Market review
The third quarter saw exceptionally volatile markets as risk aversion resurfaced on European debt woes and global slowdown concerns. Quarterly returns for the bond market were 2.8% and cash, as measured by the STeFI Index, returned 1.4%. While the yield curve was largely unchanged at the end of the quarter, it belied exceptional volatility. A range-bound July gave way to a massive August rally as emerging market local debt shrugged off currency weakness and traded like safe haven Treasuries. The rally, however, was short-lived as continued risk aversion weighed on currencies in September and emerging bond market yields rose aggressively. Huge inflows quickly turned to massive outflows as foreigners reduced holdings in South African bonds. The money markets started to discount a further rate cut and pushed the timing of the first expected hike out to 2013.

Portfolio review
Inflation moved higher during the quarter, and is now at 5.3%, with food inflation continuing to be the primary driver. Activity data continued to be weak, with strike action taking its toll on the purchasing managers index (PMI) which plummeted to 44.2, before recovering somewhat. The disappointing second quarter GDP number and increasingly difficult global environment show the challenges the South African economy faces, and growth for both this year and next has been revised lower. The combination of low growth and rising inflation poses a serious dilemma for the South African Reserve Bank, which opted to keep rates on hold. The Investec High Income Fund returned 1.7% over the quarter. Against a backdrop of increasing inflation and huge global uncertainty, bonds fluctuate between offering fair value and being somewhat expensive.

Portfolio activity
Given the inordinate volatility in the bond market, we maintained a cautious stance. We favoured the shorter end of the curve as local issuance remains concentrated in the long end. We also preferred highly-rated credit, particularly floating-rate notes, and added selectively to the portfolio where spreads on new issues looked attractive.

Portfolio positioning
Rand weakness, the volatility of the South African financial markets and the huge turnaround in fixed income investment flows seen in the third quarter are a stark reminder that global factors are important drivers of our markets. With the situation in Europe likely to flare up from time to time and deepening concerns about the extent of the global slowdown, caution continues to be warranted. We expect volatility and bouts of risk aversion to continue into year-end, providing policymakers with an exceptionally awkward backdrop against which to manage the economy. The rand and the bond markets will continue to be at the mercy of global investment flows. The possibility of another interest rate cut has risen significantly. While the South African Reserve Bank will closely monitor the impact of the weaker rand on inflation, the Bank will carefully consider the country's growth prospects. With slowing growth and rising inflation, the yield curve will remain steep as investors demand a higher risk premium for holding longer-dated instruments. The portfolio will be positioned to take advantage of the attractive spreads offered in the credit markets. We will also maintain a relatively cautious position on duration, although we do believe that the steepness of the curve does warrant some exposure to longer-dated bonds. With only modest exposure to the bond market, the risk to the portfolio of a big sell-off in yields is limited. We remain positioned strategically and will be able to take advantage of opportunities that arise.

Market review
The second quarter saw a strong recovery in the bond market as risk appetite returned to global markets. Quarterly returns for the bond market were 3.9% while cash returned 1.4%. Emerging market debt attracted large inflows and South Africa was no different. Foreigners bought in excess of R35 billion of our local debt during this quarter and this was one of the main reasons for the rally.

Portfolio review
Domestic inflation surprised on the upside with food inflation being the primary driver. The South African Reserve Bank (SARB) seems to be leaning towards holding rates for longer, with the first hike being priced in for year-end. Growth in manufacturing production continues at a sluggish pace, with weak car production numbers probably linked to Japan-related supply disruptions. The manufacturing numbers will cause a drag on GDP figures. Globally, growth remains disappointing. The Investec High Income Fund returned 1.8% over the quarter.

Portfolio activity
Due to the rallying of the bond market, we maintained a cautious stance while the benchmark duration lengthened significantly. Local issuance remains concentrated in the long end of the curve. During the review period, we continued to favour highly rated credit, particularly floating rate notes, and added selectively to the portfolio where spreads looked attractive.

Portfolio positioning
Global market sentiment improved in the second quarter and investors had a greater appetite for risk. Going forward, debt problems in the euro zone and uncertainty about the debt ceiling issue in the US could affect local markets, as foreign capital could rapidly be withdrawn.

The rand remains overvalued due to the large inflows, and we are increasingly concerned that the local currency could depreciate into year-end. A weaker rand will add to the inflation woes and make the SARB increasingly worried about inflation. The Bank is equally concerned about the sluggish pace of growth in the SA economy and the absence of employment growth. The monetary authorities are thus likely to hold-off on interest rate hikes for as long as possible. This should result in steeper yield curves as investors demand a higher risk premium for holding these instruments.

We continue to position the portfolio to take advantage of the attractive spreads offered in the credit markets. We will maintain a cautious position on duration, although we believe that the steepness of the curve warrants some exposure to longer-dated bonds. With only modest exposure to the bond market, the risk to the portfolio of a big sell-off in yields is limited. We remain positioned strategically and will be able to take advantage of opportunities that arise.