The fund returned 0.49% in September, bringing its return for the 12-month period to 7.18%. The fund return remains ahead of the Short Term Fixed Interest (STeFI) threemonth index (6.02%) as well as its benchmark (6.62%) over the one-year period.

South African fixed income markets weakened in September. The All Bond Index fell by 0.07%, after delivering a positive return (0.14%) in the previous month. The shorterdated bonds performed best, with bonds maturing in one to three years returning 0.64%, followed by medium-term maturities which delivered 0.4% on the month. Long bond performance was poor, outweighting the impact of better performing shorterdated bonds. Bonds with a maturity of 7 to 12 years were almost flat, and long-dated maturities fell by 0.44% on the month. The combined GOVI index rose just 0.01%, following 0.18% achieved during August. The poorer performance over the month didn't detract meaningfully from the 12-month returns, which were up 6.7%. Inflationlinked bonds underperformed, posting -0.31% on the month, after returning -0.74% the previous month.

Following an already volatile August, market turmoil intensified as weaker global and domestic growth continued to impact market performance in September. The market focus on a possible normalisation of interest rates at the US Federal Reserve's September meeting, but the Federal Open Market Committee (FOMC) again left rates on hold, for the first time citing the risks posed to US growth from emerging market economic weakness and volatility in global asset markets. The US dollar index (DXY) extended gains, which heightened general concerns about growth and disinflation. Emerging market currencies were hard hit. Following these developments, and persistently mixed US activity data, even in early-October there remains considerable uncertainty about the timing of the first Fed rate hike.

Short-dated forward rate agreements (FRAs) suggest that South African rates will rise to 6.50% during 2015 (up 25bps from a month ago) and hit 7.5% by end-2016 (up 25bps from the previous month). Following the FOMC's decision to pause, the South African Reserve Bank (SARB) also held rates steady at the September Monetary Policy Committee (MPC) meeting. The MPC's statement continued to highlight upside risk to its inflation forecast, mostly from the currency. Recent currency weakness resulted in an upward revision to SARB headline and core inflation forecasts for 2016 and 2017, but its short-term outlook for 2015 improved thanks to lower oil prices. The SARB revised its growth forecasts lower over the forecast horizon. In its concluding remarks, the MPC acknowledged that it was mindful to not have an undue negative impact on short-term growth prospects and that this played into the decision to keep rates on hold for the time being. Three- and five-year negotiable certificates of deposit (NCDs) - 8.57% and 9.30% at month-end, respectively - continue to hold their appeal amid the interest rate outlook and thanks to the inherent protection offered by their elevated yields. But while these instruments look quite attractive at current levels, the fund has not added aggressively to its holdings due to the possibility of increased volatility over the short term, which may result in more attractive entry levels. Bank funding remains strained due to a combination of new regulatory requirements (Basel III) and the increasing drawdowns on loan facilities by infrastructure products. As such, bank credit spreads have remained at their recent wide levels of approximately 140bps (in the five-year range). This has enhanced the attractiveness of floating-rate assets for the fund. The fund maintains a cautious outlook and we prefer to be selective in its exposure given the current phase of the credit and business cycle.

Economic data released in September continue to paint a picture of weak domestic growth, with few bright spots. Following supply-side data, which revealed a contraction in gross value added in the second quarter, the SARB Quarterly Bulletin provided a breakdown of the expenditure side. Most of the contraction was accounted for by a very large adjustment in inventories, but outside of this, other demand drivers remain weak. Household spending accelerated off a weak base to 4.6% y/y. Household debt levels were a little lower, but the higher interest rate (announced at the July MPC meeting) put a floor under debt service costs, which were unchanged at 9.4% of disposable income. Gross fixed capital formation - notably by the private sector - remained weak at 1.3% y/y. Government spending was up just 0.2% y/y, in line with National Treasury's commitment to keeping expenditure under control. Net exports offered a glimmer of hope, with an improvement that yielded a trade surplus on the current account of the balance of payments. The services balance deteriorated in line with pressure on tourist arrivals, and the nontrade deficit was -3.5% of GDP. Taken together, the deficit on the current account narrowed to -3.1% of GDP from -4.7% in the previous quarter.

Foreign outflows from the local bond market over the quarter (R9.5 billion) contributed significantly to the rand's depreciation of 14% in July, with the local unit closing at R13.85/dollar. This performance was in line with emerging market peers and continues to reflect negativity towards the asset class amid concerns about China and general risk aversion following the credit downgrade in Brazil. We continue to believe that over a longer-term horizon the rand is, at worst, fairly valued at current levels. The weak rand will continue to assist in a recovery of the trade account and help offset the slump in commodity prices for our exports. However, given the renewed risks posed to growth from electricity supply shortages, structural bottlenecks in the economy and the recent deterioration in South Africa's terms of trade position (following the fall in commodity prices), we believe that the rand might be the only pressure valve for the local economy in the shorter term. As such, the fund has maintained its exposure to offshore assets. The fund utilises JSE currency futures to adjust its exposure synthetically, but still maintains its core holdings in offshore assets, which has the added effect of enhancing the yield of the fund.

Forward-looking data remain discouraging. The PMI print for September was largely unchanged at 49 index points, portraying a manufacturing sector that is performing below trend. Business activity fell again to 46.6 from 48.6, while prices paid ticked up to 77.6 from 76.3, partly offset by rising new orders and an improvement in the employment index. After two months of big cuts in retail fuel prices, October will see a small under-recovery as the currency has weakened beyond the fall in oil prices. This bodes poorly for inflation in coming months. Vehicle sales in September contracted heavily, reflecting continuing weak consumer confidence that - although an improvement on the second quarter of 2015 - remains below trend at -5 index points in the third quarter. It is clear that the MPC remains in a very uncomfortable position. Following the relatively hawkish tilt at the SARB that resulted in a further re-pricing of rate expectations across the curve, the belly of the curve (five to ten years), continues to hold its appeal relative to cash rates. However, the considerable yield pick-up in longer maturities suggests that the value point on the bond and interest rate curve remains along the longer end, and the fund continues to hold and increase its exposure to very attractively priced credit in those tenors. In addition, the fund continues to target floating-rate exposure in the shorter end of the curve (less than five years) due to the prospect of rising shorter-term rates. The fund will continue to remove its duration hedges into any widening in bond yields. At current levels, we believe duration assets are starting to look relatively attractive on a valuation basis. The fund will continue to add selected exposure to longer-dated fixed and shorterdated floating-rate corporate bonds through new issuances. Only those that offer attractive entry levels, based on our assessment of the underlying credit quality, will be considered.

The listed property market continued its good run in the third quarter (up 6.24%, but gaining only 0.82% in September), which brings its year-to-date performance to 13.26%, and to 25.82% on a rolling 12-month period. The yield gap between the property index and the current 10-year government bond remains quite stretched; however, it is important to note that many property stocks are trading at one-year forward yields in excess of 8%, which makes them relatively attractive. If the lowyielding high-cap stocks from the sector are excluded, the yield on the property sector rises to approximately 8.5%. The fund has been adding selectively what we consider to be undervalued, high-quality stocks to its holdings. It will continue to take advantage of any property stocks that offer upside to their net asset value (NAV) valuations and the fund maintains property holdings that offer strong distribution and income growth. In the event of a moderation in listed property valuations, which may be triggered by further bond market weakness, the fund will look to increase this exposure at more attractive levels. We also continue to favour preference shares, given the steady dividend yields on offer, and maintain the current level of holdings in the fund. Preference shares are linked to the prime rate and, subject to the risk profile of the issuer, currently yield between 8.5% and 11% (subject to a 15% dividends tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). In addition, most of the bank-related preference shares trade at a considerable discount, which enhances their attractiveness for holders from a total return perspective and increases the likelihood of bank buybacks.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the South African economy. However, we believe the current fund positioning correctly reflects appropriate levels of caution. The fund yield of 8.57% continues to be attractive relative to the duration risk within the fund. We continue to believe this to be an adequate proxy for expected fund performance in the 12-month period ahead. As short-term rates move higher, the benefit from the longer-term rise in fund yield, due to our increased floating-rate exposure, should dampen any element of shorter-term capital loss. As is evident, we remain cautious in our management of the fund. We continue to only invest in assets and instruments that we believe have the correct risk and term premium so as to limit investor downside and enhance yield.

Portfolio managers
Mark le Roux, Nishan Maharaj and Adrian van Pallander

The fund returned 0.39% in June, bringing its return for the 12-month period to 6.84%. The fund return remains ahead of the Short Term Fixed Interest (STeFI) three-month index (5.94%) as well as its benchmark (6.56%) over the one-year period.

South African fixed interest markets remained under pressure in June. The All Bond Index fell a further 0.2%, after a weak -0.72% return in the prior month. The long end was again hardest hit, albeit less so than in May, with long bonds posting a return of negative 0.47% for the month. The combined GOVI index fell 0.14%. Despite another month's poor returns, performance over 12 months remains quite strong. Following some weakness in May, inflation-linked bonds (ILBs) and cash outperformed during June, returning 0.43% and 0.51% respectively.

Data published in June continued to show soft growth outcomes, but rising inflation pressure. Both CPI and PPI prints for May surprised to the upside, the former rising 4.6% y/y from 4.5% - driven mainly by food and transport costs. PPI was also higher at 3.6% y/y, from 3.0%, with food and fuel prices as well as machinery prices the main contributors to the acceleration. The weaker currency and moderately higher international oil prices will add to the cost of running transport in the next two months' data, and the July print will be exacerbated by an annual increase in electricity prices of about 13%. Short-dated forward rate agreements (FRAs) suggest that South African rates will rise to 6.25% during 2015 (unchanged from a month ago) and hit 7.0% by end-2016 (unchanged from a month ago). These elevated short-dated rate expectations (and the rise in bond yields) can be attributed to deteriorating inflation expectations. The biggest source of upside risk to inflation in the South African Reserve Bank (SARB) assessment is the vulnerability of the currency to changes in the US Federal Reserve's policy settings and the impact on prices of wage settlements which continue to exceed both inflation and changes in productivity. Three- and five-year negotiable certificates of deposit (NCDs) - respectively 8.50% and 9.27% at month-end - continue to hold their appeal relative to the interest rate outlook and the inherent protection in their elevated yield levels. However, given the increased possibility of the SARB commencing its rate hiking cycle earlier than expected, and the tendency for markets to be too aggressive in their pricing of cycle depth, the fund has chosen not to increase its holdings in these instruments and initially hedged a large portion of its shorter date fixed-rate exposure to protect against excessive capital loss. During the month of June, the fund removed these hedges as short rates moved to a level that adequately compensated for the risks that lie ahead. The fund will not hesitate to re-engage on these hedges if levels become expensive. Bank funding remains strained due to a combination of new regulatory requirements (Basel III) and the increasing drawdowns on loan facilities by infrastructure products. As such, bank credit spreads have remained at their recent wide levels of approximately 140bps (in the five-year range). This has enhanced the attractiveness of floating-rate assets for the fund. The fund maintains a cautious outlook and we prefer to be selective in its exposure, given the current phase of the credit and business cycle.

Growth data remain mixed and muted. Aggregate private sector credit growth was 9.5% y/y, but the breakdown showed credit extended to businesses remains strong, whereas household credit extension is languishing at 3.2% y/y. Manufacturing production in April contracted by 2% y/y, while mining production slowed to 7.7% y/y from 19.5% in March. Eskom's load shedding continued while the National Energy Regulator of South Africa (Nersa) considered its application for an additional 12.3% topup tariff for next year to cover costs related to the running of its open cycle gas turbines (OCGTs). The combined weak economic data and deteriorating inflation trend continues to undermine confidence amongst both businesses and consumers. According to survey data from the Bureau for Economic Research (BER), business confidence fell to 43 index points in the second quarter of 2015, implying that 57% of respondents view current conditions as dissatisfactory, and consumer confidence slipped to -4, from 0 - well below the long-term average of 5 index points.

Foreign outflows continued in June, recording a R7.75 billion outflow. Although the rand was relatively unchanged over the quarter, the outflows in early June saw it touch a high of 12.60 versus the US dollar. Over both the month and the quarter the rand outperformed its emerging market peers, despite continued local negativity around structural bottlenecks to growth coming more into the spotlight. We continue to believe that over a longer-term horizon the rand is, at worst, fairly valued at current levels. The weak rand will continue to assist in a recovery of the trade account, especially as mining output and manufacturing production stabilise following industrial action last year. However, given the renewed risks posed to growth from electricity supply shortages and other structural bottlenecks, we believe the rand might be the only pressure valve for the local economy in the shorter term. As such, the fund has marginally increased its exposure to offshore assets by reducing its short position in JSE currency futures. This allows the fund to maintain its core holdings in offshore assets and fluctuate exposure synthetically, with the added effect of enhancing the yield of the fund. The fund continues to hold exposure to high-yielding emerging markets with strong fundamentals, particularly those where interest rates have already started to normalise.

On 29 June Nersa rejected Eskom's application for an additional tariff top-up for the 2016/17 fiscal year (an implied municipal increase for July 2016), mostly on technical grounds, but also because Eskom has failed to deliver on past promises. This is not to say that Eskom cannot reapply, or that the overall inflation impact (once clawbacks are included) will be materially below the SARB's current forecasts, but the upside risk from this source is perhaps somewhat diminished. That said, a combination of rising retail fuel prices, another recent spike in domestic maize prices and the persistent vulnerability of the currency to interest rate normalisation in the US remain. The gold companies' wage offer - which ranges from 7.8% to 13.0% as a starting offer - is unlikely to be viewed favourably, especially when combined with the latest BER inflation expectations which saw long-term (5 year) expectations jump 0.2ppts and aggregate expectations rise a large 0.6ppts in the second quarter.

This economic environment is extremely challenging for the SARB's Monetary Policy Committee (MPC). When they meet again from 21-23 July, they will have a June CPI print, which is likely to be higher than 5% y/y and rising smartly. Despite the 'reprieve' from Nersa, the fact that two members of the committee voted in favour of a hike at the May meeting, coupled with persistent upside inflation risk, makes us believe there is a significant risk that the MPC raises the repo rate by 25bps at this meeting. The value point on the bond and interest rate curve remains along the longer end, and the fund continues to hold and increase its exposure to very attractively priced credit in those tenors. The front to belly of the curve (<10 years) remains at levels that offer little benefit relative to cash rates. It will also struggle to see an aggressive rally amid the SARB's continued rhetoric of "rate normalisation". This makes fixed-rate bonds (or equivalent credit) relatively unattractive. We are therefore targeting increased floatingrate exposure in this area of the curve. The fund will continue to remove its duration hedges into any widening in bond yields. At current levels, our outlook is relatively neutral on duration as valuations have moved in line with recent SARB rhetoric and fundamental backdrop. We continue to add selected exposure to longer-dated fixed and shorter-dated floating-rate corporate bonds through new issuances. Only those that offer attractive entry levels, based on our assessment of the underlying credit quality, will be considered.

The property market was down slightly in June (-0.36%) and maintained its relative underperformance to other fixed interest assets over the quarter as it was down 6.2%. However, the sector maintains a positive return of 6.61% year-to-date and +26.98% for the 12-month period. The yield gap between that of the property index and the current 10-year government bond remains quite stretched; however, it is important to note that many of the stocks within the property sector are trading at 1-year forward yields in excess of 8%, which has increased their relative attractiveness. The fund has been selectively adding what we consider to be undervalued, high-quality stocks to its holdings. It will continue to take advantage of any property stocks that offer upside to their net asset value (NAV) valuations and maintains property holdings that offer strong distribution and income growth. In the event of a moderation in listed property valuations, which may be triggered by further bond market weakness, the fund will look to increase this exposure at more attractive levels.

We also continue to favour preference shares, given the steady dividend yields on offer, and maintain the current level of holdings in the fund. Preference shares are linked to the prime rate and, subject to the risk profile of the issuer, currently yield between 7% and 9.5% (subject to a 15% dividends tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). Furthermore, the recent budget did not make any changes to the dividends tax policy which should also enhance the attractiveness of these assets.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the South African economy. However, we believe the current fund positioning correctly reflects appropriate levels of caution. The fund yield of 8.33% continues to be attractive relative to the duration risk within the fund and we continue to believe this to be an adequate proxy for expectations around fund performance in the 12-month period ahead. As short-term rates move higher, the benefit from the longer-term rise in fund yield, due to our increased floating-rate exposure, should dampen any element of shorter-term capital loss. There are risks that are starting to threaten the relatively sanguine environment depicted by the local bond market. Liquidity from Europe and Japan will remain a supportive element; however, the soft patch in US data seems to be firmly behind us and markets are readying themselves for a September rate hike by the Federal Open Market Committee. The uncertainty around the current pricing of various asset classes, more especially fixed interest, suggests that the volatility and risk premium required to hold these types of risky assets should be higher than is currently being priced into markets. In addition, there is an added risk that the SARB raises interest rates by too much, or too soon, resulting in a slowdown of domestic growth. Although this will support the long end of the local bond market, we remain wary of excessive negativity as the hiking cycle recommences locally and in the US. As is evident, we remain cautious in our management of the fund. We continue to only invest in assets and instruments that we believe have the correct risk and term premium so as to limit investor downside and enhance yield.

Portfolio managers Mark le Roux and Nishan Maharaj

The fund returned 0.68% in April, bringing its return for the 12-month period to 8.09%. The fund return remains ahead of the Short Term Fixed Interest (STeFI) three-month index (5.88%) as well as its benchmark (6.47%) over the one-year period. South African fixed income markets remained under pressure in April. The All Bond Index fell a further -0.49%, after a weak return (-0.53%) in the previous month. The long end was again hardest hit, and long bonds yielded a negative return of -1.1% on the month. The combined GOVI index fell -0.43%. Inflationlinked bonds (ILBs) again out-performed on the month as the market moved to price in deteriorating inflation prospects. ILBs posted a positive return of 3.06% in April, well above the cash return of 0.51%. While fixed income, on the whole, saw another month of poor returns, its performance over six and twelve months remains supportive. Short-dated forward rate agreements (FRAs) suggest that South African rates will rise to 6.75% during 2015 and hit 7.25% by end-2016 (unchanged from a month ago). These elevated short-dated rate expectations (and the rise in bond yields) can be attributed to deteriorating inflation expectations following the rise in global oil prices. The strong global tailwinds for bonds continued to turn in April. Global oil prices tick higher after a weak start to the year, and the effects of this were again amplified in the domestic economy by a weaker currency. As a result, the retail petrol price rose for the second month, up Rc162/litre in April - a hike that was exacerbated by adjustments to the fuel levy and additional allocation to the Road Accident Fund, adding Rc80.5/litre to the increase.

Foreign inflows turned positive in April, with a total of R13.5bln of inflows in the month. This helped the rand to appreciate marginally; it touched a low of R11.65 to the dollar in early April before settling at around R12 by the end of the month. In addition, emerging market currencies enjoyed considerable gains in April, with the Russian rouble up close to 12% and the Brazilian real up 5%, contributing towards a much stronger risk sentiment feeding through to the rand. We continue to believe that over a longer term horizon the rand is, at worst, fairly valued at current levels. The weak rand will continue to assist in a recovery of the trade account, especially as mining output and manufacturing production stabilise following industrial action last year. However, given the renewed risks posed to growth from electricity supply shortages and other structural bottlenecks, we believe that the rand might be the only pressure valve for the local economy in the shorter term. As such, the fund has marginally increased its exposure to offshore assets by reducing its short position in JSE currency futures. This allows the fund to maintain its core holdings in offshore assets and fluctuate its exposure synthetically, with the added effect of enhancing the yield of the fund. The fund continues to hold exposure to high-yielding emerging markets with strong fundamentals, particularly those where interest rates have already started to normalise. Food prices, until recently a strong contributor to disinflation, also look less favourable. Food inflation continued to slow in annual terms to 5.9% y/y in April from 6.5% y/y the month before, but the pace of deceleration has moderated, and the monthly change remains strong. Maize prices are still elevated after the Crop Estimates Committee confirmed a weak forecast for the current harvest as drought in the North West and Free State damaged yields. The SARB's Monetary Policy Committee did not meet in April, but public comments from members reiterated the committee's concern that inflation risk lies to the upside of current forecasts, and the room to pause afforded by the oil price has shrunk. A speech made by Deputy Governor Mminele in the US in April highlighted the challenges facing the domestic economy, and he spoke of the immediate priority of strengthening growth momentum. However, he reiterated that it is the view of the MPC that interest rates need to normalise over time, and that the flexibility provided by the lower oil price has been "reduced". In our view, this statement, coupled with the upward revisions to SARB inflation forecasts during the March MPC meeting as well as rising fuel and food price pressures, may raise the risk that interest rates will be increased during the course of this year. Three- and five-year negotiable certificates of deposit (NCDs) - respectively 8.26% and 8.80% at month-end - continue to look appealing relative to the interest rate outlook. The fund has started to increase its holdings of these instruments due to their attractiveness over longer-dated fixed rate government bonds. Bank funding remains strained due to a combination of new regulatory requirements (Basel III) and the increasing drawdowns on loan facilities by infrastructure products. As such, bank credit spreads have remained at their recent wide levels of approximately 140bps (in the five-year range). This has enhanced the attractiveness of floating rate assets for the fund. The fund maintains a cautious outlook and we prefer to be selective in its exposure given the current phase of the credit and business cycle. The very weak growth context remains not only a moderating element in the outlook for the interest rate cycle, but a clear concern for policy makers. Mining and manufacturing production started the year very weak, both with deep contractions in January. Production improved in February, but the forwardlooking PMI indicator was well below the breakeven 50-level through the first quarter of 2015, and the April print (45.4) started the second quarter on a very weak note. Retail sales have bounced a little, and fiscal data suggest some resilience in consumer resources, but poor employment prospects, weak confidence, electricity challenges and rising associated costs coupled with global growth headwinds are likely to keep the foundation for domestic growth under pressure.

The value point on the bond and interest rate curve remains along the longer end, and the fund continues to hold and increase its exposure to very attractively priced credit in those tenors. The front to belly of the curve (<10 years) remains at levels that offer little benefit relative to cash rates. It will also struggle to see an aggressive rally amid the SARB's continued rhetoric of "rate normalisation". This makes fixed-rate bonds (or equivalent credit) relatively unattractive. We are therefore targeting increased floating rate exposure in this area of the curve. The fund will continue to remove its duration hedges into any widening in bond yields. At current levels, our outlook is more constructive as duration valuations look somewhat cheap relative to our fair value estimates. In addition, we continue to add selected exposure to longer-dated fixed and shorter-dated floating-rate corporate bonds through new issuances. Only those that offer attractive entry levels, based on our assessment of the underlying credit quality, will be considered. The property market managed to hold onto gains in April, with a 0.04% return for the month, and delivering a return for the year so far of 13.74%. The yield gap between property stocks and the current 10-year government bond increased to 272 basis points, mainly due to the selloff in government bonds. Although the fund continues to hold a decent allocation to local and offshore listed property, recent moves in the bond yields have caused us to become a bit more concerned with property valuations in the short term. Hence, the fund has started to selectively reduce some of our local and offshore property holdings. It will, however, continue to take advantage of any property stocks that offer upside to their net asset value (NAV) valuations and the fund will maintain property holdings that offer strong distribution and income growth. In the event of a moderation in listed property valuations, which may be triggered by further bond market weakness, the fund will look to increase this exposure at more attractive levels.

We also continue to favour preference shares, given the steady dividend yields on offer, and maintain the current level of holdings in the fund. Preference shares are linked to the prime rate and, subject to the risk profile of the issuer, currently yield between 7% and 9.5% (subject to a 15% dividends tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). Furthermore, no changes to the dividend tax policy were announced in the recent national budget, which should also enhance the attractiveness of these assets. We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the South African economy. However, we believe the current fund positioning correctly reflects appropriate levels of caution. The fund yield of 8.32% and duration risk should continue to provide an adequate buffer against any adverse short-term developments and assist the fund in meeting its performance target for 2015. Despite the deterioration in April, the outlook for the bond market remains balanced. Growth remains a challenge at home and globally, with disappointing growth data out of the US reflected in the Fed's less hawkish tone in April. Liquidity from Europe, Japan, and to a lesser degree the US, is still a supportive element, with the market not sufficiently confident in US data to fully price in rate hikes at this time. In the short term, there remains a risk that the SARB raises interest rates by too much or too soon in this environment, and domestic growth slows again. This would support the long end of the local bond market. As is evident, we remain cautious in our management of the fund. We continue to only invest in assets and instruments that we believe have the correct risk and term premium so as to limit investor downside and enhance yield.

The fund returned -0.05% in February, bringing its return for the 12-month period to 9.22%. The fund return remains ahead of the Short Term Fixed Interest (STeFI) three-month index (5.79%) as well as its benchmark (6.37%) over the one-year period. South African fixed income markets came under pressure in February, partly reversing the strong gains achieved in January. The All Bond Index fell -2.8%, after an impressive 6.49% return in the previous month. While yields rose across the curve, the longend was hardest hit. Long bonds yielded a negative return of -4.3% for the month, and the combined GOVI index yielded -2.6%. Despite the poor one-month performance, returns over three, six and twelve months remain strong. Inflation-linked bonds remained under pressure, with a negative return of -0.3%, while cash out-performed, returning 0.5%.

Short-dated forward rate agreements (FRAs) suggest that South African rates will rise to 6.25% during 2015 and hit 6.75% by end- 2016 (up from 5.75% and 6.5%, respectively, a month ago). This change in short-dated rate expectations (and the rise in bond yields) can be attributed to a partial reversal in the prices of oil and food during the course of the month. The sharp adjustment in oil prices in January resulted in widespread revisions to inflation and growth projections, both locally and globally. The tailwinds following these changes helped drive January's bond market performance, but the market partly retraced in February as global oil prices ticked higher. At current levels ($61 per barrel), the oil price is still significantly below the average price in 2014 ($99 per barrel), but the retracement was a reminder that much of the adjustment has already been made. In the US, mixed economic data in February (despite a strong January payrolls print) kept the debate about the timing of a normalisation in Fed interest rates alive. Data out of Europe was even more contradictory, with growth indicators including Purchasing Managers Index (PMI) data and retail sales (particularly in Germany) a bit better against weak expectations, but inflation data reinforcing concerns about deflation in the region.

Strong foreign inflows in January were largely reversed in February. This exerted considerable pressure on the currency, with the rand weakening to just over R11.80/$ over the course of the month. Its decline can also be attributed to the stronger dollar that has been driving emerging market currency weakness. We continue to believe that the market has overshot in its negativity towards the rand and that the currency is probably, at worst, fairly valued at current levels. The weak rand will continue to assist in a recovery of the trade account, especially as mining output and manufacturing production stabilise following industrial action last year. As such, the fund continues to have a low exposure to offshore assets (to reflect our more bullish view on the rand) by maintaining our short position in JSE currency futures. This allows the fund to maintain its holdings of offshore assets while synthetically restoring its exposure to the rand. It has the effect of not only reducing our net offshore exposure but also enhancing the yield of the fund. The fund continues to hold exposure to high-yielding emerging markets with strong fundamentals, particularly those where interest rates have already started to normalise.

Despite the slightly higher oil price in February, South Africa should benefit from fuel prices that are likely to be much lower for most of 2015 than they were in 2014. Measured inflation is expected to continue to slow towards the end of the first quarter this year before picking up modestly in the second quarter. The tabling of the 2015/16 Budget on 25 February provided some more insight into the fiscal measures signalled in the Medium- Term Budget Policy Statement (MTBPS) in October 2014. True to its commitment to raise revenue, National Treasury made tax adjustments of almost R17bn, against guidance of R12bn. Expenditure remains capped at 2.5% in real terms over the medium term, and the projection for the deficit for the coming fiscal year is -3.9% of GDP, from -4.1% in the current year. Disappointingly, this again implies a deterioration in the fiscal position relative to the MTBPS guidance (-3.6%, as previewed in the MTBPS), re-enforcing the pattern of poor fiscal adjustment of the past few years. The public sector borrowing requirement was revised higher for the current year, and a series of large redemptions in 2017 and 2018 will keep pressure on Treasury to manage its portfolio while finding adequate funding to meet these commitments. National government debt forecasts were revised marginally lower over the medium-term (to a peak of 43.7% of GDP in 2017/18, from 45.9%), owing mostly to higher nominal GDP expectations, and a moderation in interest service costs.

The Budget's tax changes will have a mostly transitory impact on inflation. A petrol price increase of 80.5c/litre - due to hikes in both the fuel price levy (+30c/l) and Road Accident Fund levy (+50c/l) - will add 0.4 points to monthly CPI in April. Increases in excise taxes are likely to be felt by March. The budget also proposes an increase in the electricity levy, which will add to inflation over the next year. We have adjusted our forecasts to reflect these changes, but it has not altered our current view that the repo rate will remain on hold throughout 2015. Three- and five-year negotiable certificates of deposit (NCDs) - respectively 7.89% and 8.45% at month-end - are starting to look appealing relative to the interest rate outlook. The fund has started to increase its holdings of these instruments due to their attractiveness over longer dated fixed rate government bonds. Bank funding remains strained due to a combination of new regulatory requirements (Basel III) and the increasing drawdowns on loan facilities by infrastructure products. As such, bank credit spreads have remained at their recent wide levels of approximately 130bps (in the five-year range). This has enhanced the attractiveness of floating rate assets for the fund. The fund maintains a cautious outlook and we prefer to be selective in its exposure given the current phase of the credit and business cycle.

Despite lower oil prices relative to last year, growth-related data published in February remains mixed. January's PMI was seasonally high at 54.2, but reversed sharply to 47.6 in February, suggesting the manufacturing sector remains under pressure. Credit extension accelerated moderately to 9.2% y/y from 8.5%, mainly on an adjustment to corporate investment valuations and ongoing general loan growth. Household lending slowed again to 3.5% y/y. Trade data - although typically volatile - painted a very weak picture of the export sector, with a deficit in January of R24.2bn. Overlaying all was ongoing load shedding, with a very constrained Eskom offering little prospect of relief in coming months. The value point on the bond and interest rate curve remains along the longer end, and the fund continues to hold and increase its exposure to very attractively priced credit in those tenors. The front to belly of the curve (<10 years) remains at levels that offer little benefit relative to cash rates. It will also struggle to see an aggressive rally amid the SARB's continued rhetoric of "rate normalisation". This makes fixed-rate bonds (or equivalent credit) relatively unattractive. We are therefore targeting increased floating rate exposure in this area of the curve. The fund will continue to remove its duration hedges into a widening in bond yields. At current levels we are more constructive in our outlook as duration valuations look somewhat cheap relative to our fair value estimates. In addition, we continue to add selected exposure to longer-dated fixed and shorter-dated floating-rate corporate bonds through new issuances. Only those that offer attractive entry levels, based on our assessment of the underlying credit quality, will be considered.

The property market continued to push higher in February, delivering a monthly return of 3.16%. The yield gap between property stocks and the current 10-year government bond increased to 227 basis points, mainly due to the selloff in government bonds. Although the fund continues to hold a decent allocation to local and offshore listed property, recent moves in the bond yields have caused us to become a bit more concerned with property valuations in the short term. Hence, the fund has started to selectively reduce some of our local and offshore property holdings. It will, however, continue to take advantage of any property stocks that offer upside to their net asset value (NAV) valuations and maintains property holdings that offer strong distribution and income growth. In the event of a moderation in listed property valuations, which may be triggered by further bond market weakness, the fund will look to increase this exposure at more attractive levels. We also continue to favour preference shares, given the steady dividend yields on offer, and maintain the current level of holdings in the fund. Preference shares are linked to the prime rate and, subject to the risk profile of the issuer, currently yield between 7% and 9.5% (subject to a 15% dividends tax, depending on the investor entity). The change in capital structure requirements as mandated by Basel III will discourage banks from issuing preference shares. This will limit availability (and boost possible buybacks). Furthermore, the recent budget did not make any changes to the dividend tax policy which should also enhance the attractiveness of these assets.

We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the South African economy. However, we believe the current fund positioning correctly reflects appropriate levels of caution. The fund yield and duration risk should continue to provide an adequate buffer against any adverse short-term developments and assist the fund in meeting its performance target for 2015. The outlook for the bond market in 2015 remains constructive. Despite the strong start to the year, the market is currently trading at around the same levels as in early 2014. Continuing liquidity from the developed world, the impact of low oil and food prices on inflation, and concerns about slow growth in SA have all provided some support to bonds. The key risk factor for bond yields, however, is the vulnerability of the currency, especially given that improved fiscal and current account deficits still leave SA among the world's worst on the twin deficit front. Eskom also poses a considerable risk to growth. As is evident, we remain cautious in our management of the fund. We continue to only invest in assets and instruments that we believe have the correct risk and term premium so as to limit investor downside and enhance yield.

Portfolio managers
Mark le Roux and Nishan Maharaj Client