The Reserve Bank cut the repo rate by a further 150 basis points during October. This was in the context of a continued benign inflation outlook and ongoing rand strength. With the Reserve Bank now having shown its dovish hand as far as monetary policy is concerned, it is clear that the impact of further rand strength on inflation will mean more rate cuts.

The fund manager's preference is however that a consolidation phase should be followed, allowing the Reserve Bank to assess the potential inflationary impact of their own actions before moving further. In particular, the demand side of the economy appears to be coming close to boom times, with the retail sector enjoying its most favourable environmental conditions for a long time.

Bonds have continued to drift downwards, with both fundamental economic conditions as well as bond market specific technical issues providing support. The fund has been able to take advantage of that by being generally long in duration. The fund manager's do believe, however, that the current downward move in bond yields is discounting a sustained structural downward shift in inflation, to the extent that breakeven inflation is now below 5% for inflation-linked bonds. It is still too soon to assess the sustainability of the inflation downtrend, but it is likely that the market will overshoot on the downside given its current optimism. While fundamentals remain supportive, yields are at fair value at best, and a move to a more cautious approach in the fund is fast approaching.

The past quarter has been dominated by three particular driving forces : The continuing strength in the rand, the apparent recovery in the US economy, and the more aggressive than expected easing in local monetary policy. The impact of these forces had seen SA inflation prospects brighten dramatically, a selloff in global bonds and a further normalisation in the shape of the local yield curve. Strangely enough, the local forces did not dominate, and in the end, the All Bond index could only eak out a rough 2.7% return against the 2.9% return delivered by cash. A single quarter's performance does not however spell out the complete story - perhaps only a single chapter at best. More interesting times still lie ahead. Aspects such as the sustainability of the apparent US recovery, the depth of response of the SARB to the fall off in the supply side of our economy, as well as potential policy shifts on Foreign Exchange reserve accumulation are issues that will undoubtedly have a major impact on the likely direction of bond yields going forward. The fund manager's still expect that global bond yields are in expensive territory and it is a matter of time before risks are priced in more fully.

For the quarter the fund has performed adequately, although the significant underweight position in the 12+ area of the yield curve detracted from performance. The fund has been re-positioned in a more focussed manner with a smaller number of stocks since mid-quarter, and the fund manager's expect that this will enhance performance potential going forward. Given the levels at which bond yields ended the quarter, significant capital gains (ie, more than 5%) are not expected in the near term. but total returns over the next 12 months are still expected to outperform cash holdings.

By taking advantage of recent market strength we further reduced the modified duration of the fund. This decision was based mainly on the view that the bond market is already priced for widely expected disinflation. The bullish inflation outlook is particularly well priced at the long end of the yield curve.

Instead, exposure to short and medium dated bonds is deemed more appropriate as this offers a better risk to return payoff. The overweight exposure to the shorter area of the yield curve is a function of the extent of the year-old bond market rally, expensive global bond markets and the expectation that domestic short-term interest rates will be reduced further in months ahead. This should give further momentum to yield curve normalisation, with short-term interest rates expected to trade at lower levels compared to long dated bonds.

The modified duration of the fund remains shorter than that of the All Bond index as it has an underweight position in the long end of the yield curve. Bonds, particularly at the long end of the yield curve, are pricing off the expectation of a lower inflation figure by the end of next year.

Recent rand strength has improved the inflation outlook for 2003, while the latest inflation figures are showing promising signs that South Africa has seen the inflation peak. Should this be the case, the opportunities for monetary policy easing during 2003 are encouraging. This could lead to the normalisation of the yield curve with short term interest rates trading at a lower yield than long-dated bonds. Under this scenario, short to medium-dated bonds offer a superior return to risk payoff compared to long-dated bonds.

The modified duration of the fund remains shorter than that of the All Bond index as it has an underweight position in the long end of the yield curve. Bonds, particularly at the long end of the yield curve, are pricing off the expectation of a lower inflation figure by the end of next year.

Recent rand strength has improved the inflation outlook for 2003 while recently released inflation figures are showing promising signs that we have seen the inflation peak. Should this be the case, the opportunities for monetary policy easing during 2003 are encouraging. This could lead to the normalisation of the yield curve with short term interest rates trading at a lower yield than long dated bonds. Under this scenario, short to medium dated bonds offer a superior return to risk payoff than long dated bonds.