The third quarter of this year was particularly cruel for emerging markets, especially due to the barrage of persistent negative news fl ow from Turkey and Argentina. This was in addition to existing headwinds, like the escalating risk of more international trade restrictions between the US and key trading partners, which, if they come to fruition, may have potentially dire consequences for emerging markets. As market sentiment soured, foreign investors predictably responded by becoming large-scale sellers of emerging market bonds and currencies.

In the case of South Africa, foreign investors sold R17 billion worth of rand-denominated RSA government bonds over the quarter, contributing to net sales of just short of R60 billion for the fi rst nine months of this year. Although dwarfed by the excessively sharp depreciation of the Turkish lira and Argentinian peso, the rand (like most other emerging market currencies), failed to escape the carnage and depreciated by around 11% against the US dollar from the end of June to early September. In the process, the local currency reached its weakest level against the greenback since June 2016. Although the rand regained some lost ground during the last three weeks of September, it is still about 20% weaker than its best level this year. This, in turn, contributed to heightened market fears of additional future infl ationary pressure and a possible rate increase by the South African Reserve Bank (SARB). Although the SARB has thus far resisted the temptation to hike its policy rate, it did use every single opportunity to warn against the risks to higher infl ation, which implies higher future rates should infl ation indeed accelerate too fast for its liking.

While negative international developments had been prominent, local data releases also contributed to negative market sentiment. The rate of infl ation at both consumer and producer levels continued to tick higher, with the latter now just outside the top end of the infl ation target range. Most disappointing was the release of gross domestic product (GDP) data for the second quarter of this year, which confi rmed a "technical" recession (that is, negative growth for two consecutive quarters). From a bond market perspective, it is noteworthy that weak economic growth could hamper tax revenue collection, particularly corporate income tax, and if unmatched by expenditure cuts, put fi scal consolidation at risk. This, in turn, would lead to a higher funding requirement and possibly more sovereign credit rating downgrades. Fortunately, the latest available data shows that South Africa’s cumulative main budget fi scal defi cit for the fi rst fi ve months of the 2018/19 fi scal year is still largely on track relative to the Budget presented in February this year.

The events described above not only forced bond yields across the yield curve to higher levels (yields rise as bond prices fall), but also contributed to signifi cant intra-quarter volatility. The extent of this volatility is demonstrated by the trading range of 8.57% to 9.25% of the benchmark R186 (maturity 2026). A late quarter relief rally caused the R186 to gain some lost ground, but it still closed the quarter 15 basis points (bps) higher at 8.99%. The net increase in yields during the quarter led to a disappointing JSE ACSA All Bond Index (ALBI) return of 0.8%. Although the infl ationlinked bond market initially failed to escape negative market sentiment, real yields stabilised at higher levels towards the end of the quarter, bringing to an end the sharp rise in real yields that started in April this year. As a result, the JSE ASSA Government Infl ation-linked Index (IGOV) returned only 0.5% for the quarter. However, this was a signifi cant improvement considering the second-quarter return of -4.6%. Cash retained the top position for the period under consideration, returning 1.6%.

Investment view and strategy

The recent more sustained pick-up in global bond yields notwithstanding, our view remains that most developed bond markets are still not appropriately priced. In the case of the US, the strong pace of economic growth, the low level of unemployment and evidence of sustained higher infl ation support further US monetary policy tightening. We believe that the US Federal Reserve (Fed) is in a position to lift its policy rate by at least another 25bps this year. More importantly, at a global level, the trend continues to gradually shift from quantitative easing to quantitative tightening.

Locally, our main concern with regard to the bond market remains the strong link between lacklustre economic growth and fi scal consolidation - or more specifi cally, the rising debt burden of Government, which arises as a consequence of a lack of fi scal consolidation and therefore continues to threaten the country’s sovereign risk profi le. The risk of a failed economic recovery has risen following a slew of disappointing data releases the last few weeks. This makes us question the quality of tax revenue collections, which, in turn, keeps the risk of a budget defi cit overrun at elevated levels.

On the monetary policy front, we maintain our view that the central bank will remain hostage to the opposite forces of a lacklustre economic growth outlook and upside risks to infl ation. For now, to us this suggests a stable policy path. The risk to this view is skewed in favour of some upside risk to infl ation and thus interest rates.

While the observable investment theme and related realtime developments mostly have negative consequences for the local bond market, it is important to note that current market valuation is largely refl ective of this. Cheaper market valuations following the sell-off during the second and third quarters of this year afforded us an opportunity to cautiously increase risk by selectively buying nominal bonds. We shall continue to look for opportunities to increase bond market exposure, but only into bouts of weakness, considering the level of uncertainty discussed above.

The fund underperformed its benchmark performance on a net basis for the 12-month period ending September 2018. This was mainly attributed to the underweight exposure to the top performing long-dated nominal bonds over the period under review.

The fund is conservatively positioned, with a small underweight modifi ed duration position. We will continue to look for opportunities to increase our holding of fi xed rate nominal bonds, with a preference for those bonds with a higher running yield.

The fund aims to offer a combination of capital growth and high income yields. Capital growth is primarily achieved by actively taking advantage of interest rate cycles.

Local developments continued to be the primary driver of improved investor sentiment during the first quarter of 2018. Following the outcome of the ANC elective conference in December 2017, hope of much-needed changes in policy direction received several boosts as the new cabinet asserted itself with decisive action and initiatives.

From a pure bond market perspective, the main highlights of the above are important governance related changes at some of the troubled state-owned enterprises and the tabling of a more market-friendly National Budget. Consequently, investor and consumer sentiment received a boost - a crucial element to lifting lacklustre and subtrend economic growth. The changes enticed foreign bond investors to return, following the selling spree in the aftermath of the tabling of a shocking Medium-Term Budget Policy Statement in October 2017. At the end of March, net foreign investor purchases of local currency bonds reached R25 billion, a significant positive swing considering net selling of around R6 billion earlier this year. Investor action served as a precursor to the decision by Moody’s ratings agency to retain South Africa’s sovereign credit rating at Baa3, the lowest investment grade rating. Although the market had already priced in the likelihood of an unchanged rating, the decision to change the sovereign outlook from negative to stable was telling in terms of the agency’s view on the impact of recent political changes. In contrast, Standard & Poor’s ratings agency released a more sober report, where the difficulty of solving South Africa’s structural issues featured strongly.

The confluence of Moody’s ratings decision (which prevented the large-scale selling of SA bonds by foreign investors), sustained rand strength, meaningfully lower inflation expectations and improved sentiment following recent political changes, enabled the South African Reserve Bank (SARB) to lower the repo rate by 25 basis points in March. The fact that the stronger rand played a role in stemming the balance of payments improvement did not pass unnoticed, though.

The strength of the bond bull rally is well illustrated by the movement in the benchmark RSA R186 government bond (maturity 2026). The R186 yield dropped from a recent weakest yield of 9.47% in mid-November to close the first quarter of 2018 at 7.99%. For the quarter under review, the drop in yield was 60 basis points. Yields of longer-dated bonds decreased by even more, as the slope of the yield curve flattened. As a result, the All Bond Index rendered a total return of 8.1% for the first quarter. In stark contrast, cash returned a mere 1.7%. The sharp decrease in nominal bond yields also dragged real yields to lower levels, despite the fact that the demand for inflation protection had been less urgent - considering the more benign inflation outlook. Although still well below the return offered by nominal bonds, the Inflation-linked Government Bond Index still managed a very respectable return of 4.1% over the quarter.

The fund underperformed its benchmark for the 12-month period ending March 2018. Although the fund had been a net buyer of nominal bonds since November last year, it still ended the first quarter of this year with an underweight position in top performing long-dated nominal bonds. This had been the main detractor from relative performance. It was only partly offset by the holding of higher-yielding non-government bonds.

Despite the net buying of nominal bonds since November last year, the fund is still relatively conservatively positioned. This is reflected by the small underweight modified duration position, which in turn is the result of underweight positions in the 7-12 and 12+ year maturity bands.