Inflation continued to increase, reaching 5.3% in September. This trend is likely to continue and will probably breach 6% by year end. The economy has remained weak, plagued by a lack of competiveness and import substitution. This has led the market to price in a 40% probability of a 0.5% rate cut during the next six months. We believe a rate cut is very unlikely and have positioned the Fund accordingly.

Some analysts think an interest rate cut is required to stimulate economic growth, but the problem in South Africa is not the cost of money. Lower interest rates are unlikely to lead businesses to rush out and invest in new plants and equipment. Structural issues, such as the increasing cost and low productivity of labour, are far more important. These problems need to be addressed before the economy can grow sustainably. We also believe the Reserve Bank, with its inflation-targeting mandate, is unlikely to drop the repo rate to 5%, a rate below the inflation rate of 5.3%, in the face of rising prices.

The current account deficit, which has been masked by high export commodity prices and funded by portfolio inflows, leaves the rand vulnerable to weakness. Rand weakness will cause a vicious circle of higher inflation and increased wage demands, which already exceeded 6% over the past 12 months, in a low inflation environment.

With administered prices such as electricity and property rates increasing at well over 10%, and wages rising at above 6%, we struggle to see how the Reserve Bank can contain inflation sustainably below its target of 6%. This environment skews the interest rate risks to the upside. The market does not currently reward investors for interest rate risk because of the flat yield curve. We have reduced the duration of the Fund further to 67 days.

The second quarter of 2011 was one of continued stability of the exchange rate and interest rates. The inflation rate has increased slightly from 3.7% to 4.6% over the past three months as higher fuel and food prices impacted the basket but this increase was well within market expectations. The price stability over the past year has caused inflation expectations as measured by the BER to decline to 5.8% from over 8% three years ago. Consensus expectations are for inflation to increase further, peaking at just over 6% in 2012 before moderating.

We are concerned that the outlook for inflation over the next few years could be worse than the outcome anticipated by the market. The reason being the strength of the rand over the past two years, and hence lower imported inflation, has offset the deteriorating domestic inflation picture. Some of the drivers of the domestic inflation are electricity price increases and substantial real wage increases with no offsetting productivity growth. In time the rising costs of doing business in South Africa will impact our competiveness leading to a deteriorating current account and possibly a weaker rand. A weaker rand will be the transmission mechanism of the higher domestic costs into the headline inflation number as the rand price of imported goods will increase. However the rand is unlikely to weaken as long as international investors continue to favour emerging market debt and equity. Foreigners invested a net R23bn in the South African bond and equity markets in the first halve of 2012.

The Monetary Policy Committee of the Reserve Bank is unlikely to increase interest rates pre-emptively if inflation rises slowly as private sector credit growth is still only 5% and economic growth fairly muted. For this reason we favour the six month area of the yield curve as it benefits from a higher yield compared to cash and three month assets but is still relatively short in duration.

The duration of the Fund on 30 June was 69 days.

Money market interest rates remained stable though March. The rand has strengthened 8% against the US dollar over the past two months. Normally a stronger rand results in lower inflation however, in this case the effect may be somewhat muted as the majority of the rand's recent strength against the US dollar was due to dollar weakness. As the dollar weakens commodity prices tend to appreciate in US dollar terms to offset the pure currency translation effect. This effect is often magnified by investors who buy 'hard' assets in an effort to hedge the dollar weakness. Investor buying, together with strong fundamental demand, has led to the rapid price appreciation of many commodities such as oil and basic foodstuffs. Unfortunately these higher commodity prices will be felt in the inflation numbers despite the stronger rand.

The duration of the Fund is 68 days.

2010 was an interesting year for investors and demonstrated how difficult it is to forecast the future, even over relatively short time periods. The consensus in January 2010 was the interest rate cutting cycle had come to an end and rates would remain flat for some time. As it turned out rates were cut a further three times during 2010 as the inflation rate fell.

Once again at the start of the year the consensus expectation is that interest rates will remain unchanged for some time. This may turn out to be the case but the shape of the money market yield curve means the potential upside of investing with this view is relatively small compared to the downside risk of this view being wrong. We believe that interest rates may increase sooner than is generally anticipated and have positioned the Fund accordingly. The duration of the Fund at the end of December was 59 days.