There were some encouraging signs for South African fixed income assets over the quarter. Consumer price inflation fell to below 5% per annum. Improving global growth supported emerging markets with R26.7bn of net foreign inflows into South African bonds over the quarter. The probability of political change increased, headlined by growing criticism of current ANC leadership and pressure on global firms such as KPMG and Bell Pottinger.

These improvements, while positive, do not materially improve South Africa’s economic fundamentals. Thus we have not changed our fixed income investment view.

Low economic growth and poor tax collections suggest government revenue will fall short of expectations. Conversely, government expenditure is expected to grow in excess of inflation. The difference between the two, the fiscal deficit, is likely to be worse than forecast and add to already-high government debt.

Similarly, the financial position of state-owned enterprises (SOEs) continues to worsen. The recent South African Airways bailout caught the public’s attention, but it is the much larger challenges at Eskom that should be monitored. Eskom’s 2018/19 tariff application to the National Energy Regulator of South Africa (Nersa) referenced a Deloitte report, commissioned by them, which concluded that 19% per annum electricity tariff increases are required over the next five years for government debt to GDP to merely stabilise at current levels. We don’t know how accurate Deloitte’s findings are, but Eskom’s financials support the conclusion that either the government must bail-in some of Eskom’s debt, or South Africans must pay substantially more for electricity. These scenarios, and similar at other SOEs, are likely to be negative for fixed income investments.

We believe there are above-average risks of further sovereign ratings downgrades, a weaker currency and higher bond yields. The low risk nature of money market instruments makes them attractive in this context.

Fixed and floating rate money market instruments currently offer similar starting yields. Relative returns between the two thus depend on if, and when, the South African Reserve Bank (SARB) will cut interest rates again. Weak growth and low inflation argue for lower rates, but the risks outlined above argue for monetary discipline. Approximately half of the Fund is invested in floating rate notes. These should provide some protection against macroeconomic shocks, but also expose the Fund to lower returns should rates be cut. We believe this is an appropriate balance between limiting risk and delivering suitable returns within the Fund.

No new issuers were added to the Fund. Maturities were reinvested into longer duration money market instruments to take advantage of the upward sloping yield curve.

Commentary contributed by Mark Dunley-Owen

Sentiment towards South Africa is poor. It is tempting to believe that excessive bad news is priced into South African assets, which should deliver attractive returns if reality turns out to be less negative than feared. Unfortunately, we do not believe this is likely.

The fundamentals of the South African economy are deteriorating under the current government. One way to highlight this is to discuss South Africa in the context of variables which we regard as important to any investment, namely cashflow, financial flexibility and management.

Three investment questions to ask are:

Does South Africa generate sustainable positive cashflow?
Does South Africa have the financial flexibility to respond to an uncertain future?
Does the management of South Africa, i.e. the government, have a track record of value creation?

Government debt to GDP provides an answer to the first two questions. A material rise in debt to GDP over a relatively short time period indicates sustained negative cashflow, most likely due to excessive and unproductive government spending. As debt to GDP rises, financial flexibility falls and the government has fewer ‘bullets in the chamber’ to respond to surprises.

South Africa’s government debt to GDP has risen from 26% in 2009 to 51% today. In rand terms, government debt has increased by R1.1 trillion rand over the last 5 years, suggesting the government is spending over R200 billion per year more than it earns. This trend may worsen if government revenue falls short of and expenditure exceeds forecasts following recent political events. This cannot continue indefinitely, and probably for not much longer, without negative economic consequences such as further downgrades, currency weakness and higher borrowing costs.

Government’s track record on value creation is similarly poor. A measure of this, which affects all South Africans is the quality of services provided by the state, such as electricity, education and health - all of which are poor. Those with some accounting understanding should look at Eskom’s balance sheet and cashflow statement to get a sense of the mismanagement. Others can consider that the combined construction cost of Medupi and Kusile has risen to R295 billion. To put that in context, one could build 22 Sandton Cities, the most highly valued shopping centre on probably the most expensive land in South Africa, for the same price.

South Africans, ourselves included, are often guilty of excessive pessimism. We wish that were true today, but objective measures such as these suggest otherwise.

In the midst of these challenges, we remain focused on maximising long-term client wealth. In the Money Market Fund, we have maximised duration whilst minimising credit risk, within regulatory limits. The steep money market curve allows investors to benefit from attractive yields at the longer end. More than 90% of the Fund is invested in securities issued by the big South African banks and high quality corporates. Investments during the quarter were made in line with this strategy.

Commentary contributed by Mark Dunley-Owen

The first quarter of 2017 was characterised by a gradual improvement in South Africa’s economic outlook, undone by the cabinet reshuffle on 30 March and the subsequent downgrade by S&P Global Ratings.

Prior to this, South Africa’s short-term economic indicators were improving. The current account deficit narrowed from 6.2% of GDP in 2014 to an acceptable 1.7% of GDP, inflation appeared to have peaked at 6.8% in December, and the rand strengthened by about 20% against developed market currencies. The prices of local fixed income assets reflected the sentiment that times were getting better. The yield on the 10-year South African government bond rallied 140 basis points from its December 2015 high and the JSE All Bond Index (ALBI) returned more than 50% in dollar terms from its low in January 2016.

In the one week following the cabinet reshuffle, the 10-year South African government bond reversed all its quarterly gains and the ALBI lost 10% in dollars. The government’s decision to remove Pravin Gordhan and other ministers has materially increased South Africa’s risks. At time of writing, it is too soon to predict the final outcome of these actions, but a reasonable conclusion is that the range of future scenarios has decreased. Two different and binary scenarios now seem more likely than the middle ground.

One scenario involves the current political leadership remaining and worsening mismanagement of a struggling economy. The other scenario involves sufficient political and social pressure to force leadership change that leads to more rational future economic policies. Which of these scenarios occurs will have a large but opposite impact on South African assets, particularly rand-denominated government bonds.

Current bond yields are a weighted average of these two outcomes. This makes investing particularly difficult, as short-term performance may largely depend on politics. We have no unique insight in this regard, and instead remain focused on limiting risk so that our clients have a reasonable chance of adequate long-term returns.

It is worth noting that, irrespective of short-term developments, long-term fixed income performance is related to South Africa’s economic prospects, in turn dependent on structural challenges such as capital investment, policy certainty and education. Sustainable improvements in these will require strong leadership making difficult decisions.

Money market instruments continue to offer good relative value. One-year bank deposits require little duration or credit risk, yet offer real returns in excess of inflation.

Barring material moves in the exchange rate, the Reserve Bank is likely to keep rates unchanged for the near future. Investments were targeted towards one-year bank NCDs and selective floating rate notes that offer reasonable yields. We maximised coupon duration to benefit from the steep curve.

Commentary contributed by Mark Dunley-Owen

2016 brought with it numerous events, both domestic and international, to remind investors of the uncertain and unpredictable times that we are living in. Who would have thought that we would be faced with the unlikely scenarios of Brexit, a Trump presidency or that many of the developed countries would have 10-year bonds with negative yields at some point in the year? Two of the dominant local stories for 2016 were the heightened political uncertainty and the rating agencies' reviews of the country - adding to volatility in the markets.
South Africa managed to retain its investment grade ratings on both its local and foreign currency debt from all three rating agencies. While this was good news for fixed income investors, it unfortunately does not mean that the threat has gone away, and the political uncertainty is far from over.

Despite the volatility in 2016, the 12-month bank NCD rate ended the year around the same level it started, at around 8.45%, having traded in a 50-basis point range over the year. The 10-year government bond (R186) rallied in 2016 from 9.71% down to below 9%, and the rand strengthened from R15.56/US$ to under R14.00/US$.

In November 2016 the annual rate of inflation as measured by the South African Consumer Price Index (CPI) was 6.6% year-on-year (y-o-y). This is off the peak of 7.0% y-o-y in February, but well above the lowest point of 5.9% y-o-y in August. Food remains a large driver of inflation, with the latest reading of 11.8% y-o-y as the drought persists. Food inflation is expected to moderate from here and average annual inflation should fall to below the 6% y-o-y upper end of the South African Reserve Bank's target band in 2017.

The Monetary Policy Committee (MPC) left the repo rate unchanged again in November, bringing the total repo rate hikes to 75 basis points for the year, with all hikes occurring in the first quarter. There is a general feeling that we may be at the end of the current repo rate hiking cycle, with inflation expectations moderating given the current levels of the rand.
South Africa's Gross Domestic Product (GDP) appears to have bottomed, with the latest forecast from the MPC of 0.4% for 2016 and then 1.2% for 2017, showing improvement. However, the current account deficit remains a concern, with the latest estimate at 4.0% of GDP for 2016.

We still maintain that the shape of the money market yield curve is too steep, and the Fund's strategy is to continue taking advantage of this steepness by investing in the longer end, which offers the best value for the associated risks. With the prospect of interest rates not rising in the near future, we are reducing our allocation to pure floating rate notes. We are focusing on a mix of short-dated treasury bills for liquidity and longer-dated bank NCDs with maturities between six months and one year. No new issuers were included in the Fund over the fourth quarter.

Commentary contributed by Gary Elston