Economic overview

After surprising the market with a January rate hike, the monetary authorities spent quarter two trying to downplay expectations for interest rate hikes and reassure us that the tightening cycle will be measured and protracted. The market seemed to accept this and expectations have moderated from around 250 basis points down to 150 basis points of tightening over the next 18 to 24 months. The three-month JIBAR rate remained virtually unchanged at 5.82% for the quarter, while the 12-month JIBAR rate broke through the 7% barrier to close at 7.12%. The total return from the Stefi money market index now reflects the January hike in full and was 1.42% for the quarter. The stagflationary bind facing the monetary authorities became a whole lot more complicated this quarter. The economy imploded on the back of the platinum strikes, while inflation went flying through the top of the target band (6.6%). It is time to test the resolve of the flexible inflation targeting mandate! What is more important to the South African Reserve Bank (SARB) - is it inflation targeting credibility and the resulting stable inflation expectations or the horrendous economic growth backdrop that could do with continued support from monetary policy?

Our view is that policy makers will continue to try and juggle both. Provided the economy starts to recover from the strikes and that inflation is forecast to come back within the target band over their horizon, we believe they will want to do nothing. If either of these variables does not behave, their hand will unfortunately be forced. A further complicating factor is that South Africa has one of the lowest real interest rates in the emerging peer group. With the recent spike in inflation, we are now back at a -1% real interestr rate and this in an environment of fluid global capital flows, which concerns both the SARB and investors. Given that inflation is likely to stay comfortably above the top of the target band for most of the second half of the year, policy makers are likely to have to at least try and achieve zero real rates with interest rate hikes of between 50 and 75 basis points over the next 12 months. So, our view is that there is indeed some sort of a tightening cycle under way, which will be very data dependent and constantly at the mercy of global liquidity conditions.

Portfolio overview

The January hike is now fully transferred through to the portfolio yield. A measured tightening of policy is good news for long-suffering money market investors and returns are likely to rise above inflation, which is a welcome reprieve. In addition, the volatility in rates and change in the shape of the yield curve will create opportunities for active return from interest rate views, while yield enhancement from credit and term premia remains feasible as long as the environment for risk is benign. The yield on the portfolio continues to rise and has moved above 6% (annual effective) as at quarter end.

Portfolio positioning

- Duration - the interest rate risk in the portfolio remains very low at around 60 days in anticipation of further rate hikes, while the weighted average term-to-maturity is close to the 120-day maximum in order to maximise yield.

- Yield curve - although 12-month fixed rates have stabilised post the January hike, they remain fairly elevated at around 7% given our benign view on the likely progression of the tightening cycle. This leaves the curve fairly steep and we see some value in moving further along the curve, adding a portion of exposure to fixed rates in the portfolio.

- Credit - spreads in the money market are tracking sideways as a deteriorating fundamental backdrop is offset by a search for yield and lack of issuance. We continue to invest in a range of high quality and diversified exposures, balancing the need for yield with a very strong risk-cognisant approach when evaluating issuer exposure.

The investment objective of the Momentum Money Market Fund is to provide a medium whereby investors can obtain undivided participation in diversified portfolio of such money market instruments as defined from time to time.

The primary performance objective of the portfolio is to obtain as high a level of current income as is consistent with capital preservation and liquidity. Capital gains will be of an incidental nature. The portfolio will be managed in compliance with prudential investment guidelines for retirement funds in South Africa. The Trustee shall ensure that the investment policy set out in this supplemental deed is carried out. The
portfolio shall be subject to all relevant provisions of the Deed, as amended by this supplemental trust deed, the regulations and any relevant further supplemental deeds entered into in the future. For the
purpose of this portfolio, the manager shall reserve the right to close the portfolio to new investors on a date determined by the manager. This will be done in order to be able to manage the portfolio in
accordance with its mandate. The manager may, once a portfolio has been closed, open that portfolio again to new investors on a date determined by the manager.

Economic overview

Another quarter passed with an unchanged repo rate (5%), but we saw the strongest indication yet from the Monetary Policy Committee (MPC) that the easing cycle is over and the market should prepare for a normalisation of monetary policy from the very accommodating levels we have enjoyed for a long time. The three-month JIBAR rate remained roughly unchanged at 5.14%, while the 12-month rate rose 17 basis points to end the quarter at 5.99%. The total return from the SteFi money market index was 1.28% for the quarter.

South African Reserve Bank governor, Gill Marcus, delivered a somewhat more hawkish MPC speech at the September meeting, which resulted in a significant shift in market expectations for the future profile of the repo rate. Central to the change in rhetoric appears to be a deterioration in the inflation outlook from the persistently weak rand, the reality that the abnormally accommodative global policy in the US is not sustainable and is likely to start normalising and a more vociferous emphasis that monetary policy can't do much more for domestic growth and that the focus is likely to shift towards managing stubbornly high inflation to maintain policy credibility. We believe this likely brings the start of the tightening cycle forward a little to the first half of 2014 (from the end of 2014). The global backdrop remains very fluid and any changes to the factors driving the policy outlook will shift expectations for the first hike.

A normalisation of domestic monetary policy will become inevitable in a global environment where policy makers are reducing the availability of liquidity that we draw on to fund our twin deficits. The current level of negative real rates make us vulnerable to any sudden withdrawals of capital and so, while the policy normalisation need not be dramatic given the underperforming economy, our estimates suggest around 2% worth of tightening is likely to restore a more realistic balance to our local policy setting in a global context. It is merely the timing of the move higher in rates that will be uncertain given all that is going on in the global economy at present.

Portfolio overview

Unfortunately for money market investors, this does mean likely negative real returns for some time to come, although the capital stability in cash is hugely appealing in markets where uncertainty remains so elevated. Portfolio returns continue to be driven by yield premia from term and credit spreads as opposed to any value added from interest rate and yield curve risk given the flat environment for interest rates. The yield on the portfolio has risen over the quarter, although the spike at quarter end was caused by realised profits on the disposal of some investments. The yield at the end of the quarter was 5.20% per annum.

Portfolio positioning

o Duration - there is minimal interest rate risk in the portfolio with rates at such low levels. Modified duration is around 60 days, while the weighted average term-to-maturity is close to the 120-day maximum in order to maximise yield.

o Yield curve - exposure is concentrated in the three to six-month area as the money market yield curve remains relatively flat and investors are not compensated for moving out longer, considering how much of the term-to-maturity limit for the overall fund gets used up by doing this. The yield curve has steepened over the quarter given rising interest rate expectations, but we feel the yield pick-up does not compensate for the duration risk one takes when moving out longer.

o Credit - credit spreads have stabilised, but at low levels as yield enhancement through credit continues to be the game. Investors are not being paid as much yield pick-up as, say, 12 months ago for moving into the commercial paper market, away from the big banks. We continue to invest in a range of high-quality and diversified exposures, balancing the need for yield with a very strong risk-cognisant approach when evaluating issuer exposure. There are definitely some sectors within the credit market in which fundamentals have been exposed by the lack of economic growth and the rising uncertainty in their environments. We have reduced exposure to these sectors in the portfolio.