With interest rates rising from 11% to 13% in the three month area of the money market the fund increased its exposure to cash over the past six months. While credit spreads have opened up over the past six months, the cash returns were further enhanced, by adding credit overlays in the form of credit linked notes. These instruments were used to give exposure to good credit such as Old Mutual, ABSA, Investec and Daimler Chrysler.

While SIM does not expect further monetary tightening the volatility in the money market has however increased and is expected to remain high in the foreseeable future. The overall strategy will be to identify entry opportunities to increase the duration of the portfolio by buying long-term instruments once the money market has stabilised.

With inflation probably close to peaking and with the SARB running a pretty tight monetary policy, SIM expects the yield curve to remain inverted through the remainder of 2002 and going into 2003. The South African bond market is also attractively priced relative to the G7 bond markets suggesting that the yield curve can shift down during coming months. This could imply the end of the run for Inflation linked bonds, where the real yield on the benchmark R189 has run from 6.25% at issue to 3.63% at the end of Q3-2002. The R189 yield is now trading only 2% above that of the USA benchmark inflation linked bond, which would seem rather rich.

This could however spell the start of the next bull-run in nominal bonds. To this purpose we have reduced our exposure to Inflation linked bonds, while also reducing our du-ration of the CPI bonds remaining in the portfolio. We have also started taking exposure to nominal bonds, which we feel will outperform the Inflation Linked bonds, should inflation subside.

There's a hint of opportunism in June's conversion of Sanlam Balanced Flexible into Sanlam Inflation Linked Fund. Its aim is to beat inflation by 500 basis points (before fees and with income reinvested) and, in a scared market, the approach (first, lose no money) has appeal. The strategy is simple: plenty of cash (42%) and inflation-linked bonds (23%) and a low exposure to quality dividend-paying shares (29%). Competing funds include Allan Gray Stable and Marriott Core Income.

Performance

Performance during the month was driven, for the most part, by the inclusion of inflation-linked bonds, some credit linked notes and cash. Metals and minerals as well as transport, added further positive returns, but the exposure to the rest of the equity market proved to be negative. Specifically, the exposure to banks and life assurance as well as the IT sectors were weak. The fund managers were however able to reduce some of this negative performance by selling futures.

Outlook

The reshaping of the government yield curve since the beginning of 2002 but specifically since the second quarter of 2002 suggests that the SARB has tighten its monetary policy enough to achieve its inflation target of 3% to 6% by the end of 2003. A more favorable inflation outlook and a more stable currency will make it possible for the SARB to relax its monetary stance towards the second half of 2003. In light of the imminent global recovery and investors renewed risk appetite, the fund managers further also believe that local economic growth will be supported by an expansionary budget, capital spending acceleration and export recovery, with a sideways move in the R/$ to Q4. For this reason the fund managers have not reduced the equity exposure completely, but have removed some of the IT and banking exposure. To this extent the fund managers will remain risk averse but will look for entry levels to the equity market as opportunity becomes available.

SIM is currently looking for an accumulated two per cent of monetary easing during 03H2, which will have a negative effect on the expected return from the money market on a one-year investment horizon. The rate on the 3-month NCD is expected to fall to 11.3% by 03Q3, suggesting that re-investment risk will become the dominant risk in the money market towards the end of 2002 (but possible even sooner). To this extent the fund managers will continue to buy longer dated money market paper in order to lock in current favorable rates.

Stable money market rates over the shorter term will anchor the short end of the capital market around 11.5% (on the R150). The short end of the capital market will drift lower on a 12-month investment horizon, when interest rate expectations become more favorable. The 10-year area of the curve is expected to rally to around 11.0% within the next 12 months as a result of stabilizing inflation expectations. On a two-year view the 10-year government bond is expected to rally to 10.25%, implying a noticeable flattening of the yield curve especially during the latter half of 2002. The fund managers will thus therefore time the entry to the Nominal bond market in order to get some bond exposure during this downward run.

Performance of the fund during the first quarter was driven by the now familiar story of strong performance from rand hedges. The absence of bonds from our fund also contributed well to performance. Gold, oil and the platinum sectors contributed most whilst our bank and life assurance exposure cost us dearly during the quarter.

During the first quarter our most noteworthy transactions centered around the financial and industrial sectors. The fund manager lightened banks across the board and also reduced the exposure to telecommunications. On the buying side the fund manager included diversified construction group Barlows, re-introduced Didata and increased holdings in defensive IT company Reunert. Of the financials the fund manager increased Liberty International and Liberty Group whilst Tongaat was also introduced to the fund.

The stabilization and recovery of the rand will very much be the focus of Q2 2002. After the very strong run in Resources in Q1 2002, the question is whether there is any more upside in the sector. The fund managear would remains at most neutral to local industrials in Q2 2002, until there is some stability to the currency, and hence more certainty as to its effect on the local economy.