The combined effect of the massive stimulus dished out by monetary and fiscal authorities around the world seems to have had the desired effect on the global economy and financial markets. The worst of the great recession has passed. What was at first called the 'green shoots' of economic recovery became more widespread during the third quarter of 2009 and a number of the largest industrial nations reported a return to positive growth. The improved economic news led to a rapid return of confidence and investors found renewed risk appetite. Global stock markets rose strongly for the second quarter in a row.

South Africa lagged the global economy going into the recession and is also lagging it in the recovery. But, buoyed by better global news, the JSE participated merrily in the widespread stock market recovery. The All Share Index climbed by 13.9%, taking the year-to-date performance to 18.6% - a number that few would have thought possible in the midst of the doom and gloom which prevailed in the first few months of the year. One of the main drivers of stock prices was the return of foreign investment into SA equities which totalled R24.8 billion during the quarter. These inflows pushed share prices higher and clearly supported the rand.

Following a very weak first half of the year, the bond market also recovered with the help of another interest rate cut by the Reserve Bank and the improved inflation outlook brought about by the stronger rand. With the steepening yield curve we have reduced our cash holdings and increased exposure to bonds.

From an asset allocation point of view, the exposure to growth assets (equity and property) was kept well within our maximum limit. The rand remains one of the most volatile currencies in the world and as we try to manage the fund's volatility we have less than the allowed maximum exposure to offshore assets.

The fund enjoyed a good quarter. The return of 5.5% was comfortably ahead of cash (1.8%). Year to date, the fund's return is 10.2% versus the 6.8% on cash, while over the past year the fund's return of 11.2% again trumps that of cash (9.9%), but shy of the cash plus 3% target.

Looking forward, the low interest rate environment is likely to remain in place for some time. Interest income from cash is therefore going to be lower than over the past number of years and we will have to seek higher income from areas such as property, preference shares, corporate bonds and inflation-linked bonds. Within equities we continue to favour the more predictable good cash generating business over the cyclical ones.


Portfolio managers
Charles de Kock and Mark le Roux

Although the global economy remains in a deep recession, the forward-looking financial markets have latched on to the 'green shoots' of economic recovery and staged a strong revival. During the quarter, developed world equities, as represented by the MSCI World Index, gained 21.0% (in US dollar terms), while emerging markets - relishing in the return of risk appetite - gained a whopping 34.8%.

Foreign inflows caused surprising rand strength and limited the rand returns to only 8.6% for the FTSE/JSE All Share Index (ALSI). In dollar terms, the index, however, performed more or less in line with the emerging markets average.

Global bond markets also responded to the 'green shoots' of recovery and longer-dated yields kicked higher, resulting in steepening yield curves around the world. The bellweather US 10-year bond yield rose from 2.7% at the start of the quarter to almost 4% before pulling back to 3.5% at quarterend. South African bonds followed the global trend higher, although not to the same extent. Rising yields result in capital losses and over the period the All Bond Index returned a paltry 0.3% - significantly less than equities and cash.

In the interest-bearing space, we have held mostly cash and inflation-linked bonds. The latter was bought at very attractive yields and in our view offered much better value than conventional bonds. The fund did not hold any conventional longer-dated bonds at all and the rise in yields therefore had no detrimental effect on the portfolio.

The preference shares we bought over the past year contributed positively to the overall return of the fund for the quarter as well as over one year. The South African Reserve Bank has come close to the end of the cutting cycle, and the dividend distributions from preference shares are now lower as these are linked to the prime interest rate. Where many ordinary shares have cut dividends in the current tough economic climate, the preference shares have continued its prime-linked payouts. Preference shares are currently yielding between 8.5% and 10.5%, depending on the quality of the issuer. These yields still compare very favourably to what is available in the money market.

From an asset allocation point of view the fund has benefitted from the upturn in equities as we added to our equity exposure at the very low prices in the first quarter. We managed to produce a return of 3.86% for the recent threemonth period, beating the target (cash plus three percent) of 2.90%. Over the past year, the fund's return of 8.32% is still behind target, but within the low equity universe of funds it remains one of the very top performers.

Looking forward, the world remains in a very uncertain space. The tremendous stimulus provided by the fiscal and monetary authorities is likely to have a positive effect eventually, but over the short term the markets may have run ahead too quickly in anticipation of a recovery.

In this fund we continue be cautious and limit the fund's exposure to 'risk' assets (equity and property) to a maximum of 40% of the entire portfolio. Conservative asset allocation combined with careful selection of the equities suitable for a defensive fund has since inception proven to be a sound approach. Even in these very difficult times returns have remained positive over all rolling 12-month periods.

Portfolio managers
Charles de Kock and Mark le Roux

The global economy is in the midst of its sharpest economic slowdown since the days of the Great Depression. The slowdown has reached every corner of the world and South Africa is no exception.

Unnerved by the depressing economic news, most investors reigned in the risks in their overall portfolios. Consequently, global stock markets performed extremely poorly as investors headed for the safety of cash.

Policy makers around the world have, however, not just watched the global economy unravel but have taken massive steps to try and resuscitate their economies with a host of measures. Interest rates have been cut aggressively in almost every country in the world, while fiscal policy has become counter cyclical too.

South Africa is no exception to this approach. As the domestic economy cannot escape the global downturn, the Reserve Bank has responded by cutting interest rates by 200 basis points so far this year, while the budget, tabled in parliament in February, is appropriately stimulatory.

It is our view that the combined effect of all the stimulus measures will eventually work and that some economic recovery is likely.

More important to us than the unpredictable economic outlook, however, is the fact that many stocks have been sold down so aggressively that it offers excellent value. As a consequence, we have used the period of weak share prices to add to equities.

This fund is by design a very conservative product and our self-imposed maximum exposure to equities is only 40%. At the end of March the fund had an exposure of 30% to equities, of which 25% is in the domestic market and 5% international.

In addition to the 30% in equities, we also have 8% in preference shares and 3% in listed property.

As policy makers have focused entirely on stimulating economic growth, we are concerned about the longer-term implications for inflation. In an environment of very low interest rates and unprecedented issuance of new bonds to finance the huge government deficits, we find bonds an unattractive area of investment. The one area of the bond market where we do find value is in inflation-linked stocks. We have invested 5% of the portfolio in corporate inflationlinked stocks at real yields between 5.5% and 6%. We have also invested 2% in a US inflation-linked bond at a very favourable yield. These will provide protection against high inflation going forward.

We are likely to buy more of these inflation-linked bonds if the opportunity arises over the next quarter.

Despite the deep negative returns on stocks, we have managed to eke out a small positive return of 0.6% in the past quarter. Although the return of 4.2% over the past year is still materially behind our benchmark, our fund is one of the best performers in its category.

The year 2008 was traumatic, with the global financial crisis far exceeding our worst expectations. Although one can only have certainty with the passing of time, it appears as though the low point for equities was reached in November. Since then, global markets, including the JSE, have recovered some of the lost ground.

As investors became gripped by fear, risk aversion was the overwhelming driving force in financial markets. The flight from risk assets to perceived safety has been extreme, resulting in equities falling to very attractive valuations, while bond yields around the world benefited from the rush to safety as well as the co-ordinated low interest rate policies being adopted by all the major global economies. The yield on US 10-year bonds fell to close to 2%, while in South Africa the yields on long dated government bonds have declined to around 7%. We find these yields totally unattractive and hold none of these assets.

Instead of holding any of these unattractive conventional bonds, we bought SA government dollar-denominated bonds at an average yield of 9.5%. The other new purchase in the portfolio is a US inflation-linked government bond maturing in 2013. This bond was bought at an attractive real yield of 3.73%. We expect to make some capital gains from a decrease in this real yield over time. The fund's combined exposure to these two instruments is 7.6%.

The fund also added to its holding of preference shares in late October, following a sharp sell-off of these assets. Our total exposure to preference shares is 8.5%. We find the tax-free yield on these instruments very attractive and an appropriate holding for a defensive portfolio.

Despite the market turmoil, we have managed to generate a positive return of 0.93% for the quarter and 6.56% for the past 12 months. Although still behind our target of cash plus 3%, we are pleased at having achieved a positive return for our unit holders over this crisis period.

Looking forward we are of the view that the unprecedented stimulatory actions by the major economic powers of the world will eventually work and prevent a 1930s style depression. Accordingly, we will look to add more risk assets to the portfolio but will stay true to our conservative mandate and try our utmost to limit the volatility of the returns.

Charles de Kock and Mark le Roux
Portfolio Managers