, we remain confident that the sector offers selective value. The changes in the property sector over the last decade (including the increased ability to hedge borrowings and large offshore exposures) have rendered the yield gap between the property index and the current 10-year government bond a poor measure of value. On the surface, it appears quite stretched. However, if one excludes the offshore exposure, the property sector’s yield rises to approximately 8.7%, which compares very favourably to the benchmark bond. The fund maintains holdings in counters that offer strong distribution and income growth, with upside to their net asset value valuations. In the event of a moderation in listed property valuations (which may be triggered by further risk asset or bond market weakness), we will look to increase the fund’s exposure to this sector at more attractive levels.

The preference share index was relatively unchanged over the quarter (-0.17%), bringing its 12-month return to 4.54%. We continue to favour preference shares given the steady dividend yields on offer, and maintain the fund's current level of holdings. Preference shares are linked to the prime rate and, depending on the risk profile of the issuer, currently yield between 8.5% and 11% (subject to a 20% dividends tax, depending on the investor entity). The change in capital structure requirements mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). In addition, most of the bank-related preference shares trade at a discount, which enhances their attractiveness for holders from a total return perspective and increases the likelihood of bank buybacks.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the SA economy. However, we believe that the fund’s current positioning correctly reflects appropriate levels of caution. The fund’s yield of 8.71% remains attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected fund performance over the next 12 months.

As is evident, we remain cautious in our management of the fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium, to limit investor downside and enhance yield.

Portfolio managers
Nishan Maharaj and Mark le Roux
as at 30 September 2017

The fund returned 0.35% in June, bringing its total return for the 12-month period to 8.56%. This is well ahead of the returns delivered by both cash (7.25%) and its benchmark (8.00%) over the same one-year period.

The market enjoyed a relatively decent second quarter, with the All Bond Index up 1.5% for the three months ending 30 June, slightly behind cash (1.85%) 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 performers over the last 18 to 24 months. The performance of 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% the second quarter and 6.2% year to date.

At the end of June, shorter-dated negotiable certificates of deposit (NCD) traded at 8.46% (three-year) and 8.99% (five-year) respectively, slightly higher than at the end of May. Market pricing now suggests that the repo rate will moderate by around 50bps by the first quarter of 2018. Given our outlook for interest rates, NCDs are looking attractive due to the inherent protection offered by their yields. Bank credit spreads remain elevated due to a combination of new regulatory requirements and SA’s poor macroeconomic backdrop. Spreads in the five-year region have widened marginally to approximately 143 basis points (bps). The fund continues to hold decent exposure to these instruments (both floating and fixed), but we remain cautious given the current local backdrop. We will therefore be more selective when increasing exposure. NCDs have the added benefit of being liquid, thus aligning the liquidity of the fund with the needs of its investors.

On aggregate, indicators continue to suggest that a moderate, albeit uneven, global recovery remains intact. In the US, despite a slight softening of the consumer activity carried over from May into June, growth is still on track to be higher in the second quarter than the first (1.4% q/q). The eurozone is doing even better, with higherfrequency macroeconomic indicators showing that the pick up in growth remains broad-based and continues to strengthen. Conditions across emerging markets were much more diverse. Concerns around indebtedness in China resurfaced strongly over the month, although government measures to ensure macro-financial stability are very much evident. More intervention is expected following the all-important five-yearly conference of the Communist Party, which will be held in the fourth quarter.

Most interesting from a global policy perspective has been the recent hawkish slant adopted by a core group of central banks (including the Fed, ECB and BoE). While just an incremental adjustment to their previous policy stances, the simultaneous signalling of a likely step-up in their individual progress towards normalisation has had meaningful repercussions across financial markets. These efforts to clear the path towards balance sheet normalisation (Fed and ECB) and possible rate hikes (BoE) are set to remain an important influence in the months ahead.

Over the last quarter, there have been some key developments on the local front. Firstly, inflation has continued to fall and the SA Reserve Bank has started to tilt towards monetary easing as growth collapsed, pushing SA into a technical recession. Muchneeded policy reform remains hamstrung by accusations of endemic corruption at the core of government and state-owned companies, pushing policymakers further into a 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 indicators. This creates a vicious cycle: no new private or corporate investment is adding to the downside risks and dragging on growth momentum 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. The SA economy is set on a path of deteriorating creditworthiness due to worsening debt and fiscal metrics. Without serious policy action, we will have to endure further downgrades into sub-investment grade over the next 12 months. This will result in our bonds being excluded from key investment indices, which we expect will trigger large outflows from the bond market. The impact will not only be felt in the financial markets, but will inevitably affect the man on the street through higher borrowing costs and possibly higher inflation over the longer term. Accordingly, local economic prospects remain quite dim.

The rand was relatively flat during June (ending at R13.07/$), but gained 2.6% over the quarter. Although this performance is somewhat behind emerging market peers, the rand has managed to appreciate in the face of the deteriorating local fundamental backdrop. Foreigners continue to accumulate bonds at a ferocious pace, with more than R40 billion worth of inflows this year alone, R21 billion coming in this last quarter. The foreign reaction has been based on a supportive global backdrop and hopes of a turnaround in SA. The fund maintains a healthy exposure to offshore assets, and when valuations are stretched, it will hedge portions of its exposure back into rands by selling JSE-traded currency futures (both in US dollar and pound). These instruments are used to adjust the fund’s exposure synthetically, allowing it to maintain its core holdings in offshore assets. (It also has the added benefit of enhancing the fund’s yield.)

In the past, when faced with such dim local prospects, 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 helped to compensate for feelings of personal misery. Unfortunately, this is currently not the case, especially in the local bond market, were yields have managed to remain quite stable at relatively expensive levels (8.65% average over the last quarter, reaching a low point of 8.38%). This is primarily due to a renewed global hunt for yield.

Given the local macro-economic backdrop, we remain cautious. We expect low growth and policy inaction to contribute to a deterioration 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 this deterioration. But low global real rates may not last forever, and when the easy money stops flowing into the country, it will expose SA’s harsh reality. It is for this reason that we adopt a cautious approach when it comes to investing in the local bond market. A significant repricing of local bond yields would be required for us to invest. In the interim, we do see selective value in short-dated inflation-linked bonds (ILBs).

The ILB curve is exceptionally flat, with almost all bonds trading at 2.5%. SA’s repo rate is currently at 7%, implying a real policy rate of 1.5% (assumed inflation at 5.4%). This implies investors can buy a short-dated ILB (5-year maturity) at a spread of 1% above policy rates, which is quite attractive, especially when one considers that over the next 12 to 18 months, the policy rate in SA will probably moderate by around 50bps, which will act as a strong anchor for shorter-dated ILBs. In addition, from a total return perspective, if inflation averages 5% over the next year, the five-year ILB will return 7.8%, which is slightly higher than the equivalent five-year nominal government bond. However, in the case of inflation averaging 5.5% to 6%, then the ILB will return 8.33% to 8.82%. In the worst-case scenario, this asset provides investors with an equivalent nominal bond return, but gives added protection in the case of an upside surprise in inflation. This makes the five-year ILB an attractive alternative to a nominal SA government bond, for the portfolio.

The SA listed property sector gained 0.29% in June, bringing its return for the quarter to just under 1%. Over the past year, the listed property has lagged the rest of the fixed income asset suite, delivering a meagre 2.29%. From our recent interactions with many of the listed property companies, it is clear that poor economic conditions have started to affect the local property market. Still, we remain confident that the sector offers selective value. The yield gap between the property index and the current 10-year government bond remains quite stretched. If one excludes low-yielding, high-cap stocks from the index, the property sector’s yield rises to approximately 8.7%. The fund maintains holdings in counters that offer strong distribution and income growth, with upside to their net asset value valuations. In the event of a moderation in listed property valuations (which may be triggered by further risk asset or bond market weakness), we will look to increase the fund’s exposure to this sector at more attractive levels.

The preference share index was flat in June, bringing its 12-month return to 6.69%. We continue to favour preference shares given the steady dividend yields on offer, and maintain the fund's current level of holdings. Preference shares are linked to the prime rate and, depending on the risk profile of the issuer, currently yield between 8.5% and 11% (subject to a 20% dividend tax, depending on the investor entity). The change in capital structure requirements mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). In addition, most of the bank-related preference shares trade at a discount, which enhances their attractiveness for holders from a total return perspective and increases the likelihood of bank buybacks.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the SA economy. However, we believe that the fund’s current positioning correctly reflects appropriate levels of caution. The fund’s yield of 8.88% remains attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected fund performance over the next 12 months.

As is evident, we remain cautious in our management of the fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium, to limit investor downside and enhance yield.

Portfolio managers
Mark le Roux, Nishan Maharaj and Adrian van Pallander as at 30 June 2017

The fund returned 0.94% in March, bringing its total return for the 12-month period to 9.00%. This is well ahead of the returns delivered by both cash (7.2%) and its benchmark (7.92%) over the same 1- year period.

SA started 2017 with such promise and exuberance, as underlying drivers of the local economy entered a cyclical upswing amid what seemed to be a much calmer and supportive political landscape. In addition, the global backdrop had become (and remains) supportive of emerging markets, with the adherence of the US Federal Reserve to a gradual path of rate normalisation, continued monetary policy accommodation on the European continent and a more upbeat growth outlook, driven primarily by cyclical upswings in China and the US. The SA 10-year benchmark bond traded below 9% for most of the quarter (supported by a rally in the rand to below R12.50/$), grinding steadily towards a low point of 8.25%. Unfortunately, this rally was short lived as political events in the last week of March caused major reversals in the rand, local bond yields and sentiment towards SA.
The All Bond Index (ALBI) returned 0.4% in March, 2.5% for the first quarter of 2017 and 11% over the last 12 months. Inflation-linked bonds (ILBs) have continued to perform poorly, returning -2.15% in March, -0.5% for the quarter and 3.4% over the last 12 months. This was due to very high initial levels of implied break-even inflation (6.5% to 7%), which necessitated a move higher in real yields, as the 12-month to 18-month inflation average and profile moved considerably lower towards 5%. ILBs now trade at approximate real yields of 2.3%, which are much cheaper than previous levels and although not screaming value, still warrant consideration for inclusion into a bond portfolio.

Domestic economic indicators published during March were mixed. GDP data for the fourth quarter of 2016 showed that growth fell by 0.3% quarter-on-quarter (seasonally adjusted and annualised) from 0.4%, but was up 0.3% year-on-year. 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. This helped to reduce the current account deficit to just 1.7% of GDP in the final quarter of 2016 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. The 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 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 they 'may' be at the end of the hiking cycle. While the repo rate was left unchanged at 7%, one of the six-member committee voted in favour of a rate cut.
At the end of March, shorter-dated negotiable certificates of deposit (NCD) traded at 8.595% (three year) and 9.135% (five-year) respectively, slightly lower than at the end of February. Initial market pricing suggested that the repo rate will remain flat over the next two years, in line with our expectations. However, more recently, given the local political backdrop, the market has started to price in the probably of a hike by the SA Reserve Bank at some point this year. Given our outlook for interest rates, NCDs are looking attractive due to the inherent protection offered by the instruments 'yields and given our outlook for interest rates. Bank credit spreads remain elevated due to a combination of new regulatory requirements (Basel III) and SA's poor macroeconomic backdrop. Spreads in the five-year region have widened marginally to approximately 145 bps (from 135 bps). The fund continues to hold decent exposure to these instruments (both floating and fixed), but we remain cautious given the current local backdrop. We will therefore be more selective when increasing exposure. NCDs have the added benefit of being liquid, thus aligning the liquidity of the fund with the needs of its investors.

Developed market macroeconomic data maintained strong momentum in March: Europe continues to be the best-performing region; the European Commission economic sentiment survey came in at a six-year high; and the German Ifo Business Climate Index jumped. 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. As widely expected, the Federal Reserve raised the federal funds rate by 25bps to 50bps. 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.
The stand-out event for domestic investors was the recall on 27 March of finance minister Pravin Gordhan and his deputy, Mcebisi Jonas, from an investor road show in London. 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 grade limit, and retaining its negative outlook. Moody's Investor Services followed with a notification of its intention to downgrade pending further information, while Fitch downgraded both SA's foreign and local currency debt to sub-investment grade. 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 rand lost 2% in March (ending at R13.40/$), and moved against emerging market trends due to the souring of the local political backdrop. Foreigners have started to accumulate bonds at a ferocious pace, with almost R25 billion worth of inflows this year alone. The foreign reaction has been based on a supportive global backdrop and hopes of a turnaround based on recent experiences in Brazil following the impeachment of former president Dilma Rouseff and the consequent rally in Brazilian assets. However, there are a few key differences. Firstly, the Brazilian government was a coalition government made up by equally strong parties that broke up their alliance in retaliation to the president's wrongful actions. Secondly, unemployment in Brazil more than doubled in a very short period (from under 5% to 10%), which caused mass protest and public outcry, further intensifying calls for the president to step down. In addition, foreign ownership of the local debt market in Brazil was under 15%, given the string of taxes that had been implemented previously to limit hot money flows into the country, and government bonds were trading at double-digits yields of 13% to 14% (implied real yields of more than 6%). From start to end, the Brazilian real weakened almost 40%, and bonds sold off 300 bps to 400 bps in the lead-up to the final impeachment. Unfortunately, SA has a one party government, an unemployment rate that is already in double digits but has not deteriorated further significantly, foreign local debt ownership of already close to 40% and local debt that still trades in single digits. Therefore, key differences exist that will cause the turnaround process to stretch on for a bit longer - meaning that valuations, although cheaper now, could get a whole lot cheaper. The fund maintains a healthy exposure to offshore assets, and when valuations are stretched it will hedge portions of its exposure back into rands by selling JSE-traded currency futures (both in US dollar and pound). These instruments are used to adjust the fund's exposure synthetically, allowing it to maintain its core holdings in offshore assets. (It also has the added benefit of enhancing the fund's yield.)

The current local backdrop remains challenging. Despite cyclical factors turning supportive of the local economy, the political landscape has once again soured, bringing into question the ability of policy makers to take the hard decisions needed to implement much needed structural reforms. In addition, rating agencies have already started to move SA down a path into sub investment grade, both from a local and foreign currency perspective, further souring sentiment towards SA assets. SA's inclusion into the Citi WGBI, relies on our local currency debt being rated as investment grade by both Moody's and S&P. S&P currently has SA one notch above investment grade, while in the next month it is very likely that Moody's will also be in a similar position. A continuation of the current status quo will inevitably lead to further downgrades of SA's key metrics, more specifically growth will come under severe pressure as optimism and hence investment into the economy will continue to slow. A downgrade to sub investment on our local currency rating would immediately trigger mandated selling of SA government bonds to the tune of R100 to R120 billion, that would be alongside natural government issuance of R190 billion - R290 to R310 billion of net selling in a single calendar year!

The current environment warrants a certain degree of caution when assessing the valuation of SA government bonds. Despite the cyclical upswing that the economy is undergoing and the supportive global environment, political uncertainty could derail an already precariously fragile local recovery. In addition, current valuations of SA government bonds, although closer to fair value, are still some way away from offering a sufficient margin of safety in their reflected yields, especially if a downgrade of the local currency debt rating becomes more of a concern. We are therefore more cautious in our approach to SA government bonds, and would need to see a further widening from the current levels of 9% to above 9.5% before committing in a meaningful way to the asset class.
The SA listed property market was down 1.4% in March, primarily driven by the sell-off in the local bond market, bringing the sector's return for the year to 1.37% and 1.46% over 12 months. The recent reporting season, as well as our recent interactions with many of the listed property companies, have continued to provide evidence that poor economic conditions have started to affect the local property market. Still, we remain confident that the market offers selective value. The yield gap between the property index and the current 10-year government bond remains quite stretched. If one excludes low-yielding, high-cap stocks from the index, the property sector's yield rises to approximately 8.4%. The fund maintains holdings in counters that offer strong distribution and income growth, with upside to their net asset value valuations. In the event of a moderation in listed property valuations (which may be triggered by further risk asset or bond market weakness), we will look to increase the fund's exposure to this sector at more attractive levels.

The preference share index was up 1.69% in March, bringing its return for year to 1% and 14.78% over 12 months. We continue to favour preference shares given the steady dividend yields on offer, and maintain the fund's current level of holdings. Preference shares are linked to the prime rate and, depending on the risk profile of the issuer, currently yield between 8.5% and 11% (subject to a 20% dividend tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). In addition, most of the bank-related preference shares trade at a discount, which enhances their attractiveness for holders from a total return perspective and increases the likelihood of bank buybacks.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the SA economy. However, we believe that the fund's current positioning correctly reflects appropriate levels of caution. The fund's yield of 9.06% continues to be attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected fund performance over the next 12 months.
As is evident, we remain cautious in our management of the fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium, to limit investor downside and enhance yield.

The fund returned 0.53% in February, bringing its total return for the 12-month period to 28 February 2017 to 9.65%. This is well ahead of the returns delivered by both cash (7.16%) and its benchmark (7.9%) over the same period.

The domestic bond market rallied further in February after a strong performance in January. The All Bond Index (ALBI) added to the previous month’s gains and was up a further 0.71%, after rising by 1.33% in January.

SA political noise increased in January and continued in February. Ongoing rumours of an imminent Cabinet reshuffle continued through February, but intensified after the tabling of the Budget for 2017/18. The risk of Cabinet changes remains high in the run up to the mid-year ANC policy conference.

On February 22, Finance Minister Pravin Gordhan tabled the 2017/18 Budget. The event was much more a political event than an economic or fiscal one, and accompanying documentation sent a very strong message about fiscal constraint and the need to transform the economy through job creation, not simply redistribution. The fiscal data presented continued the commitment of the Medium-term Budget Policy statement (MTBPS), presenting very similar economic and fiscal forecasts. The details of the tax reform required to raise a R28 billion budget shortfall included significant gains from limited bracket creep adjustment, a new 45% tax bracket for people earning more than R1.5 million per annum (expected to yield R4.4 billion) and an increase in the dividend withholding tax from 15% to 20%. Associated excise and sin taxes will make up the balance. A sugar tax and emissions tax are also being considered.

Data released in February also built on small improvements in growth momentum seen in January: The Barclays Purchasing Managers’ Index (PMI) accelerated again, to 52.5 from 50.9 - the best level since June 2016. New vehicle sales were a little weaker in February than in January, but the overall picture remains one of broadly improving conditions. Growth in passenger vehicle sales fell to -4.4% year-on-year in February, from a positive 4.7% in January, which had represented the first positive growth in more than a year. The Crop Estimates Committee released initial production forecasts for summer crops, showing that SA’s total maize harvest is predicted to increase by 78.9% from last year (13.9 million tonnes, compared to 7.8 million tonnes in 2015/16. January’s trade data posted a deficit of -R10.8 billion following December’s surplus of R12.4 billion. Most of the weakness is seasonal as post-festive season inventories are replenished, but the data showed increases in imports of basic metals, machinery and electronics, and original equipment against a broadly weaker export performance. It still means that the trade deficit is less than half of what it was a year ago (a R19.5 billion deficit in January 2016).

The first month of CPI data with new weights and referencing a new base (December 2016 = 100) showed that consumer inflation moderated to 6.6% year-on-year in January, from 6.8% year-on-year in December. The data saw a modest slowing in food inflation to 11.7% year-on-year, but with big monthly gains still visible in meat, dairy, fish and grain prices. Transport costs increased with a rise in the retail fuel price. There was no meeting of the SA Reserve Bank’s (SARB) Monetary Policy Committee (MPC) in February, but the data released since the January meeting suggest some downside risk to the SARB’s forecast for CPI to average 6.1% in 2017. Notably, the current summer grain harvest estimates have prompted lower grain prices, and the currency has been more resilient than most seem to have expected, which could see fuel prices fall in April. The tax adjustments are likely to put a bit of pressure on March and April data, but a significantly lower electricity tariff for Eskom (2.2% in 2017, from 7.4% in 2016), will provide a mid-year offset. We don’t expect the MPC to change interest rates in March, but the communication will probably be less cautious given these developments. At the end of February, shorter-dated negotiable certificates of deposit (NCD) traded at 8.665% (three-year) and 9.18% (five-year) respectively, 15 bps to 20 bps lower than at end January. Current market pricing suggests that the repo rate will remain flat over the next two years, in line with our expectations. Given our outlook for interest rates, NCDs continue to hold appeal due to the inherent protection offered by NCD yields. Bank credit spreads remain elevated due to a combination of new regulatory requirements (Basel III) and SA’s poor macroeconomic backdrop. Spreads in the fiveyear region have tightened marginally to approximately 135 bps (from 150 bps). The fund continues to hold decent exposure to these instruments (both floating and fixed) but remains cautious given the current phase of the credit and business cycle. We will therefore be more selective when increasing exposure. NCDs have the added benefit of being very liquid, thus aligning the liquidity of the fund with the needs of its investors.

Globally, political noise came in a steady stream in February as Eurosceptic parties in the Netherlands and France gained momentum, and US president Trump remained present on social and traditional media. But the bigger surprise has been the resilience in global activity data.

In the US, economic data confirmed GDP was 1.9% annualised in Q4-16, within which consumer spending remains strong at an annualised pace of 3.0%. However, inventories and net exports have become a drag. Capital expenditure continues to show a broad-based stabilisation, suggesting that growth momentum into the first quarter of 2017 has slowed a little. Data published during February were broadly positive: The Conference Board consumer confidence data beat expectations in February, reaching a new cyclical high at 114.8. The US ISM Manufacturing PMI posted a solid gain in February, up 1.7 points to 57.7 - well above the 56.2 expected, and the best reading since August 2014. The annual growth rate of the core PCE deflator, the US Federal Reserve's (Fed) preferred inflation metric, has risen from a recent trough of 1.3% (July 2015) to 1.7% in January. CPI data were stronger than anticipated too, up 2.5% year-on-year from 2.1%.

Reflecting a more buoyant economic environment, the Federal Open Market Committee (FOMC) minutes published after its 31 January to 1 February meeting show the Fed is becoming a little more confident in its economic forecasts and retained a tightening bias for the year. On balance, the minutes and subsequent comments from members suggest that the Fed may raise the federal funds rate again if economic data point to a strengthening economy. We expect the next federal funds rate hike to come in March.

In Europe, politics remained in focus with election races in France and the Netherlands heating up. Greece re-entered the spotlight as concerns about ongoing bailout funding re-emerged. The conclusion of the second bailout programme review still does not seem imminent. Greece owes debt repayments of approximately €1.5 billion in both March and April, before a staggering €7 billion is due to be repaid in July.

The rand gained 2.6% in February (ending at R13.13/$), and continues to be one of the top performers among its emerging market peers. Foreign bond flows turned positive in February to the tune of R5 billion, but remain negative year-to-date at R340 million. The fund maintains its maximum exposure to offshore assets, but has hedged a portion of its exposure back to rand by selling JSE-traded currency futures (both in US dollar and pound). These instruments are used to adjust the fund’s exposure synthetically, allowing it to maintain its core holdings in offshore assets. (It also has the added effect of enhancing the fund’s yield.)
Expectations around Trump’s ‘America First’ policies have continued to keep optimism around US growth and inflation buoyed, and core bond yields elevated. Valuations in selected emerging market countries - including SA - remain cheap, with local fundamentals in many of these economies starting to turn for the better. In SA, the combination of cheap local valuations, 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 very near term, we remain positive and constructive on medium to longer-term outcomes.

The local 10-year bond yield ended the month at 8.79%, which is pretty much in the middle of its recent 8.5% to 9% trading range. The fund has - and will continue to - increase duration into higher yields, as well as search for opportunities on the yield curve that will provide attractive investments to enhance both its yield and risk/reward profile.

The SA listed property market was up 1.26% in February, bringing its return over 12 months to 10.96%. The recent reporting season has continued to provide evidence that poor economic conditions have started to affect the local property market. Still, we remain confident that the market offers selective value. The yield gap between the property index and the current 10-year government bond remains quite stretched. If one excludes low-yielding, high-cap stocks from the index, the property sector’s yield rises to approximately 8%. The fund maintains holdings in counters that offer strong distribution and income growth, with upside to their net asset value valuations. In the event of a moderation in listed property valuations, which may be triggered by further risk asset or bond market weakness, we will look to increase the fund’s exposure to this sector at more attractive levels.

The preference share index was down 0.65% in February, primarily due to the increase in dividend tax announced in the 2017/18 Budget. However, its 12-month return remains healthy at 18.03%. We continue to favour preference shares given the steady dividend yields on offer, and maintain the current level of holdings in the fund. Preference shares are linked to the prime rate and, depending on the risk profile of the issuer, currently yield between 8.5% and 11% (subject to a 20% dividend tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). In addition, most of the bank-related preference shares trade at a discount, which enhances their attractiveness for holders from a total return perspective and increases the likelihood of bank buybacks.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the SA economy. However, we believe that the fund’s current positioning correctly reflects appropriate levels of caution. The fund’s yield of 8.95% continues to be attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected fund performance over the next 12 months.

As is evident, we remain cautious in our management of the fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium, to limit investor downside and enhance yield.