Please note that the commentary is for the retail class of the fund.

The fund returned 1.54% in March, bringing its return for the 12-month period to 7.38%, which is well ahead of cash (6.58%) and its benchmark (6.86%). March was a much better month for domestic markets and the bond market more than recovered its February losses. The All Bond Index (ALBI) rose by 2.63% in March, with longer-dated maturities delivering the best performance. Bonds with a maturity of 12 years or more gained 3.02%, compared to those with maturities of 1 to 3 years that returned 1.28%. Inflation-linked bonds under-performed with a return of 1.05%, while the cash return was 0.58%.

Global market volatility started moderating in February and improved even further in March, as most risk assets rebounded in the month after a torrid start to the year. On balance, global growth data showed some stabilisation and oil prices rose, extending the reprieve for emerging asset prices. In the US, decent employment data and a small improvement in the detail of the ISM data offset some of the earlier concerns for growth. European data were mixed, amid increasing concerns about deflation. Deflationary conditions in France and Germany contributed to European inflation moving into negative territory in February. The European Central Bank cut the deposit rate and announced a large extension in its quantitative easing programme, extending asset purchases to include non-financial corporate bonds. Politics also started to heat up, with the US presidential election gaining momentum in what looks to be a closely contested race in coming months. A heavy schedule of European elections are also in the pipeline. The UK Brexit referendum has been set for 23 June.

At the end of March, shorter-dated negotiable certificates of deposit (NCDs) traded at 9.255% (three-year) and 9.855% (five-year), respectively. NCDs continue to hold appeal amid the outlook for interest rates 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), the increasing drawdowns on loan facilities by infrastructure products and the poor macroeconomic backdrop. As such, bank credit spreads have continued to widen to levels of approximately 150bps (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.

In South Africa, March saw the release of the SARB quarterly bulletin, presenting national accounts statistics for the fourth quarter of 2015 and for calendar 2015. The biggest disappointment was a marked deterioration in the current account deficit, which expanded to -5.1% of GDP in the fourth quarter of 2015, reflecting a sharp deterioration in the trade deficit during the quarter. The shortfall in services, income and current transfers also widened at the end of last year, but the deterioration was marginal, with services benefiting from improved tourism flows, while the income deficit widened. For the year as a whole, however, the deficit narrowed to -4.4% of GDP, from -5.4% in 2014. The breakdown of the GDP statistics was more mixed. Annual and quarterly GDP growth statistics from the supply side were already known, but the demand side detail showed an improvement in growth contribution from households and fixed investment last year relative to 2014. Net exports were steady, in line with the improvement in the current account deficit. Inventories and a large residual remain growth detractors.

Domestic high frequency data have also been more mixed. The PMI print for March was better than expected with seasonally adjusted headline PMI at 50.5 - the first print above 50 since July 2015. Trade data surprised on the upside, in part reflecting seasonally strong exports, but also relatively larger export growth than in the previous year. Import value rose slightly, showing import demand remains resilient. Fiscal data were strong at the end of February: the budget balance was up R16.4bn on the month, with the cumulative deficit for the eleven months to February at -R151.7bn. This puts government well on track to meeting its -3.9% fiscal deficit target for the year. Mining and manufacturing, however, were much weaker than expected, with mining output falling -4.9% y/y in January and manufacturing contracting -2.5% y/y. Inflation data surprised to the upside in March (again), as base effects and food prices pushed the headline CPI reading to 7.0% from 6.2% y/y the month before. Warnings of impending price increases from food producers and retailers suggest that food inflation may rise steadily from here, and a large early-April petrol price hike will add significantly to inflation momentum. PPI inflation showed another surge in food prices on the month, a harbinger of more price pressure for the consumer basket.

The rand held onto its gains from February and touched a low of R14.70 to the dollar. This came on the back of a more benign global monetary policy environment that spurred inflows into the local bond market of R14.1bn in March (R15.8bn in the year to date). The rand remains one of the underperformers among its emerging market counterparts, reflecting negativity amid souring fiscal and socio-political factors. 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 continued risks posed to growth (including electricity supply shortages, structural bottlenecks in the economy and increased political risk), we believe the rand might be the only pressure valve for the local economy in the shorter term. As such, the fund maintains a healthy exposure to offshore assets, but following the currency move we saw in January, the fund has slightly reduced this position. While the fund utilises JSE currency futures to adjust its exposure synthetically, it still maintains its core holdings in offshore assets, which have the added effect of enhancing the yield of the fund.

The SARB MPC raised the repo rate another 25bps in March, bringing cumulative hiking in this cycle to 200bps, and the repo rate to 7.0%. The decision was split, with three members voting for 25bps and three for no change. At the heart of the decision remains the view that inflation risk is still to the upside of the current forecast. A concerning rise in core inflation suggests that in addition to food inflation and energy price risk, there are signs that pass-through is becoming more evident. The deterioration in the political context poses a risk to the currency and with the higher oil price and upside CPI surprise in March, is likely to contribute further to the MPC’s inflation risk assessment. We think more rate hikes are in the pipeline this year.

Volatility in both global and local markets remain extremely high. Local 10-year bond yields have traded in a 25bps range around 9.25%. These levels are not as extended as those seen in the aftermath of December’s events and suggest a more optimistic outlook for the local economy. Market pricing suggests that the repo rate will rise to 7.75% by end-2016 and to 8.25% by end-2017, which is higher than our expectations of 7.5% by end-2017. This suggests that the market is expecting the SARB to fill the credibility gap created in December and the somewhat disappointing national budget. Given the uncertainty around the political landscape and the poor growth backdrop, the fund cannot commit to extending its duration meaningfully given the near-term risks and as such has kept its duration relatively constant towards the lower end of our historical exposure. However, we continue to look for opportunities in duration and on the yield curve that will provide the fund with attractive opportunities to enhance both the yield and risk/reward profile.

The listed property market came back strongly in March as it rallied 9.48%, outperforming bonds and registering a return of 10.10% for the quarter and 4.57% over the last 12 months. The yield gap between the property index and the current 10-year government bond remains quite stretched. Given the rally we have seen over the last month, the yield on many property stocks have compressed (based on oneyear forward expectations) to yields of approximately 7.6%, rendering them slightly less attractive over a shorter-term horizon. If one excludes the low-yielding, high-cap stocks from the sector, the property sector’s yield rises to just over 8.5%. Property valuations look stretched relative to bonds, and the sector may see some softness over the near term. Accordingly, the fund is selectively reducing some of its holdings with a view to later invest in better property opportunities or other duration assets at more attractive levels, as and when these opportunities present themselves. The fund maintains property holdings that offer strong distribution and income growth and that offer upside to their net asset value (NAV) valuations. 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, depending on the risk profile of the issuer, currently yield between 8.5% and 11% (subject to a 15% dividend 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 9.11% continues to be attractive relative to the duration risk within the fund. We continue to believe this yield is an adequate proxy for expected fund performance over the next 12 months. 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 continues to be considerable downside risks to South African growth, with inflation expected to persist above the top end of the target band for most of this year and into 2017. Against the backdrop of further expected fiscal disappointments and the current flux in the political landscape, we remain concerned about the risk to South Africa’s ratings in the year ahead. At this time, we believe the negative fundamental backdrop outweighs the cheap valuation of South African long bonds. 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 0.14% in December, bringing its return for the 12-month period to 6.69%. The fund return remains ahead of the Short Term Fixed Interest (STeFI) three month index (6.08%), and in line with its benchmark (6.69%) over the one-year period.

The All Bond Index (ALBI) suffered a torrid end to 2015 as it lost 6.67% in December, which dragged down returns for the fourth quarter and the year to -6.43% and -3.93%, respectively. There was no safe place to hide on the bond curve as yields widened across the curve by approximately 125 basis points (bps) during the quarter (and some 175bps over the year). The worst-hit area of the curve was bonds with maturities of 12 years and longer; month-to-date and year-to-date returns were -8.55% and -7.04% respectively. The one-to-three year area of the curve outperformed, delivering 4.1%. The index itself experienced significant changes during the course of the year as its weighting of bonds with maturities of longer than 12 years increased from 36% to 51%. As one would expect, the riskiness of the index (as measured by the modified duration) increased from 6.54 (at the start of the year) to a peak of 7.17. However, following the sell-off in the final months of the year, this has now settled at 6.52. Still, the fortunes of the index will continue to remain largely a function of longer maturity (of more than twelve years) bond performance.

2015 was a difficult year for emerging markets (EM), and specifically for South Africa. The global environment was plagued with concerns of a more pronounced slowdown in China, a European economy that was struggling to lift itself out of recession and the effects of the first interest rate hike in the US following the financial crisis of 2008. The commodity slump added to pressure on many EM countries. These factors, combined with high levels of uncertainty (as reflected by the increase in asset price volatility) left EM currencies battered. South Africa, unfortunately, did very little to differentiate itself in a positive way from its peer group. Its deteriorating growth outlook, along with concerns around government finances and an increase in both socioeconomic unease and political uncertainty, contributed to a slump of 33.7% in the rand over the course of 2015. This weighed on local government bonds, and intensified negative sentiment during the last quarter of 2015, resulting in a significant widening of these yields.

Domestic inflation has been relatively well-behaved over the last year. Falling oil prices and limited pass-through from the weakening rand have helped keep both actual and expected inflation fairly contained. The SA Reserve Bank (SARB) expects inflation to breach the upper end of the target band in the first quarter of 2016, averaging just over 6% for the year. These expectations were based on assumptions of an electricity price increase of 12%, an oil price of $56, slightly lower world food prices and a weakening in the real effective exchange rate of 4% (as at the November meeting of the monetary policy committee). Since then, the rand price of oil has moved lower by 5%, the rand is 11% weaker, white maize prices increased by a whopping 50% and the outlook for the second-round effects of higher food prices has deteriorated. The food component of CPI represents just under 15% of the basket, implying that the risks to current inflation expectations are firmly to the upside and that the expected inflation average of 6% for 2016 is too benign. A more prudent and realistic expectation would be an inflation average of 6.3% to 6.5% for 2016. Growth and its underlying components have and will continue to remain weak, hampering the ability to pass through price increases to the consumer. The lower growth prospects will continue to restrict the SARB from acting as aggressively as it would like to limit the second rounds effects of a persistent breach of inflation targets.

Current market levels suggest that the repo rate will rise close to 200bps (bringing the repo rate to 8.25%) during the course of 2016 as the SARB will be forced to act on its hawkish rhetoric. While this would seem like a fair expectation in any other cycle, it is very difficult to see such rate hikes over the next year given the poor growth backdrop. We expect a repo rate of between 7.25% and 7.5% (hikes of between 100 and 125bps) will be more palatable for the ailing local economy.

Three- and five-year negotiable certificates of deposit (NCDs) traded at 9.71% and 10.47% at year-end, respectively. NCDs continue to hold 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.

Foreign outflows (R8.4 billion) from the local bond market during the fourth quarter contributed to a fall of 11.65% in the rand. Local macro-economic risks re-emerged and continued to highlight SA’s vulnerabilities among its peers. The rand underperformed its emerging market counterparts, reflecting increased negativity amid souring fiscal and socio-political factors. 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 continued risks posed to growth from electricity supply shortages, structural bottlenecks in the economy, the recent deterioration in SA’s terms of trade position (following the fall in commodity prices) and increased political risk, we believe that the rand might be the only pressure valve for the local economy in the shorter term. As such, the fund maintains a healthy exposure to offshore assets. While the fund utilises JSE currency futures to adjust its exposure synthetically, it still maintains its core holdings in offshore assets, which has the added effect of enhancing the yield of the fund.

The combination of a hawkish tilt at the SARB, a tepid growth outlook and poor fiscal discipline implies the need for a greater risk premium in the pricing of SA assets. The steepness of the yield curve and high absolute levels of the longer maturities suggest there is some value in attractively priced credit in those tenors, while 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. At current levels, we believe duration assets are starting to look cheap on a valuation basis, but our conviction levels have been tempered by fragile underlying fundamentals. The fund will 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.

SA’s risk profile has been significantly elevated relative to its peers following the dismissal of the minister of finance. Although the reappointment of Pravin Gordhan, a former finance minister, did offer some calm to the markets, it is highly unlikely to expect the risk premium to decrease in the run-up to the February national budget. All eyes will be on the new finance minister, and how willing and able he is to take on fiscal consolidation. Furthermore, concerns surrounding the approval of the nuclear programme do leave a very dark cloud hanging over SA’s fiscal future. During the December period, it was basically only SA’s sovereign spread that jumped higher, highlighting the market’s increased skepticism about the political will to get economy on a better footing. The listed property market fell in sympathy with the bond market in December, losing 6.1%. While listed property’s quarterly return was -4.7%, its performance for the full year remained positive at 7.99%. 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 8.5%, making them relatively attractive. If the low-yielding high-cap stocks from the sector are excluded, the yield on the property sector rises to just under 9%. 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. 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, depending on 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 8.58% continues to be attractive relative to the duration risk within the fund. We continue to believe this yield is an adequate proxy for expected fund performance over the next 12 months. 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. Unfortunately the current local backdrop looks negative as SA is differentiating itself from its peers in all the wrong ways. Until we see a strong shift towards sustainable economic growth and definite political commitment to making the necessary hard decisions, the appeal of the asset class will only increase if yields widen more to reflect the necessary risk premium. 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