A benign view on future inflation has lead to the market pricing in rate cuts totalling almost 300 basis points (bps) over the next 18-months, starting in early 2009.

CPI and CPIX rose to 13.7% and 13.6%, up from 13.4% and 13% respectively, higher than market expectations. The market has shifted from holding a very negative view on inflation to one that is very positive. Some caution is warranted as although the re-weighting and rebasing of inflation will result in a technical drop, the outcome of inflation in a year's time is dependant on actual price increases. PPI rose to a 6-year high of 19.1% driven largely by increases in basic metals and electricity tariffs.

The market is aggressively pricing in 200 bps worth of rate cuts over the next year and almost 300 bps worth of cuts over the cycle.

Despite the turmoil in global markets, and a weakening of the rand, bond yields fell around 200 bps over the quarter as the market looked to price in a very positive inflation outlook. Much of the ALBI performance was achieved in July, where the index delivered a return of 8,51%, its greatest monthly gain in 10years. Bonds consolidated their gains in August and September, continuing to outperform cash as yields ticked down further.

Credit markets have come under extreme pressure, placing huge strain on companies in both developed and emerging markets. With very little borrowing being able to take place, the downturn in financial markets is now been transmitted into the broader economy. This impending slowdown is likely to reduce inflation, and cause international rates to remain at low levels for an extended period of time.

With bond yields falling, the ALBI outperformed cash by 977 bps for the quarter. With yields falling across the curve, the long end benefited due to its higher duration. The 12+ year index returned 19,9%, outperforming the overall ALBI's return of 12,6%. Bond yields have been extremely volatile quarter as the market is caught between growth and inflationary concerns. The US 10-year yield fell 15 bps to 3,8%; euro area bonds fell 64 bps to 4.0%, while UK bonds fell 71 bps to 4,4%.

South Africa's country risk premium, the yield spread of South Africa's dollar-denominated bonds over US treasuries, increased dramatically due to the credit crisis, as well as the increased political risk specific to South Africa. The country risk premium ended the quarter 142 bps higher at 4,0%.

The current duration of the fund remains well below the ALBI duration of 5,22. After increasing bond exposure as rates rose last quarter, we have used the opportunity of falling rates to reduce exposure as bonds offer little value at the current level of yields. Although inflation is likely to come down over the next year, bonds are pricing in an overly optimistic scenario. The portfolio continues to be structured with a duration shorter than the index, positioned to generate outperformance in a scenario of rising interest rates.

With credit spreads having widened significantly, we are continuing to look to add credit exposure where see value.

Relative to US bonds, SA bonds are currently discounting domestic inflation of 3% at the short and medium ends of the curve. Implied inflation at the long end is around 1% to 2%. The level of implied inflation discounted in local bonds has fallen dramatically, as local yields have shifted down, while international real yields and the country risk premium have moved higher. While the inflation outlook is somewhat improved due to falling oil and commodity prices, the outlook for 2009 remains uncertain. The local bond market is failing to reflect the higher level of South African country risk that is being priced into global markets. As long as this remains the case, there is a very significant upside risk to bond yields.

International money markets have ground to a halt, with interbank as well as corporate lending struggling to keep going. To date, liquidity and fiscal stimulus has been used to help the markets, but as the financial crisis continues to affect the real economy, central banks may be forced to cut rates. With the USFED having delivered 325 basis points worth of cuts so far, the market is now pricing in a further 1% of rate cuts. Rates in the UK and EURO area are also pricing in lower rates going forward. Given the extent to which the global economy is slowing, there is more scope to cut rates, although inflation remains a concern.

The volatility in the rand over the last quarter was significant, and highlights the vulnerability of the currency to the high current account deficit and dependence on commodity prices and capital flows. The rand's global status as an emerging market commodity currency makes it particularly susceptible to depreciation during periods of heightened risk aversion.

While the ALBI duration has lengthened over the quarter due to issuance, bond switches and coupon payments, the effective duration of the portfolio was reduced over the quarter as rates fell. We have looked to enhance yield in the fund by adding credit exposure, taking advantage of the much wider spreads on new and existing issues.

SA bond yields moved down significantly over the quarter, as bonds moved to price in a very positive inflation outlook. The rise in bond yields has improved the value in the asset class, and has driven the decision to bring the portfolio duration closer to the index. However, there still remain significant upside risks to domestic inflation, and the potential for further rand depreciation. We will maintain our short position until we see significant value in the bond market.

At the start of the month, the market was fully pricing in a 1% interest rate hike with another 0.5% expected in the future. One-year money market paper moved up and assets could be invested earning a yield of 14%.

However, Reserve Bank Governor Tito Mboweni shocked the market by only raising rates by 0.5%, with the FRA curve and 1-year NCDs moving lower after the MPC meeting. This was the tenth interest rate hike since June 2006. The SARB now expects CPIX to peak around 12% in Q3 2008 (previous peak forecast at 9.3%in Q1 2008) and to return to within the target range by Q3 2010.

The rand experienced a recovery in the second quarter. However, the trade-weighted exchange rate has still weakened 17,4% since the beginning of the year, which is likely to exert further upward pressure on inflation. The currency continues to remain particularly vulnerable due to the high current account deficit and dependence on commodity prices and portfolio flows.

The latest inflation releases came in above market expectations; PPI figures came in worse than expected; private sector credit growth marginally up, while money supply was very similar to the previous month; and the current account deficit widened to 9% of GDP - these factors continue to highlight a deteriorating inflation outlook, which has left rates vulnerable to upward pressure. Some assets were switched into the 1-year area earlier in the month, locking in higher yields. The remainder of the portfolio is invested in JIBAR-linked exposure and some inflation-linked assets. Credit exposure remains very conservative.

The bond market experienced a harsh re-pricing in the second quarter, with yields driven higher due to a deteriorated inflation outlook, as well as a significant rise in bond yields across the world. The yield curve shifted up around 200 basis points in the short end of the curve, with bonds from 5 years out shifting up around 130-160 basis points.

With bond yields rising, the ALBI underperformed cash by 755 basis points for the quarter. As yields shifted up, the 12+ year index delivered the worst performance due to its high duration. The 12+ year index returned -8,5%, underperforming the overall ALBI's return of -4,9%.

With the market seeing the 25 basis point cut in US rates as the last in the cycle, bond yields began to move up due to inflationary concerns. The US 10-year yield rose 53 basis points to end the quarter at 4.0%. Euro area bonds rose 71 basis points to 4,6%, while UK bonds moved up 76 basis points to 5,1%.

The current duration of the fund remains below the ALBI duration of 4.68. We have used the opportunity of rising yields in order to increase the bond exposure, bringing the portfolio duration closer to the index. Given that the risks to inflation remains to the upside, the portfolio continues to be structured with a duration shorter than the index, positioned to generate outperformance in a scenario of rising interest rates.

Holding swaps instead of bonds at the short end of the curve, the fund benefited from the narrowing of the bond swap spread over the quarter. Credit exposure remains at low levels, and with credit spreads having widened significantly, we have added exposure to Telkom and Eskom at attractive levels.

Relative to US bonds, SA bonds are currently discounting domestic inflation of just under 10% at the short end of the curve, and around 6% in the medium area of the curve. Implied inflation at the long end has moved up to around 4,5% to 5%, which is a significant re-pricing from the 3% level of implied inflation that prevailed earlier in the year. The value in SA bonds has risen due to the rise in local yields, although the rise in international yields and the country risk premium has offset some of this increase in value. Despite the greater value in bonds, the outlook for inflation continued to deteriorate over the quarter and South African yields are still not compelling at theses levels.

SA bond yields moved up dramatically over the quarter, as bonds began to price in the deteriorated inflation outlook. The rise in bond yields has improved the value in the asset class, and has driven the decision to bring the portfolio duration closer to the index. However, there still remains significant upside risks to domestic inflation, and the potential for further rand depreciation. We will maintain our short position until we see significant value in the bond market.

The downward pressure on global money market rates totally reversed over the quarter due to widespread inflationary pressure. With the US FED having delivered325 basis points worth of cuts so far, the market is now pricing in rate hikes. Rates in the UK and Euro area are also predicted to rise. In response to rising inflation, many central banks, including the SARB, have been forced to continue hiking rates beyond market expectations.

The effective duration of the portfolio was maintained below the ALBI, although the duration was brought closer to the index duration by buying some stock at the long end of the curve. We have looked to enhance yield in the fund by utilising the wide bond-swap spreads in the short and medium areas of the yield curve, and we have begun to add credit exposure to the fund in order to take advantage of the much wider spreads on new issues.

The reserve bank left the repo rate unchanged at 11% at the January MPC meeting, a move that was largely priced in by the market. The SARB still expects CPIX inflation to remain above the upper level of the target range and to peak in Q1 2008.

The bond market had a poor first quarter as yields shifted up due to pressure from rising inflation, as well as a rising country risk premium. The yield curve shifted up around 50 basis points in the medium area of the curve, while the long area was affected to a greater extent as yields rose 80-100 basis points. With SA inflation consistently exceeding economist's forecasts over the quarter, and the rand depreciating significantly due to foreign selling of SA assets, SA bond yields were pushed higher.

As yields shifted up and the curve normalised, the 12+-year index delivered the worst performance due to its high duration. The 12+-year index returned -6,54%, underperforming the overall ALBI's return of -1,88%.

The rand experienced a significant fall in value over the quarter, as foreign investors sold rand assets in the context of rising economic and political risks. The rand weakened by 18,7% against the dollar and by 28,3% against the euro, to end at R8.08/USD and R12.79/Euro respectively. The weaker rand is likely to exert further upward pressure on inflation, and the currency continues to remain particularly vulnerable due to the high current account deficit and dependence on commodity prices and portfolio flows.

The current duration of the fund is well below the ALBI duration of 5.07. The portfolio is positioned to generate outperformance in a scenario of rising interest rates, as bond yields continue to offer poor value given the extent to which the inflation outlook has deteriorated. The fund does have an option position which serves to increase the duration in the case of falling yields.

The yield spread between bonds and swaps remains at wide levels, and we have utilised this spread in order to provide a yield pickup for the fund in the short and medium areas of the yield curve. With some value now beginning to appear in the credit market, we will be looking to add exposure where we see opportunities.

The effective duration of the portfolio was maintained below the ALBI, with the portfolio positioned to generate outperformance in a scenario of rising interest rates, specifically at the long end of the curve.

SA bond yields moved up significantly over the quarter with the long end delivering particularly poor performance. Despite the rise in bond yields, the level of implied inflation remains unattractive given the rise in the country risk premium, as well as the deterioration of the inflation outlook. We continue to see significant upside risks to yields and will thus maintain our short position until we see value in the bond market.

The reserve bank hiked the repo rate to 11 % at the December MPC meeting, a move that was largely priced in by the market. As in the months before, the decision was largely driven by a sharp increase in inflation expectations and a deterioration in the SARB's inflation forecast. The SARB expects CPIX inflation to remain above the upper level of the target range and to peak in Q1 2008 at an average of 7.4% before declining to the upper end of the target range in Q4 2008. The sharp increase in inflation expectations poses a risk of higher wage settlements that should concern the SARB. The SARB noted that food and particularly oil prices, combined with higher wage costs, continue to put upward pressure on inflation.

Despite 400bp worth of rate hikes since June 2006, inflationary pressures
have continued to surge. Over the month:

. CPI and CPIX accelerated to 8.4% and 7.9% respectively;
. PPI declined from 9.5% to 9.1 %;
. The trade balance narrowed from October's record number down to a deficit of RO.61 billion for the month; and
. Money supply and credit growth continue to remain high at 23.18% and 22.57%.

Q4 2007 was a poor period for the bond market as all the sectors underperforrned cash, largely due to the sharp rise in yields in November.

The curve shifted up and inverted over the quarter, as yields rose around 30bp in the 3-5 year area, 20bp in the 10-year area and 10 bp in the 20-year area.

The current duration of the fund is well below the ALBI duration of 5,04. The portfolio is positioned to generate outperforrnance in a scenario of rising interest rates, as bond yields continue to offer poor value given the extent to which the inflation outlook has deteriorated.

The yield spread between bonds and swaps remain at wide levels, and we have utilised this spread in order to provide a yield pickup for the fund in the short and medium areas of the yield curve. Credit exposure has remained at low levels as spreads have widened, and we will be looking to add exposure to the fund where we see significant value.

The effective duration of the portfolio was maintained below the ALBI as bond yields remain at levels where they offer little value. We have looked to enhance yield in the fund through high quality credit exposure, and by utilising the wide bond-swap spreads in the short and medium areas of the yield curve.

SA bond yields moved up over the quarter, with the level of inflation discounted in medium and long bonds ticking up. However, with the inflation outlook continuing to deteriorate, we continue to see upside risks to yields. We will thus maintain our short position until we see value in the bond market.