The SA economy maintained its robust pace over the second quarter. Gross domestic product - the broadest measure of output in the economy - grew at a seasonally adjusted and annualised rate of 3.1% over the quarter compared with 2.2% recorded over the first three months of the year. On a year ago, GDP growth rose by 2.3% over the second quarter compared to 1.9% over the first quarter. Local demand maintained its buoyant pace while exports rose strongly as well.

The funds' outperformance was mainly attributable to an overweight duration position and exposure to selected outperforming corporate bonds.

South Africa's current account of the balance of payments registered a surplus of R3.1bn annualised (0.3% of GDP) in the second quarter compared to a surplus of R4.2bn (0.4% of GDP) over the preceding quarter. Exports rose in the quarter, imports remained subdued, but dividend-related outflows also increased.

Inflation remained a major bugbear on the back of last year's rand collapse, rising food and energy prices and sticky administered prices. CPIXu inflation rose to 10.8% in August from 6.5% in December 2001. The deterioration in inflation and the substantial risks to meeting the inflation targets over the next two years due to rising inflationary expectations prompted the Reserve Bank to hike rates by 400 basis points since the beginning of the year. The Bank is mandated to keep average annual CPIX inflation within a target range of 3% to 6% in 2002 and 2003, and 3% to 5% in 2004.

Market Impact
The apparent stability of the benchmark R153 government bond over the past quarter, from a level of 11.99% to 11.88% hides a multitude of sins. Early in July the rate came down to a low of 11.18% as the market started believing that we had seen the peak in the producer price index. Interest rates moved up strongly thereafter as subsequent inflation numbers came through reflecting a continuation of the rise in particularly food prices.

Over the quarter the shape of the yield curve also changed dramatically. While the 10-year area of the yield curve remained largely unchanged, the yield curve became increasingly negatively sloped with the three month area rising from 12.25% to 13.1% while the longest dated government bond actually declined from 10.69% to 9.78%. The inversion was largely as a result of the belief that the higher short-term interest rates would ultimately result in a decline in inflation.

While the All Bond Index produced a return of 3.7% over the quarter, the change in the yield curve shape had a profound impact on the sub-components of the Index. The 1-3 year area had a return of 1.7% (under performing the cash return of 2.9%) while the 12+ area had a return of 7.3%.

Looking forward there is the risk that short-term rates could rise further if we continue having negative surprises on the inflation front. The current inflation outlook indicates that we are unlikely to meet the inflation targets for this year and for 2003. Bearing this in mind the current levels of bond market rates are in our view rather optimistic and as a consequence, we are maintaining our bond portfolios at a duration that is shorter than that of the All Bond Index.

Portfolio Activities
The duration of the portfolio was reduced during August as it seemed as though the market had run out of steam. This was largely done through selling of R153 bonds.

The Bond market experienced an excellent quarter with yields falling substantially on the back of a strengthening currency. The yield on the benchmark government bond, the R153, declined 121 basis points from 13.20% to 11.99% as we saw the rand firm from 11.38 to the US dollar to 10.26. The All Bond Index produced a return of 8.94% for the three months. The Aggressive Active Gilt Fund was well positioned during the quarter and produced a return of 10.03%, making it the top performing fund in the gilt category of unit trusts. [Source: MoneyMate]

The funds' outperformance was mainly attributable to an overweight duration position and exposure to selected outperforming corporate bonds.

The strength in the market can mainly be ascribed to continued foreign buying of domestic bonds, which exceeded R5 billion over the past three months. Foreign investors seem to be taking a bullish view on both the Bond market as well as the rand. The rand pullback has had the effect of calming inflationary fears.

Looking forward we expect short-term rates to track sideways for the rest of the year with inflation expected to start falling towards the target range into next year. Remember that markets look forward and with the positive inflation outlook, there should still be value in Bonds at these yields.

The first quarter of 2002 bought the bond bear out of its three-and-a-half year long hibernation. Bond yields on long-dated government bonds weakened in excess of 150 basis points during the quarter from a yield of around 11.50% to in excess of 13.00% at quarter end. The main reason behind the weakness was the resultant effect of the rand's depreciation on inflation. Both consumer and producer price inflation data releases' during the quarter surprised the market on the high side and resulted in yields tracking higher. The Reserve Bank responded to the build up of inflationary pressure by hiking rates by 1% twice during the quarter.

Looking forward, it seems apparent that the inflation picture is likely to get worse before it gets better and in response to that the Reserve Bank will in all likelihood hike interest rates again in the second quarter. With the sell-off already experienced in the first quarter, the valuation argument has become much more apparent for bonds at these yields if you can look forward through the inflation hump this year and into the rapidly unwinding trend into next year, where the sub six percent target is expected to be met. Start looking for buying opportunities this quarter.