August presented another example of political uncertainty in South Africa when rumours of the Finance Minister’s imminent arrest resurfaced. This event saw local bonds sell off over 50 basis points in one day, highlighting that both local and foreign investors are still watching South Africa very closely.

With the rating agencies in the country in September, a potential downgrade at the end of the year has once again become topical. Moody’s and S&P still emphasise the low GDP growth forecast for South Africa, as well as the potential impact on policy implementation resulting from the political uncertainty in the country. Turkey, often considered an economic peer of South Africa, recently saw Moody’s downgrading its sovereign credit to sub-investment grade, with a poor GDP growth outlook cited as one of the main drivers of the downgrade.

There have, however, been some releases of good economic data recently. The current account deficit narrowed to 3.1% of GDP, driven by strong vehicle exports. Many investors were surprised by better-than-expected second quarter GDP growth of 3.3% quarter-on-quarter (annualised), as a result of a rebound in the manufacturing and mining sectors. Despite this, the growth outlook for 2016 still remains near 0%.

Interest rate expectations have changed over the past quarter, with the latest statement from the Monetary Policy Committee (MPC) indicating that we may be at the top of the hiking cycle, seeing as inflation appears to be more or less under control if the rand stays at its current levels. The forward rate agreement (FRA) curve, which is an indicator of future interest rates, remains flat for the next two years. The latest Consumer Price Index (CPI) inflation print came in at 5.9%, driven by petrol’s decrease of 7.2% year-on-year. This is the first time this year that the inflation rate came in below the MPC’s upper target level of 6%.
We have thought that the money market yield curve has been too steep for a while now and we have taken advantage of this by investing in the long end. The curve has continued to flatten; however, we still see value there. Shorter-dated treasury bills are also attractive, as they offer a yield superior to banks and provide good liquidity for the Fund. We have, however, reduced our treasury bill holding over the quarter to about 10% of the Fund in order to take advantage of longer-dated bank paper. We have added an investment in Mercedes-Benz South Africa to increase our corporate exposure.

Commentary contributed by Gary Elston

Global yields have fallen after Brexit became a reality when the UK voted to leave the EU. This uncertainty has decreased the expectation that the US Federal Reserve (the Fed) will raise interest rates in the foreseeable future, with emerging market bonds being a beneficiary of this potential outcome as global investors hunt for yield.

South Africa managed to avoid a downgrade of its sovereign rating from all three of the rating agencies, however this risk is not off the table just yet; it has only been pushed out until December as the Credit Default Swap (CDS) market is still pricing South Africa as a BB+ rated sovereign. The 12-month JIBAR rate traded over a 20-basis point range during the quarter, reaching a high of over 8.80% in late May, as interest rate expectations were adjusted leading up to the ratings announcements. It is currently back at the 8.58% level where it started the quarter.

At the last meeting of the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB), the repo rate was left unchanged at 7% per year, with five of the six members voting for no change in the rate. However, the statement remained hawkish, citing concerns that inflation may rise due to the exchange rate pass-through that has still not materialised and the impact of the drought. Nevertheless, the Consumer Price Index (CPI) inflation reading for May came in below expectations at 6.1% year-on-year, just outside the SARB’s inflation targeting band of 3% to 6% year-onyear. The positive surprise was the lower-than-expected food prices driven by vegetables, fruit and meat. The average CPI inflation for the year is still forecasted to be above the 6% threshold, which will likely see the MPC raise rates again towards the end of the year as it follows its inflationtargeting mandate.

The constant dilemma that the MPC is facing with rising inflation and low growth was intensified when the latest GDP print came in much worse than expected at -1.2% quarter-on-quarter (annualised) and -0.2% year-on-year. These very low growth numbers are making it harder for the MPC to ignore growth when making its interest rate decisions to combat inflation.

Our strategy in the Fund remains unchanged. We still believe that the money market yield curve is steep, which provides value in the longer end of the curve where we have been able to take advantage of any spikes in the one-year area arising from the volatility in the interest rate market. We also see value in shorter-dated treasury bills for liquidity purposes, as they currently offer a yield pickup over banks, and we continue to invest in floating rate notes which will benefit from any future interest rate increases.

Commentary contributed by Gary Elston

The increased uncertainty that arose in December of last year has persisted throughout the first quarter of 2016. The current political climate and the threat of looming ratings downgrades have seen the rand and the interest rate market remain weak and volatile.

South Africa still grapples with rising inflation and a decreasing growth outlook. GDP growth continues to be revised downwards and is currently estimated to be only 0.8% in 2016. This is worrying as this metric has been highlighted as a key concern by the rating agencies. The current account deficit is also expected to remain wide at -4.6% of GDP in 2016.

The latest reading of Consumer Price Inflation (CPI) for February showed an increase of 7.0% year on year, the highest rate since May 2009 and well outside the inflation targeting band of 3% to 6% set by the South African Reserve Bank (SARB). The main drivers of this weak inflation number were: food (up 8.8%), transport (up 8.7%) and electricity (up 11.2%). The second round effects of the weaker rand are now starting to come through in the inflation numbers and the drought remains an issue for future food prices.

In the latest statement from the Monetary Policy Committee (MPC) of the SARB, inflation is forecast to average 6.6% for 2016, with breaches of the target inflation band in every quarter of 2016. This, as well as the weak exchange rate, has forced the MPC to raise the repurchase rate by 50 basis points in January and another 25 basis points in March. This brings the total increase to 100 basis points over the past three consecutive meetings and the rhetoric from the statement indicates that there are likely to be more hikes to come as the MPC sticks to its inflation-targeting mandate.

We continue to take advantage of the steep money market yield curve by investing in six-month deposits as well as floating rate notes. The floaters will benefit from the rising interest rate environment that we are in. The volatility in interest rates has caused occasional spikes in the one-year area of the curve, which the fund has capitalised on while being cognisant of duration risk. We also see value in shorter-dated treasury bills for liquidity.

The past year has been quite eventful in the fixed income space, culminating in December when the interest rate markets were negatively impacted by a sovereign rating downgrade, the shock dismissal of the finance minister, and the US Federal Reserve raising interest rates for the first time since before the global financial crisis. This has increased volatility and added to uncertainty.

Overall sentiment towards emerging markets remains negative and South Africa is no exception. Foreigners have sold over R6bn of bonds in December alone, leaving the year-to-date net inflows as only slightly positive - while the rand is currently at its weakest levels ever against the US dollar. Over the past year, the benchmark R186 government bond sold off by over 180 basis points and the 12-month JIBAR rate increased by more than 100 basis points.

The latest Consumer Price Index (CPI) inflation rate came in at a manageable 4.8% year-on-year in November. However, there is concern that inflation will breach the upper-end of the inflation target band of 6% as early as Q1 2016, with the main drivers being drought, increasing electricity prices and the weak rand. The biggest mitigating factor to the current inflationary pressures is the low oil price, as South Africa is an importer of crude oil. This is evidenced by the CPI excluding-petrol number of 5.4% year-on-year.

The above factors have left the Monetary Policy Committee (MPC) of the Reserve Bank in a challenging position. The MPC's mandate is to stabilise inflation through monetary policy, however it is difficult to raise interest rates to combat inflation without hurting growth, and South Africa's growth forecasts are continuously being revised downwards. Inflationary pressures have forced the MPC to gradually raise rates by 25 basis points in both July and November. The MPC commentary indicates that it is still concerned about inflation risks caused by the weaker rand and that South Africa is still in an interest rate hiking cycle.

Interest rates are expected to rise over the next year and this is being aggressively priced into the current curve. In addition, South African banks continue to offer higher rates for longer dated assets in order to meet their Basel III regulatory requirements. Both of these factors have contributed to a very steep money market yield curve.

We feel that inflation and interest rate risk remains skewed to the upside and have continued with our strategy of taking advantage of the steepness of the curve, while also maintaining our floating rate exposure in order to benefit from the hiking cycle. Treasury Bills have also started to look attractive again after they sold off aggressively and we have increased our exposure to approximately 15% from not holding any in July. This strategy should ensure that the Fund maintains liquidity and offers an attractive yield while taking on limited duration risk.