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.

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 yield curve inverted further over the third quarter, as market participants priced in a combination of a more benign inflation and weaker growth outcome over the medium-term due to the impact of higher policy rates and recent rand strength. Over the quarter, money market rates rose fairly dramatically ahead of and after the September hike in the repo rate.

Portfolio Activities
During July a number of longer dated corporate transactions were entered into at yields in excess of 13%. For the balance of the period shorter dated investments were made in anticipation of further hikes in short-term rates.

The local economy expanded for the 14th consecutive quarter over the first three months of the year, although the expansion was at a more subdued pace than over the fourth quarter of last year. Gross domestic product - the broadest measure of output in the economy - grew at an annualised rate of 2.2% over the first quarter after growing at 2.5% over the fourth quarter. A year ago, GDP growth rose to 1.9% over the first quarter from 1.7% over the fourth quarter. On the production-side of the economy the key drivers were the Tertiary sectors and Manufacturing, although Manufacturing's contribution was half of what it was over the preceding quarter. On the demand-side of the economy things remained fairly robust over the first quarter. The key driver was investment spending, particularly spending on inventories, although other components of domestic demand held up well.

South Africa's current account of the balance of payments registered a healthy surplus of R4.2bn annualised (0.4% of GDP) over the first quarter compared to a deficit of R2.7bn (0.3% of GDP) over the preceding quarter. The good outcome was due to a sharp fall in dividend outflows and a strong trade performance.

Consumer inflation remained a major bugbear on the back of rising food and energy prices and sticky administered prices. Consumer inflation - measured by the annual percentage change in the CPIXu - rose to 9.2% in May from 6.5% in December last year. The deterioration in inflation and the risks to meeting the inflation targets over the next two years due to rising inflationary expectations prompted the Reserve Bank to hike rates by 300 basis points since the beginning of the year. The most recent hike of 100 basis points came on the 13th June. The Reserve 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. We believe inflation is currently peaking and should decline over the second half of the year on recent rand strength over the first half of the year, declining food price inflation and stable dollar oil prices. This is expected to cause the Reserve Bank to hold off on further rate hikes in the current cycle.

Market Impact

The yield curve flattened substantially over the second quarter, as foreigners bought local Bonds and market participants priced in a combination of further monetary tightening over the near term and a more benign inflation and weaker growth outcome over the medium-term due to the impact of higher policy rates and recent rand strength.

Over the quarter money market rates rose fairly dramatically in anticipation of the June hike in the repo rate. This was particularly evident in the three-month area where rates rose by 105 basis points whereas the 12 month area only rose by 15 basis points which would support our view that the hike is likely to be the last in the cycle.

Portfolio Activities

With rates having reached fairly high levels and the Reserve Bank likely to hold off on further rate hikes in the current interest rate cycle, longer-dated money-market assets presented attractive yields. As a result the fund managers increased the exposure to longer dated assets over the quarter to the maximum level allowable.

The South African economy continued to hold up in the fourth quarter of last year despite a sharp drop in export volumes on the back of the most synchronised global slowdown in two decades. This was largely due to the robustness in local demand. Final demand expanded at an annualised rate of 3.7% in the fourth quarter compared to a rate of 2.7% recorded in the preceding quarter. Overall output in the economy as measured by gross domestic product expanded at an annualised rate of 2.5% in the fourth quarter compared to a rate of 1.2% in the third quarter.

Despite the robustness of local macroeconomic fundamentals the rand had a dismal performance last year. On a trade-weighted basis the local currency lost more than 30% of its value last year, with most of the losses incurred after September 11. More recently the currency has shown signs of stability, with the rand having gained around 8% on a trade-weighted basis.

Despite recent rand stability inflation prospects have continued to deteriorate as the impact of last year's currency depreciation feeds through. Consumer inflation as measured by the annual percentage change in the consumer price index excluding mortgage rates - metropolitan and other urban areas - (CPIX) rose to 7.5% in February this year after having dropped to a low of 5.8% in September last year. Food inflation (26% of the CPIXu basket), the first consumer inflation category to show the strong impact of the rand's collapse, rose to 12.2% in February from a low of 3.2% in June last year.

The Reserve Bank is mandated to keep average annual CPIX inflation within a target range of 3% to 6% in 2002 and 2003. For 2004 the target range changes to 3% to 5%. The Reserve Bank stated in the April release of its Monetary Policy Review that "there is a strong possibility that the CPIX target for 2002 may not be met." The Bank admitted that there was little that it could do to counter the first-round impact of last year's currency depreciation. Given the risk of a second-round feed-through which could jeopardise next year's target the Bank has hiked the benchmark repo rate by 200 basis points since the beginning of the year and expectations are for the further 100 basis points rise by June. Based on the Bank's latest projections it appears optimistic that the 2003 inflation target is achievable.

Market Impact

The factors having the greatest influence on the money market over the past quarter have been the dramatic rise in the Producer Price Index as a direct consequence of the fall in the rand as well as the flow through to the Consumer Price Index. As mentioned above, this resulted in a 200 basis point hike in the repo rate which in turn resulted in money market rates rising dramatically as set out in the Money Market watch list.

Portfolio Activities

The portfolio was kept fairly short over the past quarter. A small volume of paper was sold in anticipation of further rises in short-term rates. With rates having reached fairly high levels and even though the fund manager believes that there is likely to be a further hike in the repo rate, the fund manager is likely to start buying some longer dated assets as he believes we are nearing the end of the rate hiking cycle.