Local yields maintained their positive momentum of the past 3 months, with R153's reading new low points at 8.47%. The continuation of the benign inflation outlook, combined with a lack of a clear trend in international bond markets, continues to constitute a favourable environment for local bonds.
The Medium Term Budget Policy Statement, while indicating an increased budget deficit over the next few years, with its associated increase in net supply, failed to make a substantial impact on market sentiment. At this point, the particularly good inflation outlook is key to the direction of the local bond market over the course of the next few months, as this will also determine the extent of any changes to monetary policy. In this regard, the direction of the rand is also pivotal, as is the outlook for commodity prices. The recent hike in interest rates by China serves to heighten the risks.
However, given the medium- to longer-term growth imperatives in China, it is unlikely that the authorities there will risk a "hard-landing" type scenario and, hence, an orderly monetary policy adjustment phase is expected. This will most likely serve to prolong the China growth story, and will also serve as a favourable backdrop to a more stable rand picture going forward.
This in itself will be favourable from an inflation perspective, and will allow the current structural adjustment phase in local markets to continue. Over the medium- to longer term we will expect bond yields to continue in a downtrend. The fund will accordingly be positioned to take advantage of these movements.

Maintaining a higher duration than benchmark over the previous quarter proved to be the correct course of action, given the dramatic drop in bond yields locally. The R153 dropped from a yield of 9.9% to around 8.8% by end of September. This move was driven primarily by the improvement in local inflation expectations, which was confirmed by a 50 basis point cut in the repo rate in mid-August. It also helped that international bond yields enjoyed a positive quarter, with the US 10-year bonds trading down from 4.6% at the beginning of the quarter to end at 4.1%.
Another positive development has been the resolution of the public sector wage negotiation process, with the details ultimately showing that there is a far greater alignment of wage demands with inflation targeting than has been the case before.
Market speculation continues to focus on the possibility of further relaxation on monetary policy via another rate cut in the near future. This is unlikely in the current context and the August cut should be seen as an adjustment to the more benign inflation outlook, rather than another round of cuts. Further cuts should only be expected if another adjustment in the medium to long term inflation outlook occurs.
The first signs of domestic pricing pressures - a stubbornly high oil price and a slightly weaker currency after the recent repo rate cut - may prove to be restraining factors that keep the SARB at a neutral outlook for the foreseeable future. However, the longer term, multi-year outlook remains positive.
In the current context, bond yields appear fairly priced, but do not offer much in terms of gains on the downside in the near term unless positive surprises emerge, coupled with a positive global context. Capital risk in the fund will then be contained, initially in a fairly tight range. But medium term momentum still appears biased towards the downside. The possibility of a cyclical move upwards should not be discounted, although given the benign inflation outlook, this may well prove to be fairly restricted in extent - if realised at all.

During the second quarter, an underweight duration position was maintained for the majority of the period. The rationale for this was the fund manager's concern about the net supply of bonds onto the domestic market going forward, as well as concerns about the potential inflationary prospects, given the surge in oil prices early in the quarter.
Subsequently, the oil price declined from its highs and, in fact, all the traditional inflation drivers - oil prices, the rand, and food prices - ended the quarter in benign territory. The fund manager's reaction to the latest developments was to remove the underweight position and move longer.
The SA Reserve Bank still appears fairly relaxed about inflation prospects. The fund manager's expect, however, that the current surge in indicators of domestic demand may well trigger a negative response from the SARB even if inflation remains within the target band. The implications of such a stance would be very good for the bond market in the medium to longer term, as it would demonstrate that the SARB is well ahead of the curve and in control as far as inflation is concerned. This should be of great comfort to bond investors. As it currently stands, a moderate hike in the repo rate early on (ie, in the second half of 2004) may well trigger further rand strength, which sets in motion a positive spiral for inflation prospects. How this would impact on growth prospects, however, is not certain, but growth prospects should be adequately supported by the expansionary fiscal stance of government going forward.
As far as fund positioning is concerned, a moderate overweight position is justified given the change in the inflationary outlook, but concerns remain about the sustainability of a rally downwards should global bond yields remain in a strong uptrend. Recently, renewed concerns about the growth prospects in the US have led to lower bond yields in that country, but most growth indicators remain firmly in positive (and above trend) territory.

have maintained an underweight duration position in the fund through the past month. This has been as a result of our bearish view on global bond developments. In particular, we view US bond yields as being vulnerable to upside movements once the employment numbers there became more favourable. We also expect that the US Fed will begin a gradual process of preparing the market for the eventual (and inevitable) rate hikes. This will have substantial market impacts from both a currency and bond perspective.

Locally, the SARB is expected to maintain a relatively neutral view given that current forecasts show inflation as being contained within the inflation band. The key inflation risk at present is the substantially higher than expected oil prices. Where the key risk was food prices a mere two months ago, these fears have now abated. What has rescued us from an inflationary surge due to the higher oil prices has been the continuing strength of the rand. Even though commodity prices have fallen from their peaks, they remain high and the terms of trade remain favourable for South Africa. We do not, therefore, expect major moves in the levels of the rand either way.

In the absence of significant driving factors, one might assume that the local bond market offers good value over a 12-month time horizon, but the net supply of bonds from both government and corporate issuers remains a concern. This may well cause yields to remain at fairly high levels for a significant period despite a relatively benign fundamental outlook.

The fund remains underweight duration in the short term, but is actively seeking to lengthen duration when yields are adjudged to offer good long-term value.

The fourth quarter of 2003 produced more of the same as far as markets were concerned, with continued rand strength, recovery in the US economy, and aggressive easing in local monetary policy. However, by quarter end, the first signs of a chink in the rand's armour were starting to appear. The currency's retracement from a low of below R6.10/$ to R6.90/$ during December showed that the rand had probably reached its strongest levels. The magnitude of the trade deficit for the second month in a row also came as something of a surprise. However, one of the key driving forces for the rand - the terms of trade - still appears to be favourable, with gold and platinum prices the key positive drivers.

Inflation prospects remain particularly favourable at present, and it is only the possibility of sustained drought conditions that remain a concern for food prices during 2004. It is also likely that the market, while being surprised by the limited extent of the most recent 50 bps interest rate cut, may well be surprised even further by the possibility that there will be no further rate cuts in this cycle. This has major implications for positions in the short end of the yield curve and it is therefore unlikely that major gains will be seen here. Technical factors in the market may well continue to be a driving force for gains further along the maturity spectrum in the short term, but it is unlikely that these will be sustained in the face of increasing inflation risks in the medium term. The fund is being repositioned for this, having already reaped the benefit of a normalisation in the yield curve over the past three quarters. Performance has been consistent and is steadily shifting up, which is pleasing. The fund manager's do not, however, expect that bond funds will experience significant capital gains, but they will still outperform cash returns.