Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%. Global government bond yields rallied hard from the beginning of July as the markets reacted to signs that policy tightening was starting to impact credit markets.

Domestically, we witnessed a modest slowdown in growth and evidence of somewhat weaker consumer spending, particularly evident in the motor vehicle retail sector. Rising inflation, mostly on the back of sharply higher food prices, and a pick-up in inflation expectations were met by a further interest rate hike in August.

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief.

Equities recovered strongly from their August lows, gaining 6.7% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index (ALBI) was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The Investec Cash Plus Fund earned a return of 2.1%, performing broadly in line with the benchmark. Despite the continued higher inflation and global credit woes, bonds rallied while money market yields rose as the market began to anticipate the peak in local interest rates.

The portfolio was very conservatively positioned until mid August. We kept bond exposure very low before adding some exposure in the latter part of August into September. Credit spreads continue to widen so we remained cautious in this area.

Performance was helped in July by keeping duration short and we performed in line with the index. Adding duration and some bond exposure in August and September positioned us well for the rally and we outperformed in those months.

Portfolio activity
We traded the duration quite actively over the quarter. We bought short dated government bonds and longer dated money market instruments as yields rose, lightening up again as yields rallied.

Due to concerns regarding global credit events our participation in local auctions was limited. However, we added some attractively priced securitisations. We slightly reduced our exposure to very short dated non-government bonds, preferring the higher yield on money market instruments.

Market outlook and portfolio positioning
The bond market is starting to look through the peak in CPIX inflation and is anticipating the end of this interest rate cycle. Even though inflation is forecasted to remain outside the targeted band of the South African Reserve Bank (SARB) for the next six to eight months, bond yields and longer dated cash yields have already started to rally.

Our view is that inflation will only peak next year and as such there is still a risk that yields will sell off again. The October monetary policy committee decision is a close call and the SARB governor will hike interest rates if he solely looks at inflation. However, we expect that he will have watched the global events with concern and may well decide to pause in order to ensure that this credit crisis has indeed passed.

The biggest risk to our portfolio is that short-term rates continue to rise and bond yields sell off aggressively again. The portfolio is also at risk of underperforming if credit spreads widen dramatically. Our view is that bond market yields may rise, giving us a better buying opportunity in the next month or two.

Market review
Money market yields sold off aggressively in the second quarter, driven by the long end of the yield curve, which kicked up 0.88% during the period. With the deterioration in the inflation data over the quarter, the market had priced in a full 0.70% of further interest rate hikes prior to the June Monetary Policy Committee meeting. Therefore, the market was not surprised by the South African Reserve Bank's 0.50% increase in the repo rate at the beginning of the month.

Sentiment remained negative through most of the quarter helped by hawkish rhetoric from the South African Reserve Bank (SARB), domestic inflation data surprising on the upside as well as increased global inflationary concerns. Rising global yields coupled with a rise in volatility put pressure on riskier emerging market assets as investors demanded to be compensated for the uncertainty. Over the quarter the local government debt curve rose sharply with the benchmark R153 and R157 peaking at 9.15% and 8.58% respectively. Bonds underperformed cash. The All Bond Index lost 1.7% over the quarter while cash (as measured by the STeFI Index) earned a return of 2.2%. The All Bond Index (1-3 years) returned 0.7% over this period.

Fund performance
The Investec Cash Plus Fund earned a return of 1.9% over the quarter. Your portfolio was cautiously positioned for the sell-off in yields, letting the cash duration drop through June and maintaining only a very modest exposure to the bond market. We did increase duration somewhat into the latter part of the sell-off, but are still maintaining a very cautious stance.
The portfolio benefited from letting the cash duration fall. As inflation expectations deteriorated, both the short end and the very long end sold off more than the middle area of the curve. Credit spreads did not perform well over the quarter and the slight widening of some of the corporate holdings in your portfolio detracted from the overall performance.

Portfolio activity
The portfolio kept investments largely within the very short end of the money market curve, letting the cash duration fall for most of the period. As R153 yields rose towards last year's highs, we did begin to selectively add a little more bond exposure.

Most of the buying of duration over the quarter was concentrated in the short end of the money market curve and the short end of the bond market. The corporate holdings were kept relatively unchanged although we did replace maturing issues with some of the new instruments that were issued at higher yields.

Market outlook and portfolio positioning
The bond and money market is going to be fixated on the CPIX releases over the next few months. Since we broke out of the official inflation target band, there has been extra pressure on the SARB to hike rates. At present the market is pricing another 50 basis points hike in August and a 40% chance of a further 50 basis points hike in October. This would have seemed excessive a few months ago, but inflation fears have risen in most global economies and we have seen deteriorating inflation expectations across the globe. Real rates globally have also been rising which will keep our rates higher for longer.

The major causes of higher inflation have been food and fuel, but we are starting to see signs of 'pass through' inflation as retailers pass on higher costs to the consumer. This together with higher than expected wage increases will keep the SARB vigilant. On the positive side we are starting to see a slowdown in credit demand from the consumer as reflected in falling car and retail sales figures. This will be encouraging to the Governor as he has been warning consumers to reduce spending.

We have added selectively to our bond market exposure, as we see some value in the bond market. As rates rise further we will continue to increase our overall duration. Thus, the biggest risk to our view is that inflation surprises on the upside and the SARB has to hike rates more aggressively. As inflation stabilises and growth in the economy moderates, we will see rates settle before rallying into the latter part of the year.

Market review
Money market yields were volatile in the first quarter of the year. The one year Jibar rallied strongly into February only to sell-off again during March, ending the quarter at a level not far off from the start of the year. A dovish February monetary policy committee statement and positive budget gave rise to the rally into February. However, global risk aversion coupled with domestic factors started to weigh on the market towards the end of March. With the release of a large current account deficit at 7.8% of GDP, strong retail sales and hawkish comments from the Reserve Bank Governor, the market started to price in a 60% chance of a further rate hike. A higher oil price with an underrecovery of more than 60 cents a litre as well as maize futures reaching R2000 a ton added impetus to rate hike concerns. Over the quarter cash (as measured by the STeFi index) earned a return of 2.1%, against the All Bond Index return of 1.6%.

Fund performance
The Investec Cash Plus Fund earned a return of 1.9% over the quarter. The portfolio was reasonably active over this period. We increased the duration and bond exposure of the portfolio in early January in anticipation of a market friendly budget and the seasonal coupon flows. The Minister of Finance did not disappoint and the unexpected budget surplus and the removal of the retirement fund tax caused bond yields to rally in February. We used this opportunity to reduce the bond exposure and shorten money market duration. With cash expected to outperform bonds in the coming months we have again increased our cash duration and remain cautious on bonds. Performance was helped by active management over the quarter and increasing exposure to the one year area of the cash curve. Bond yields continue to trade well below cash yields and in March cash comfortably outperformed bonds. We still maintained a small exposure to longer dated bonds and this was a small drag on the overall performance of the portfolio.

Portfolio activity
The portfolio was active over the quarter as we had two positive months where bonds outperformed cash followed by a negative return month for bonds. The portfolio could thus increase the duration, and decrease the cash holdings in January and February to benefit from the bond rally. We then reduced the bond holdings at the lower yields in order to protect the portfolio from capital loss in March. Although we did not meaningfully increase the overall exposure to credits over the quarter, we did however continue to add to exposure in attractively priced securitisation issues.

Market outlook
The inflation outlook has deteriorated on the back of rising global oil and food prices. These pressures will ensure that the South African Reserve Bank (SARB) remains cautious on interest rates for the foreseeable future. While there are some signs that consumer demand may be moderating, demand for credit remains at elevated levels. The SARB continues to use every opportunity to 'warn' SA consumers to curb their spending and reduce debt. The risk of further interest rate hikes will persist. If oil prices suddenly moderated and food prices stabilised at current levels, the inflation outlook would improve sufficiently that the SARB could hold off on any further interest rate hikes. This could result in a rally in the bond market and thus our very limited exposure would limit our ability to outperform our cash benchmark. However, the portfolio's low overall duration position will give some capital protection in the event of a sell-off. The large cash holding is also giving the portfolio a higher overall yield due to the fact that bond yields are currently trading below cash yields.

Market Highlights
The long end of the bond market rallied hard over the quarter as it looked through rising interest rates and higher inflation and responded to the strengthening Rand, lower oil prices and increasing risk appetite for emerging markets. The 2008 area of the curve was the pivot point with yields shorter than that rising in response to monetary policy, while those beyond fell during the 3 month period.

The market has been driven by the following factors over the quarter:
a) Rand: The local currency again lived up to its reputation as the most volatile currency in the world as we saw the Rand/USD reverse most of its second quarter depreciation and rally back below R7.00/$ at year end from close to R8.00/$ in early October, buying sentiment in the bond market.
b) Inflation: Oil prices reversed the big gains from earlier in the year in the last month of the third quarter and then traded largely sideways into the end of November. This together with the stronger Rand, meant a sharp reversal of the big petrol price increases seen previously and lower inflation into year end than initially forecast by the market. Although inflation will still be pressurised by high food prices and some of the lagged effects of the weaker Rand earlier in the year on tradable goods, the outlook has improved markedly, although a test close to the upper end of the band by mid-2007 is still likely.
c) Global yields: Bond markets continued to rally on concern that global growth is going through a soft patch.
d) Supply of bonds. Government finance figures continued to improve with revenue collections running well above budget and the MTBS slashed forecast deficits over the next few years, resulting in a reduction in the amount of stock offered at the weekly government auctions and a shortage of paper. This helped the inversion of the SA yield curve with the longer dated bonds outperforming the short dated bonds. Your portfolio was well positioned for this with an overweight position in 7-12 year area of the curve.

Outlook
The Rand is expected to remain largely range bound between R7.00-R7.50 in the coming months and inflation should rise close to the upper band in the second quarter. The SARB may well hike rates by another 0.50% at the MPC meeting in February, but this would probably be the final one in the cycle and the bond market in particular will continue to look through the peak in both interest rates and inflation. With a likely top of the interest rate cycle sometime within the first half of 2007, the money market curve should also start to invert in the coming months and the risk reward profile will favour moving further out along that curve and increasing duration.

The immediate outlook for bonds is likely to be dominated by the change in the index and the positive seasonal pattern, offset by a little profit taking in emerging markets after a very strong fourth quarter and weakness is global bond yields. This combination should give rise to a reasonable trading range and outperformance of the long end. Concern about the current account deficit has receded for the moment, but it remains a long term structural overhang that makes the Rand susceptible to global shocks. The shortage of government supply, combined with the significant lengthening of the index in the early part of 2007 will keep the market well supported into the budget in March. Furthermore, local investors have remained very underweight in their exposure to bonds and any increase in bond holdings will add further support to the market. As was the theme for much of 2006, the global environment remains a little more mixed. The US interest rate cycle may well have peaked, although recent signs of stronger economic activity and Federal Reserve comments are likely to keep market participants guessing in the months to come. On the other side of the Atlantic, reasonable growth will keep the European Central Bank vigilant. The oil price will continue to be a key determinant of the path of inflation, and if recent weakness persists will make the outlook for inflation into midyear more moderate.

We will thus look to selectively increase duration through purchasing the long end of the cash curve, while maintaining selective exposure to the bond market to take advantage of the changing shape of the curve.