Emerging Markets staged a strong recovery in the third quarter, with the Morgan Stanley Emerging Markets Index up by 13% off the bottom. We believe that the sell-off was a good thing: appetite for risk has corrected as investors have been reminded that Emerging Markets are not a one-way bet. We continue to believe that Developed Markets offer more value than Emerging Markets, particularly on a risk-adjusted basis.
Growth is slowing in the US, with the consumer now visibly retrenching. This should, however, be offset by stronger performances from Europe and Japan and is a necessary development in the global rebalancing process. Inflation remains the wildcard and needs to be closely watched. While the global economy can comfortably manage a period of lower growth, a sustained increase in inflation would undermine the significant progress made over the last few years.
The domestic economy continued to perform well. We expect at least one more rate hike this year, and believe that the impact of recent moves will only really be evident early in 2007. Higher rates are not necessarily bad. Credit extension has been very high and the emerging middle class consumer has not yet had to deal with the other half of the credit cycle. The last 2 rate cuts were probably not needed and, in our view, growth actually needs to moderate somewhat. The weakness in the rand will help restore balance to the economy and give Industrial SA an opportunity to compete.
Developed Market Equities remain our preferred asset class. Earnings are high in the local market and with good value in Europe and Japan the argument to diversify remains compelling (albeit less so than was the case before the rand weakened). In the domestic market, local equities remain our preferred asset class. Although earnings are high, ratings are attractive and we believe that the economy will comfortably absorb higher rates - as it did in the last tightening cycle. Bonds have consolidated after the recent sell-off, delivering a return of 2% for the quarter. We consider current yields to be close to fair value. Property stocks rallied strongly in the quarter after the dramatic sell-off in the previous quarter. We acquired property stocks in the sell-off for the first time in many years and believe that they currently offer investors reasonable value. Yields are quite stretched, but distribution growth should be strong over the next few years.
Looking at the underlying sectors, Resources lagged the market for the first time this year returning 1%, as against 12% from Industrials and 10% from Financials. The commodity cycle is showing increasing signs of maturity. While the underlying markets remain tight, concerns over slowing global growth have led a decline in commodity prices across the board. We expect commodity prices to decline materially once supply reacts to current high prices. In the quarter we switched Anglo American into BHP Billiton. Anglo has been pushed on speculation of a take-out, which we consider unlikely, and offers a lot less value than BHP Billiton (20 times normal earnings as opposed to 16). We continue to find good value in Sasol, Impala and, increasingly, in BHP Billiton.
Within Industrials we reduced our weightings in the more defensive counters: Remgro, SAB and Tiger Brands in order to buy the more attractively priced interest rate sensitive stocks. While the outlook for a retailer like Edcon has undoubtedly softened, on an 8 p:e forward and a 7% dividend yield it is priced for a 30% decline in earnings. We consider this outcome to be very unlikely.
Within Financials we increased our weightings in banks, which continue to trade at very attractive ratings and have proven the robustness of their business models in previous cycles. They are less attractively priced than retailers, but their income statements are less geared and therefore come with less risk.

Louis Stassen and Karl Leinberger
Portfolio Managers

The Coronation Balanced Fund generated a return of 1.1% for the quarter. For the 12 months to 30 June 2006 the fund returned 33.7%, underperforming the benchmark return of 36.4%. However, over a rolling 3 year period, the fund strongly outperformed the benchmark with a return of 33.0%, as against 30.8%.
Emerging Markets experienced a sell-off in May when the Fed responded to data releases showing an up-tick in inflation with hawkish commentary indicating that interest rates would be increased further. This precipitated a global re-pricing of risk, with the Morgan Stanley Emerging Market Index declining by 17% from its high and the Morgan Stanley Commodity Index by 20%. In our view, these developments are not necessarily unhealthy. Excess liquidity is being taken out of the system and global risk appetite is returning to more normal levels. This should assist in 'reigning in' global imbalances and strengthening the foundations of the improved economic performance we are currently seeing from previous laggards Europe and Japan. In this uncertain environment, two things that do require careful attention are 1) how the US housing market responds to higher interest rates and 2) whether inflation increases materially from current low levels or not. Low inflation, despite strong economic growth, has been at the heart of the 'goldilocks' economy because it has smoothed out the cycle and allowed central bankers to keep interest rates low. Financial assets have appreciated strongly in this environment and any breakdown in the cycle would be negative.
In the local market, the rand declined to levels we consider to be much closer to fair value. We have long warned that the rand was overvalued and that investors had a unique opportunity to diversify their assets. The decline in the rand should be positive because it will help restore some balance to the economy by making general industry (producers) more competitive. We hold significant positions in local manufacturers and exporters that will benefit from a weaker rand. Holdings in stocks such as AECI, Delta and Oceana will demonstrate their leverage to a weaker rand over time. Higher interest rates will also force some restraint on the consumer. This would not be a bad thing. The risk lies in a heavy-handed response from the Reserve Bank, although we expect a more modest response (with the lessons from the interest rate response in 1998 still fresh in the minds of all concerned).
Local equities remain our preferred asset class in the domestic universe. Bonds and Property, priced for perfection only a few months ago, have sold off materially and we have increased our weightings in both asset classes.
Looking at the underlying sectors, Resources returned 21% in the quarter - a significantly better performance than Financials and Industrials which both returned a negative 5%. Commodities sold off less than we expected and rand weakness then supported the sector. We continue to hold big positions in Impala and Sasol, both of which contributed to performance in the quarter. We expect the inevitable supply response to high commodity prices to be more muted in platinum and oil and believe that the rand gearing in these companies will be positive when the commodity cycle eventually turns. We have increased our position in Mittal, which offers good upside despite our conservative assumptions on long term steel prices. Mittal is also one of the less obvious beneficiaries of the government's GDFI programme, with sales in the local market netting $100 a ton more than exports.
Industrials performed poorly over the period. AECI, Netcare and Omnia contributed to performance while Woolworths, Edcon and ABSA detracted. The local sell-off was fairly indiscriminate, with our holdings in defensive counters like Tiger Brands and Woolworths declining almost as much as the more interest rate sensitive cyclical counters. We used the weakness to increase our holdings in MTN, Woolworths and Mr Price at attractive prices. Financials also performed poorly. We increased our holdings in FirstRand and ABSA, despite the deterioration in the outlook for interest rates. Banks have shown their resilience through the cycle over long periods of time and we consider them to be more defensive than the credit retailers. We continue to build on our positions in Liberty and Discovery, two companies that have not been given due recognition by the market for their good long-term growth prospects.
Bonds and Property had a negative quarter returning minus 4% and minus 14% respectively. The sell-off in these assets is of some comfort to us, given our conviction that they were overvalued. We used the sell-off to buy property stocks for the first time in a long time and increase both our weighting and duration in bonds.

Louis Stassen & Karl Leinberger
Portfolio Managers

The Coronation Balanced Plus Fund generated a return of 9.32% for the first quarter of 2006. Over the 12-month period to 31 March 2006 the fund, with a return of 42.44%, has convincingly outperformed its benchmark return of 40.07%.

The bull market continued unabated with the All Share Index returning 13%, and 57% for the rolling 12 months. The past three years have generated an extraordinary amount of wealth for ordinary South Africans as asset prices have re-priced for the lower level of interest rates. Our experience closely mirrors that of other countries which have moved from high to low inflation environments and enjoyed a commensurate decrease in interest rates.

Over three years property unit trusts have returned 44% per annum, the All Share Index 43% per annum, the average house 24% per annum (ABSA House Price index) and the bond market 14% per annum. Adjusting for inflation of 4% per annum, real returns have been nothing short of exceptional - making this the third largest equity bull market in our history. Only the bull markets of the late 1960s and the 1970s eclipse the returns achieved thus far. However, these returns have been well earned; the base was low, with investors having endured poor returns for the three preceding years and growth has been strong as the economy has benefited from a cyclical upturn, underpinned by some very real structural changes in the economy.

Within the fund, we have invested close to the maximum weighting offshore. In our opinion, the rand is overvalued at current levels and, while it will remain strong for as long as commodity prices remain high and emerging market sentiment remains positive, it should in time depreciate. The opportunity afforded by rand strength to diversify one's holdings is even more compelling when one considers the outperformance of emerging market equities to developed markets. Stocks in emerging markets no longer trade at material discounts to their peers in the developed markets.

Local equities remain our preferred asset class in domestic mandates. Bonds and property have been fully re-priced for the current low inflation, low interest rate environment. However, this is not quite yet the case for equities. Although we are concerned at the extent to which foreign holdings of South African shares has increased, we remain confident that there are sufficient stock-picking opportunities to enable us to continue to deliver good returns to clients over the medium term.

Looking more closely at the underlying sectors, Resources performed in line with the broader market, returning 13% for the quarter. Impala performed strongly once again while Sasol detracted from overall performance. Platinum is a market with very strong fundamentals. In the commodities market a rising tide is lifting all boats and we believe that, in time, supply will respond to high prices and that prices will decline. In the case of platinum, an undisciplined supply response is unlikely and demand will continue to grow with legislated demand for autocatalysts. Impala is a quality company with a shareholderfriendly management team that trades on an undemanding rating. Sasol is a world class company that has taken a knock with the windfall tax announcement in the 2006 budget.

South Africa has gone to tremendous lengths to create an investor-friendly climate and this gives us confidence that we will ultimately see a rational outcome. In the interim, we gain comfort from the fact that we use a conservative normal oil price of US$32 per barrel to value the company.

Industrials performed in line with the broader market, also returning 13% for the quarter. Lewis, New Clicks, Bidvest, Tiger Brands and Netcare were positive contributors while SABMiller and Pick 'n Pay detracted from performance. Looking specifically at Pick 'n Pay, if one adjusts for the loss-making Australian operations, then the core business trades at a significantly lower premium rating than it has for much of the last decade. While Woolworths, Spar and Shoprite are undoubtedly more formidable competitors than they were in the past, we believe that Pick 'n Pay is a business with real franchise value and an unrivalled track record that trades at an undemanding rating.

Financials also performed in line with the broader market, returning 14% for the period. Discovery Holdings has disappointed the market with the losses incurred in the US. The local business is high quality, enjoys significant barriers to entry and should continue to grow market share. Thus we believe that this disappointment presents the kind of buying opportunity rarely found in companies of this quality.

Bonds had a reasonable quarter, returning 1.5%, while inflation linkers once again outperformed with a return of 2.7%. The bond market has shrugged off rising yields in the US, Europe and Japan and is, in our view, priced for perfection. When compared to US yields, current yields imply either zero sovereign spread or significantly lower levels of inflation than what we believe will be achieved over the duration of South African bonds. With a very strong rand in the base and government having communicated its intention to pursue stimulatory macro policies, the risk of capital losses for investors is high. Louis Stassen & Karl Leinberger Portfolio Managers

The Coronation Balanced Plus Fund generated a return of 7.1% for the quarter which resulted in a strong return of 35.0% for the calendar year. This compares favourably with 31.6% from the benchmark and 27.1% from the peer group average.
The domestic equity market continued its march upwards in the fourth quarter, returning 8% for the quarter and 47% for the year. Resources outpaced the rest of the market with a return of 72% for the year, significantly ahead of the 35% returned by the Financial Index and 36% from Industrials.
Returns have been exceptional as the South African economy has benefited from finding itself in a real sweet spot. Commodity prices are at multi-decade highs and the domestic economy is booming as consumers benefit from low interest rates, high real wage increases and falling prices of imported goods. Confidence levels are high and the strong performance of the last few years will, in all likelihood, be sustained over the medium term as the government steps up its investment in infrastructure and companies react to growing demand by investing in increased capacity.
Until very recently, returns have come mostly from strong earnings growth. But in the latter part of the year shares started to re-rate, in some cases quite strongly. We take the view that the market is now more fairly priced, with the level of earnings highish and ratings now fairer. We do, however, remain of the view that equities are the most attractive asset class. Earnings growth is likely to remain strong over the medium term and it is our view that the ratings of bonds and property stocks are quite stretched.
Rand strength in the second half of the year reversed all the weakness we experienced in the first half. With the currency at current highs we continue to steadily increase our clients offshore cash weightings. This cash will be invested in international equities when we reduce our weighting in local equities.
Resources had another strong quarter, returning 7%. Resources have surprised this year after underperforming the market for three years. We have maintained our significant weightings in Impala and Sasol, but are light in the diversified mining houses. Commodity prices are significantly above what we would consider normal, or mid-cycle, levels to be. As in all previous cycles, there is every expectation that current conditions will last long into the future. While it is difficult to call the timing thereof, we are of the view that supply will respond to strong demand and that prices will decline. Oil and platinum, however, are two commodities where the supply response is likely to be more muted. This gives us some comfort in what appears to be top of the cycle conditions for resources companies.
Financials had a strong quarter, returning 12%. Banks performed well after market expectations of a rate hike were pushed out to late 2006. We have started taking profits in FirstRand, which has performed well, and investing the proceeds in Absa and Standard Bank. Standard Bank trades at less than 10 times its earnings a year out. We consider this to be undemanding for a company that has a track record second to none of achieving strong real earnings growth over very long periods of time. The insurers actually outperformed banks as sentiment improved after indications that the impasse with the Pension Fund Adjudicator would be resolved. We initiated positions in Discovery and Liberty in the quarter but were unable to build full positions before the news-flow improved and the shares re-rated.
Industrials lagged in the quarter, returning 6%. VenFin was a star performer, returning a massive 41%. For several years VenFin has been a core holding in our portfolios. The Vodafone take-out vindicated the long-term nature of our investment case. Vodacom is an asset of very high quality that the market was undervaluing because it was unlisted. In addition to this, VenFin's stake was of strategic value to both Telkom and Vodafone and was always going to attract a control premium when the time came for VenFin to sell.
Bonds had a good quarter, returning 5%. Yields declined as short-term inflation prospects improved and the Reserve Bank adopted a more dovish tone in its commentary. We are underweight bonds as we are of the view that they are priced for perfection. The short-term inflation outlook is good and risk appetite is high, as evidenced by the compression in emerging market spreads. The market is extrapolating current low levels of inflation over the entire term of our bonds and there is some risk that this will not be the case. The reasons are twofold. Firstly, the benefits of an appreciating currency and abnormally low food inflation are already in the base, and secondly the government has indicated that it will pursue more stimulatory, pro-growth macro policies in the future.

Louis Stassen & Karl Leinberger
Portfolio Managers