The South African economy is anticipated to deliver superior economic growth during 2011 but does face a challenging environment. The potential negative impacts around the North African & Middle East (5% of SA exports) uprisings and the Japanese (9% of SA exports) crisis could impact our growth expectations, especially our export and consumer related sectors. Rising inflation is a major issue in emerging markets and is starting to come through in South Africa. While the strong Rand has provided a buffer for inflation, the strong rise in food, oil and electricity prices will feed into inflation over the next few months. This together with the high consumer debt levels will constrain household consumption expenditure in the year ahead. While the mining sector is anticipated to provide a meaningful contribution to economic growth, it is largely reliant on robust economic growth being sustained in the likes of China and India. The manufacturing sector has improved with utilisation levels slowly rising but the strong Rand remains a thorn in the side impacting their global competitiveness. With a million job losses during the recession and unemployment at relatively high levels, sustained job creation is required from both the private and public sectors to reduce unemployment meaningfully. This requires a significant increase in labour productivity and incentives to encourage the private sector to start investing and spending on capex in the coming years.

The weak USD has resulted in the Rand remaining strong which is playing a significant role in containing the underlying inflation pressure. However, when we do reach the strong currency base effect by the second half of this year, South African consumers will be more exposed to the impact of these inflation pressures. The Economist Food Index (proxy for global food commodity prices) has moved up 50% YoY whereas SA food inflation is only up 2.8% YoY due to the good grain harvests over the past three years and the strong currency. If we combine this inflation pressure of food and oil with the increasing labour cost due to high real wage settlements during 2010 and high increases in electricity tariffs, the inflation risk to the upside remains high. If this is accompanied by any Rand weakness, inflation will increase substantially more than expected. Over the past quarter, the yield curve has shifted upwards (between 30bps-60bps) and after strong foreign flows into SA bonds in 2010, foreigners have been net sellers of R7 billion of SA bonds over this quarter. As indicated above there is a risk of South African yields moving higher due to inflation pressure which will create more attractive opportunities.

The South African economy is on track to deliver positive economic growth for 2010 despite industrial action having impacted negatively during the second and third quarters. Robust mining production due to demand from major emerging markets and rising commodity prices has resulted in mining starting to come through. Rising disposable income, low interest rates and increases in credit extension has contributed to a cyclical uptick in household consumption expenditure. However, the high consumer debt levels will limit its ability to support strong economic growth over the medium to long term. Consumers also face a potential risk in rising inflation, which could happen fairly rapidly should the Rand depreciate against the major currencies. The manufacturing sector is difficult with the continued strengthening of the Rand constraining its growth potential. Despite this, there appears to be some pick up with automotive production starting to normalize and the PMI moving back above the 50 level in November. Government expenditure is anticipated to remain supportive of economic growth in the future with the stable fiscal and monetary position of government allowing for this flexibility. Despite the increased borrowing for infrastructure related projects (public enterprises included), government debt to GDP is forecasted to peak at 43% in 2013, well below levels of its developed market peers. Unemployment however remains a key concern with the difficult economic environment not being very conducive to job creation. The public sector has contributed to some formal job creation in recent months while, the private sector has lagged and is unlikely to make a meaningful impact in the short term. While the economic environment will remain challenging in the year ahead, economic growth should be better than expected due to base effect of industrial action during 2010.

Based on the CPI numbers released over the past two months it appears that inflation has troughed which reduces the probability of South African policy makers implementing another rate cut in the beginning of 2011. However, the weak USD and strong investment flows to emerging markets have resulted in the Rand remaining strong which is playing a significant role in containing inflation. The strong USD price increases since the start of 2010 in agricultural commodities (Corn up 38% and Wheat up 24%) and crude oil which was up 20% has been offset by the Rand strength but the base effect of this currency strength will be eliminated during the second half of 2011. Combined with the increasing labour cost due to high real wage settlements during 2010 and very high increases in electricity tariffs, these increases in commodity prices raise the risk of inflation surprising on the upside. If this is accompanied by any Rand weakness, inflation will increase substantially more than expected. Despite bond yields in developed markets moving higher over this quarter due to further concerns around Euro sovereign debt and the longer term negative effects of the unprecedented level of quantitative easing, the real yields of South African government bonds remain attractive on a relative basis. However, during the past quarter the yield curve has shifted upwards and after very strong foreign flows into SA bonds we have seen foreigners becoming net sellers. As indicated above there is a risk of South African yields moving higher due to inflation pressure which will create more attractive buying opportunities. In line with our philosophy we remain focused on the quality of the instruments and the cash flows of the underlying issuers and the Oasis Bond Fund is invested in high quality instruments.