Economic overview

This quarter saw the monetary authorities having to rethink their stance on policy. Global and domestic data reinforced the slow pace of the economic recovery and the downward pressure on inflation that is the legacy of the global credit crisis. The repo rate was cut by 50bp at the September Monetary Policy Committee (MPC) meeting, bringing the cumulative easing cycle to 600bp over the last two years. The 3-month JIBAR rate dropped 60bp to end at 6.02%, while the 12-month JIBAR rate declined a mammoth 84bp to end at 6.42%, reinforcing the market expectation that rates are going to stay low for a long time.

Portfolio overview

The yield of the portfolio continues to drift down as new cash and maturing cash is invested into lower yielding instruments, given the downward shift in money market rates. The portfolio has been positioned with the expectation of lower rates and remains fully invested at the longest permissible average term-to-maturity (90 days). In addition, there continues to be good value in credit spreads although these have come in over the quarter. The fund invests in a range of different issuers, with the credit spread earned still fairly attractive relative to risk-free government paper or traditional passive bank deposits. The decline in the portfolio yield, while inevitable due to further cuts in rates, has been delayed by the sound management of interest rate risk (term-to-maturity) and the addition of credit spreads to the portfolio. All in all, this has allowed the yield to remain fairly elevated at 6.76% (from 6.93% last quarter).

Portfolio positioning

Duration - the portfolio remains positioned for a flat to declining interest rate environment, with duration close to the maximum 90 days.

Yield curve - the curve continues to flatten, which is odd for this late stage of the easing cycle. This emphasises the view that rates will remain lower for longer. Investors are only paid an extra 40bp for going from three-month to 12-month investments. With still more cuts unlikely, we prefer to remain invested in the 3-6 month area and add yield via credit spreads, rather than push the boat out on investing in longer dated fixed rates.

Credit/Diversity - credit spreads continue to compress as the search for yield in the market intensifies. We are invested in a range of high quality non-bank issuers, which enhance yield and add to the diversity of the fund.

Economic overview
This quarter saw the strongest indication yet from the monetary authorities that we have reached the end of the easing cycle. The committee remained on hold at the May meeting and Reserve Bank Governor, Gill Marcus indicated a strong preference for keeping interest rates on hold for a lengthy period rather than trying to push the monetary policy envelope any further, given the very stimulative fiscal policy setting for the economy. It is thus, not surprising that money market rates remained stable with the 3-month JIBAR rate, declining 5bp to end at 6.61%, although the 12-month JIBAR rate surprised by falling a more substantial 22bp to 7.28%.

Portfolio overview
The yield of the portfolio began to come down this quarter as the impact from the repo rate cut in March began to filter through to new investments made. We were positioned with the expectation of lower interest rates, i.e. we have extended the term-tomaturity of instruments as long as the mandate permits. This has cushioned the impact of the rate cut on the portfolio, which has meant that the yield has declined less dramatically than the 50bp point cut. In addition, we have aggressively positioned the portfolio to take advantage of the very generous credit spreads available in the market, which add defensive properties to the portfolio yield. All in all, this has resulted in the yield declining to 6.93%.

Portfolio positioning
Duration - the portfolio remains positioned for a flat to declining interest rate environment, with duration close to the maximum 90 days. Yield curve - the curve continues to flatten which is odd for this late stage of the easing cycle. In our view, investors are not really being compensated by investing out longer on the yield curve with the 12-month rate only around 60bp higher than the three-month rate. Given that we think we are at the bottom of the easing cycle, we are selling out of longer-dated fixed rate paper and moving back into the three to six month area. We are doing this in a measured way, as there is clearly no dramatic upside risk to rates at present.

Credit / diversity - credit spreads continue to compress as the search for yield in the market intensifies and investors come to the realisation that going forward the environment appears less risky and that borrowers should no longer be paying the excessive credit spreads they were at the height of the credit crisis. We have been well positioned for an improvement in the credit market and look for this trend to continue.

Economic overview
This quarter saw a changing of the guard at the Reserve Bank as Gill Marcus began her stint as governor and assumed the responsibility of chairing the Monetary Policy Committee (MPC). We witnessed an immediate change in communication style and an increase in transparency, with clear indications given to the market as to the leanings of the authorities. It emerged at the January meeting that certain members of the committee were in favour of further monetary easing, and indeed the repo rate was cut by 50bp at the next meeting in March. This brought the whole money market curve down, with the 3-month JIBAR rate falling 56bp to end at 6.67%, while the 12-month JIBAR rate declined a mammoth 71bp to end the quarter at 7.48%. It is evident that the uncertainty around the hike in electricity prices and the resulting second round impact on inflation, forced a delay in the Reserve Bank's acceptance that inflation was set to come down significantly. Rand strength also appears to have sustained itself for longer than the authorities were expecting. Hindsight is an exact science, but the authorities erred in being on hold for the last six months and now find themselves reacting procyclically to the strong rand and falling inflation at a time when the economy already seems to have taken off and other emerging market peers have started the move to more neutral monetary policy, albeit at a gradual pace. This should limit their ability to ease rates further, with the rand being the key risk factor.

Portfolio overview
From the portfolio's perspective, the rate cut will reduce the returns from investments further, although, as inflation declines investors' real rate of return will improve. We have long held the view that rates should be cut further and fortunately the portfolio was well positioned with a long modified duration position and an extended, weighted, average term-to-maturity, allowing the full benefit of declining rates and generous credit spreads in the market to come through in the portfolio performance. The yield of the portfolio actually increased during the quarter to end at 7.67%.

Portfolio positioning
Duration - the portfolio remains positioned for a flat to declining interest rate environment, with duration at the maximum 90 days.
Yield curve - oddly, the yield curve actually flattened after the rate cut, with the 12-month JIBAR rate declining more than the 3-month JIBAR rate. Given that we think we are at the bottom of the easing cycle, the curve is now too flat and we remain sanguine about the outlook for rates going forward. We would look to sell some of our longer-dated fixed rate paper and move back into the 3-6 month area.
Credit/diversity - there are still great opportunities to enhance yield by adding to the credit (non-bank) exposure of the fund. However, we have seen a noticeable tightening in spreads this quarter as supply of paper is declining and the search for yield by investors intensifies with rates at such low levels.

Economic overview
Monetary policy remained on hold for the entire quarter as a 7% repo rate seems to be the optimal level that the authorities are comfortable with at present. The 3-month jibar rate rose 21 basis points to end at 7.23%, driven higher by a crowding-out from the huge government issuance of treasury bills. The 12-month jibar rate, less impacted by technical factors, edged up marginally to end at 8.19%. Since the last cut in August, the cyclical down-trend in inflation has surprised in its strength, with CPI entering the target band for the first time in nearly 3 years, albeit it marginally at 5.8%. At the same time, the economy is showing signs of emerging from the credit crisis-induced slump, but the momentum is coming mainly from external trade and government spending. The consumer remains under huge pressure, with rising unemployment, falling real disposable income and high debt burdens. This creates a dilemma for the monetary authorities who, we believe, have enough evidence that further rate cuts are required to give the consumer some relief on debt servicing cost. They will also instill some much-needed confidence for households and businesses and ensure the economic recovery gains more traction.
We still feel there is an opportunity for further easing as global rates remain low and capital pours into emerging economies, strengthening commodity currencies and suppressing inflation. Concerns over further rate easing sending the wrong message to consumers are unfounded. Rate cuts would merely reduce the pressure on strained household balance sheets and not result in a renewed wave of expansion. It remains to be seen whether they are forced into easing further. The forward market seems to think that it is not currently pricing-in flat short rates for 12 months, and it also believes that it should rise gradually from here.

Portfolio overview
Despite monetary policy being on hold, the portfolio's yield drifted down during the quarter as instruments matured and cash that was invested at higher rates in Q3 is now being reinvested at lower rates. We have tried to protect against this by keeping the portfolio's weighted average maturity at the maximum 90 days as well as taking advantage of the attractive yields available in the commercial paper market. The yield of the portfolio declined to end the quarter at 7.38%.

Portfolio positioning
Duration - the portfolio remains positioned for a flat to declining interest rate environment, with duration at the maximum 90 days. Yield curve - the yield curve remains very steep with the market pricing in over 1 % worth of hikes in 2010. We have a more sanguine view on rates and look to include some longer dated instruments in the portfolio to enhance the yield. Clearly, the ability to do this is a bit limited by the term to maturity restriction imposed on the fund. Credit / diversity - there are still great opportunities to enhance yield by adding to the credit (non-bank) exposure of the fund. The pressure remains on corporates to pay up for funding in an environment where credit from banks remains in short supply.
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