Market review

During the quarter, low interest rates and further quantitative easing continued to support financial assets. Low nominal cash yields have drawn investors into riskier asset classes. Emerging market equities, along with commodity prices and emerging market currencies, were the clear winners. The MSCI Emerging Markets Index rose 18.2% over the quarter while the MSCI World Index gained 13.9%. Zinc, copper and aluminium ended more than 20% higher, outperforming a substantially weaker US dollar. Gold breached the $1300 mark, to gain 5.4% over the quarter and 19.4% year to date. Platinum and Brent crude both returned 8% in the past three months. Ten-year US Treasuries strengthened, with yields ending the quarter below 2.5%.

Local economic activity moderated, with GDP expanding by 3.2% in the second quarter, down from 4.6% in the first quarter. Concerns about the global economic recovery and subdued demand locally, coupled with the favourable inflation outlook, motivated the South African Reserve Bank to further reduce the repo rate to 6%. The August inflation number of 3.5% was the lowest since-mid 2005. The rand was one of the strongest emerging market currencies over the review period, gaining more than 10% against a weak US dollar. Bond yields fell sharply, boosted by foreign investor demand and continued downward pressure on inflation. The All Bond Index ended the quarter 8% higher, behind listed property (13.7%), but well ahead of cash which returned 1.7% over the period.

The FTSE/JSE All Share Index rose 13.3% over the quarter. The non-resources sector led the market higher, with a significant increase in mergers and acquisitions globally spilling over into the local market. Old Mutual confirmed that it was in discussions with HSBC on its stake in Nedbank. Nippon Telegraph proposed a cash buyout of Dimension Data and Wal-Mart made a cash offer for Massmart. Both the gold and platinum sectors ended down over the quarter, with platinum miners losing 2.3% while gold mining gave up 1%. Consumer services, which include the general retail sector, gained just shy of 25% over the same period. Food retailers, banks, life insurance and personal goods continued to perform well ahead of the broader market.

Portfolio review
The portfolio generated a positive return in the third quarter. The result was less pleasing in the context of a domestic equity market that enjoyed strong gains. Our cautious stance and defensive positioning were the chief reasons we lagged during the quarter.

Portfolio activity
The portfolio's equity weighting remains above average on a gross basis, but we continued to steadily reduce the net domestic equity weighting through a combination of selling and selective hedging. We now have a higher weighting in global equities and within domestic equities, we have a more defensive stance. Our local stocks should outperform the broader market in the medium term. The portfolio's cash holdings remain high and position us to take advantage of future opportunities.

Portfolio positioning
We continue to be comfortable with a dramatically reduced exposure to risk assets. Our underlying equity holdings (domestic and global) have a quality and defensive bias. The reasons for our positioning remain intact and we would require a significant decline in risk assets or strong evidence of a sustainable earnings recovery, to change the composition of the portfolio. The prospect of another round of quantitative easing and increased liquidity has resulted in a euphoric rush for risk assets. It is increasingly clear that the market remains relatively optimistic about the outlook for risk assets (commodities and emerging markets) and higher yielding currencies. Moreover, this tendency reasserted itself surprising early during recent corrections. In contrast to a similar scenario in 2009, the market has rallied in anticipation of the liquidity boost, with a blatant disregard for both the level of the market and starting valuations.

We retain our long-term scepticism and believe that a reversal of the recent uptrend is inevitable and represents a latent risk. Our scepticism is rooted in the belief that the US Federal Reserve is risking long-term credibility, in a futile attempt to reflate an economy that will require many years to overcome the cyclical headwinds created by previous crises. If this new programme of quantitative easing fails, it would have a disastrous effect on risk assets everywhere.

We are once again at odds with the prevailing opinion reflected in stock price movements. Such a view suggests that embracing risk is the correct way to be positioned and that it is pointless to fight the flood of liquidity that will engulf markets in the medium term. We do not share this belief. The fragility of the economic recovery remains a concern and we believe it prudent to look for downside protection.

In contrast to early 2009, we are less optimistic about the prospective returns for equities and we anticipate that returns will be lower than in 2009. If our expectations prove to be wrong, the equity market will have to be engulfed in a bout of speculative euphoria or the economy will have to grow at double its current run rate (or both). Neither of these outcomes, whether in isolation or in combination, strikes us as being very probable at this juncture. Aggregate valuations are no longer cheap and the current absolute level has historically set the scene for uninspiring prospective returns for equities. Less favourable valuations have led us to maintain our level of caution. As a consequence, we remain defensively positioned with significant hedges and a high cash position.

Market review
The second quarter of 2010 reminded investors and market commentators that excess global indebtedness, which had resulted in the global financial crises, was not likely to be resolved in a few short months or by some extraordinary policy miracle. The spotlight remained firmly focused on Europe, with certain countries in the region straining under the heavy burden of unsustainable funding requirements. Global share markets headed lower as uncertainty rose around the likelihood of a V-shaped economic recovery. The MSCI World Index dropped sharply, closing 12.5% down over the quarter, dragging this year's returns into negative territory (-9.6%). Emerging markets fared somewhat better, shedding 8.3% over the quarter and 6% year to date. The FTSE/JSE All Share Index lost 8.2%, dragging the year's returns 4.1% lower. The weaker rand detracted from US dollar returns. The local currency depreciated 4.9% over the quarter and 3.5% year to date against the dollar. The rand gained significantly against the euro, appreciating 12% over the first six months of 2010. Resources were worst hit over the quarter, with platinum and diversified miners off 11% and 18.2% respectively. The gold sector was the best performer over the quarter, rising 16.5%. Other defensive sectors also performed admirably: food and drug retailers ended 11.9% higher and fixed line telecommunications surged 10.5%. Industrials lost 7% with general retailers (4.1%) outperforming the local banking sector (-9.9%) by a wide margin. Bonds, cash and listed property provided positive returns over the quarter. Cash returned 1.7%, bonds 1.1% and listed property rose 0.6%. Year to date, listed property remains the best performing asset class (10.6%).

Portfolio review
The portfolio generated a satisfactory positive return in the second quarter. The result was very pleasing in the context of a domestic equity market that declined sharply over the review period. Our cautious stance and early positioning contributed strongly to the performance.

Portfolio activity
The portfolio's equity weighting remains above average on a gross basis, but we have steadily reduced the net domestic equity weighting through a combination of selling and selective hedging. We now have a higher weighting in global equities and within domestic equities we have a more defensive stance. In our view, market participants have bid up the prices of certain interest-rate sensitive stocks (credit retailers and banks) to relatively optimistic levels. Our fundamental view on domestic banks remains unchanged, but we continued to reduce the portfolio weighting during the quarter. We used the proceeds to increase our exposure to recent laggards and select resource stocks. The portfolio's cash holdings remain high and position us to take advantage of future opportunities.

Portfolio positioning
We remain very comfortable with a dramatically reduced exposure to risk assets. Our underlying domestic and global equity holdings have a quality and defensive bias. We remain concerned about the fragility of the global economic recovery and still have doubts regarding the level of earnings that can realistically be sustained. Market participants remain eager to resume the recent momentum in risk assets (commodities and emerging markets) and higher-yielding currencies. We remain very sceptical and believe that a reversal of this well-established trend is inevitable and represents a latent risk. In contrast to early 2009, we are less optimistic about the prospective returns for equities and we anticipate that returns will be lower than in 2009. If our expectations prove to be wrong, the equity market will have to be engulfed in a bout of speculative euphoria or the economy will have to grow at double its current run rate (or both). Neither of these outcomes, whether in isolation or in combination, strikes us as being very probable at this juncture. Aggregate valuations are no longer cheap and the current absolute level has historically set the scene for uninspiring prospective returns for equities. The recent correction has been insufficient to change our fundamental view and outlook. Less favourable valuations and more than adequately discounted long-term fundamentals have led us to maintain our level of caution. As a consequence, we remain defensively positioned with significant hedges and a high cash position.

Market review
2009 marked the end of the recession and provided asset markets with ample opportunity to retrace some of the losses sustained in the wake of the worst global financial and economic crises in decades. Along with commodities and the corporate credit markets, emerging economies were the prime beneficiaries of improving global growth prospects, the strong recovery in risk appetite, the weak US dollar and low borrowing costs across the developed markets. Emerging market equities rose 8.6% over the last quarter and 79% in 2009, well ahead of developed markets. The MSCI World Index returned 4.2% over the quarter to push the year's gains to 30.8%. All returns are quoted in US dollars. In sync with other commodity currencies, the rand regained its composure in 2009. Record capital inflows and higher commodity prices fuelled a 28.7% gain against the US dollar. 2009 was not a good year for bond markets, reversing some of their gains of the previous year. Bond prices fell in 2009 as economies recovered and the cost of massive fiscal and monetary stimulus started to hit home. The increase in bond issuance over the next few years and large fiscal deficits will keep the pressure on bond markets. Offsetting this over the near term, will be the improved domestic inflation outlook and expectations of growth below the historical average. The All Bond Index lost 1% over the year, but marginally outperformed cash over the second half of 2009, gaining 4.1%. In the fourth quarter, the All Bond Index returned 1.1%, underperforming cash. The listed property sector showed some resilience in a very difficult trading environment, gaining 4% in the last quarter to finish the year 14.1% higher. Improved growth prospects and a higher risk appetite supported domestic equities. The All Share Index (ALSI) ended December on the year's high, returning 2.9% over the month and 11.4% over the quarter. Strong foreign investor interest to the tune of over R75 billion in net equity inflows boosted the market's rating and pushed the year's returns to 32.1%, erasing all of 2008's losses. Over the quarter, the basic materials (17%) and consumer goods (18.7%) sectors recorded similar returns, beating the ALSI. There was a large divergence in the sub-sector performances in the final quarter. The gold sector struggled (-1.2%), but platinum (17.7%) and general miners (23.1%) outperformed. In the consumer goods sector, SABMiller and Steinhoff stood out as strong performers. Food producers (8%), general retailers (3.3%), banks (7.2%) and the life assurance sector (9.7%) all posted positive returns over the quarter, albeit below the overall market. The construction and telecommunications sectors, down 8.2% and 3.2% respectively, continued their underperformance during the year.

Portfolio review
The portfolio generated a satisfactory absolute return in the final quarter of 2009. Market conditions in the fourth quarter were not ideal for the way the fund is positioned. In particular, the strongly rising domestic equity market (led by stocks we do not hold) and the firmer rand represented significant headwinds. Contributors included the solid absolute performance of our offshore equity holdings and a welltimed increase in our domestic bond weighting.

Portfolio activity
Our equity weighting remains above average on a gross basis, but we are steadily reducing the net domestic equity weighting through a combination of selling and selective hedging. We now have a higher weighting in global equities and within domestic equities, we have a more defensive stance. We increased the domestic bond weighting significantly in response to higher yields and market weakness. Over the quarter, we sold our positions in Old Mutual Plc, SABMiller and Bidvest in their entirety. The fund's cash holding remains high and positions us to take advantage of opportunities.

Portfolio positioning
We have dramatically reduced our exposure to risk assets in recent months. Our underlying domestic and global equity holdings have a quality and defensive bias. We concur with the market's anticipation of a global economic recovery. We do however have our doubts about the shape of the recovery and the level of earnings that can realistically be sustained. In contrast to a year ago, we are less optimistic about the prospective returns for equities and we anticipate that returns will be lower than in 2009. If our expectations prove to be wrong, the equity market will have to be engulfed in a bout of speculative euphoria or the economy will have to grow at double its current run rate (or both). Neither of these outcomes, whether in isolation or in combination, strikes us as being very probable at this juncture. Aggregate valuations are no longer cheap and market leadership has narrowed significantly. Both these conditions have historically set the scene for uninspiring prospective returns for equities. In the fourth quarter the market was characterised by extraordinary narrow leadership, giving a false impression of underlying market strength. Five stocks led the market higher in the quarter. Their cumulative weighting in the ALSI (close to 40%), masked the lacklustre performance of the remaining constituents of the market. The five stocks (dubbed the "famous five") are Anglo American, BHP Billiton, Naspers, Richemont and SABMiller. Their collective performance has been phenomenal, especially considering their lofty starting valuations at the end of the third quarter of 2009. The US dollar 'carry trade' has resulted in a flood of liquidity into commodities, emerging markets and higher yielding currencies. The reversal of this well-established trend is inevitable and represents a latent risk. We have positioned our portfolio accordingly. Less favourable valuations, below average volumes and strong upward price momentum (in a very narrow group of stocks) have therefore increased our level of caution. Our highest level of conviction is fully expressed in our avoidance of the current momentum. Valuations no longer compensate us for accepting risk. We do not enjoy being ultra bearish, but there are many issues that are of concern to us:
· There have been emerging market equity inflows at record highs.
· Global long-bond yields are under upward pressure - when will the exit strategy by central banks begin?
· China - is it an economic miracle or a bubble? The Chinese banking system is opaque. Bank lending exploded in 2009 and the quality of lending remains highly debatable.
· The US faces a potential second wave of credit problems as a consequence of increased foreclosures and continued lack of credit availability.
In summary, we are defensively positioned with significant hedges and a high cash position. It is becoming increasingly obvious that our positioning is once again out of step with the prevailing market trends. Risk premiums have reduced to the point where the downside is once again being underestimated or ignored - this does not bode well for future returns.