Market review

Ben Bernanke featured in most of the third quarter highlights. Towards the end of the quarter he surprised markets when he held back on the much anticipated tapering of the third Quantitative Easing program. Investors rushed back into risky assets with the news that 'easy money' was here to stay for a bit longer. Global bond and equity markets made impressive gains, particularly in September, which provided some relief for battered emerging markets. But investors are probably still concerned about how the market will respond when the inevitable tapering does take place and the second quarter gave us some indication of what could happen down the road.

Overall global economic data reaffirmed a gradual recovery in economic activity. The next challenge for central banks will be the prudent cutting back in accommodative central bank policies.

On the local front, high inflation, a weak rand and a pedestrian economy leaves the SA Reserve Bank in a difficult spot and rates seem to be on hold for now. The rand weakened 13c during the quarter to close to R10.06 to the dollar. Domestic nominal and inflation-linked bond yields were largely unchanged, but that hides some fairly dramatic yield movements during the quarter. The 10-year RSA bond yield touched 8.2% during the quarter and closed at 7.62%.

The All Bond Index gained 1.9% during the quarter but has only added 0.5% year-to-date. Inflation-linked bonds returned 1.2%, while cash yielded 1.3% for the quarter. Inflation-linked bonds are still in negative territory year-to-date (-2.0%). Property stocks lost 1.3% during the quarter and also proved quite volatile. Compared to the last couple of years, fixed income assets have been exceptionally volatile over the past two quarters.

What SIM did

As mentioned in the second quarter commentary, we added significantly to the Fund's duration during the latter part of the second quarter. After the Federal Open Market Committee surprise announcement of 'no tapering', local bond yields dropped significantly and the yield curve flattened. We used this opportunity to reduce our long-dated bond exposure slightly. We still believe the yield curve is too steep and hold long-dated government bonds in the portfolio. Long-dated yields are between 8% and 9% compared to cash, which is offering just over 5%. The Fund's higher duration paid dividends and a very good September meant the Fund outperformed cash during a difficult third quarter.

SIM strategy

Fixed income valuations are now closer to our long-term fair value, with nominal bonds still offering some value. Our preference for nominal bonds over inflation-linked bonds has diminished slightly with the decline in breakeven inflation from about 6.4% to about 6% over the past couple of months. Listed property still looks expensive relative to nominal bonds but there have been some opportunities to add property exposure during the vigorous selloffs that have occurred during the past couple of months. We have increased the Fund's risk from a low base and have ample scope to increase risk further should opportunities arise in the coming months.

Market review

Investors were again treated to a highly volatile quarter across the board. Equity, fixed income and currency markets see-sawed the world over as the US indicated it was considering tapering off its Quantitative Easing (QE) activities in the not too distant future. Investors initially reacted by selling off risky assets but soon there was no place to hide, as fixed income assets also incurred heavy losses. US treasuries weakened from 1.85% in March to 2.49% by the end of June. Obviously markets fear that the reduction in liquidity provided by the US Federal Reserve will jeopardise the global economic recovery and negatively impact market confidence. But, contrary to popular belief, housing numbers, employment and general confidence in the US are in a much better place than a year ago - and thus the inevitable talk of easing QE bond purchases.

The news was particularly bad for emerging markets, which experienced significant portfolio outflows during the quarter. The rand wasn't spared and lost about 60c in Q2, ending at close to R9.87 to the dollar. The SA bond market suffered significant outflows and experienced one of worst selloffs in recent history. The 10-year RSA yield reached a low of about 6.2% in early May; only to touch 8% in late June, a massive 180 basis point yield swing from bottom to top.

During the quarter, the 10-year RSA bond yield increased from 6.91% to 7.69%. The All Bond Index retraced -2.3% during the quarter, inflation-linked bonds -4.9%, while cash yielded 1.3% for the period. As is evident from these performances, inflation-linked bonds were particularly hard hit, with the R197 ending the quarter at a yield of 1.62% from 0.77% at the end of March. Property stocks - eased 0.4% during the quarter, a return that belied the volatility the asset class experienced during the quarter, with property returns plummeting -11% during May.

What SIM did

During April and May, we reduced the Fund's ILB exposure slightly to take advantage of the low real yields compared to nominal bond yields. As mentioned previously, we saw bonds sell off significantly during May and June, which enabled us to increase the Fund's bond exposure during the latter part of the quarter at very attractive levels compared to our calculation of fair value. We mostly bought long-dated bonds as we feel the curve is too steep, with investors being generously compensated for taking on RSA term risk (yields of between 8 and 9%). For the first time in a while, we also increased the Fund's property exposure during the dramatic market swings in May and June.

During the past few quarters we have highlighted the increased risk of fixed income assets experiencing capital losses and the Fund's defensive positioning reflected these fears. While the pace and suddenness of the market move surprised us, the Fund was well positioned to weather the storm and redeploy capital at more attractive valuation levels. What is comforting is that the Fund posted positive returns in all three months of the quarter. Our defensive stance, which we admittedly entered into too early, ended up paying generous dividends to investors in the second quarter.

SIM strategy

Over the last few quarters we have viewed nominal and inflationlinked bonds as expensive. But the recent normalisation in yields has definitely changed the fixed income investment landscape. has definitely changed the fixed income investment landscape. Nominal bonds have gone from being expensive to being marginally cheaper from a longer-term perspective. ILB's have also re-rated closer to our long-term fair value. Currently we prefer nominal bonds to ILB's due to the high implied breakeven inflation between the two asset classes. Although we've made some investments back into listed property, we'll wait for better valuations before we move aggressively into this asset class. Overall valuations are now better balanced compared to the past year and should provide reasonable returns going forward.