Equity markets advanced in the quarter with the MSCI World index returning 4.6% in Dollars. In local currencies, the S&P 500 returned 5.7% in the quarter, the MSCI Europe ex UK 7.8%; and the UK's All Share index 3.7%. The MSCI Emerging Markets Free Index returned 5.5% and the Japanese Topix index 2%. Smaller companies under-performed significantly with the HSBC index returning 1.3%, but out-performed in the UK and Asia.

The Dollar fell 1% against Sterling (although it recovered 1.8% in September). It rose 1.9% against the Euro in the quarter and gained 3.2% versus the yen. The yield on 10 year government bonds fell to 4.63% in the US, to 3.71% in Germany, to 4.52% in the UK and to 1.68% in Japan. The Citigroup Global Bond index returned 1.4% in Dollars in the quarter.

The Federal Reserve again left rates unchanged at 5.25% in September, but markets now discount at least 50 basis points of cuts next year. Evidence of a slowdown in the US economy is accumulating, including from the housing market, employment data, consumer surveys and retail spending. Estimates of growth for 2007 in the range 1.5% - 2% are becoming more common. The retreat in commodity prices has brought headline inflation down, but core rates are still edging up. Rates were increased to 3.25% in Europe shortly after the quarter end, were kept at 0.25% in Japan but were increased to 4¾% in August in the UK. Economic data continues to be firm outside the US.Oil prices fell below $60 per barrel and the gold price fell to $580 per ounce.

The Benchmark index returned 3.3% in the quarter while the fund returned 1.9%, and the average fund in the sector returned 2.9%. The global equity fund returned 4% while the global bond fund returned 0.7%, both below benchmark. Together, they accounted for 2.7% of the quarterly performance. Asset allocation contributed -0.8%, despite the over-weight position in equities and solid performance from other funds. This may be the result of anomalies in the timing of month-end pricing. The equity position was raised to about 5% over-weight relative to the benchmark, and has been raised further subsequently. Bond exposure was also raised but remains below benchmark, as a result of our preference for equities. Investors continue to expect the US slowdown to have a negative impact on corporate earnings, but evidence for this is scarce. Earnings estimates in the US are now fading, but still increasing elsewhere, and markets discount much worse. The valuation of equity markets is very cautious, with a price/earnings ratio of 15.8 for 2006 and 13.8 for 2007, incorporating the consensus expectation of 14.6% earnings growth this year and 9.9% next.

In contrast, bond yields have fallen faster than expected and are close to our targets. We are sceptical that a US slowdown will have a significant global impact, and regard the probability of even a US recession as low.

If corporate earnings continue to defy pessimistic expectations, it is only a matter of time before equities break higher. Autumn is seasonally the strongest quarter of the year, and the US market tends to perform well in the year prior to the Presidential election. On the basis of valuation in absolute terms and relative to bonds, of the outlook for earnings and of past patterns, we are therefore positive about the prospects for equities for the rest of this year and in 2007. With an overweight position in equities, this should benefit the performance of the fund. However, with global markets rising together and smaller companies underperforming, the opportunities to add value from satellite positions in equity markets is limited, and tight credit spreads means that there are few opportunities to add return in the bond market either.

The MSCI World index delivered a neutral term in US dollar terms (down 0.3%), with a strong April giving way to a sharp fall in May and a followthrough in June. In local currencies, the S&P 500 was up 2.7% in the quarter, the MSCI Europe, excluding the UK, down 3.7% and the UK's FTSE All Share index down 1.8%. The Japanese Topix index fell 8.1% and the MSCI Emerging Markets Free Index was down 2.9%. Smaller companies underperformed in the quarter. The dollar fell 6.6% against sterling, 5.7% against the yen and 3.2% against the euro in the quarter.

Bond markets were weak and bond yields rose across developed markets. The Citigroup Global Bond index produced a return of 3.2% in US dollars in the quarter. The Federal Reserve raised US rates to 5.25% and is expected to raise them again to 5.5% in August. Investors were expecting a peak at 5% a few months ago, but are now contemplating a move as high as 6%. Interest rates were raised to 2.75% in Europe, but kept at 4.5% in the UK and at zero in Japan. The Japanese authorities ended the policy of quantitative easing, which resulted in a very sharp drop in money supply. Oil prices remained around $70 per barrel, the gold price reached over $700 per ounce but then retreated back to $570 before recovering to just above $610 at the end of the quarter. Other metal prices also soared but then fell back.

Our exposure to equity markets was reduced to below neutral in early May, but raised first back to neutral and then to slightly over-weight in June. We expect to raise exposure further in the third quarter. Exposure to bonds has been increased, though we remained moderately underweight, and our duration position has been lengthened. Though we remain underweight that of the index, we recognise we are probably approaching reasonable buying levels as bond yields continue to rise. Holdings are likely to be increased further at the expense of cash when there is further evidence of the commitment of central banks to continue tightening policy and market expectations have shifted accordingly. The underlying global equity holdings performed well in April but had a difficult May and June due to the negative impact of market volatility on investment in services and an underweight in utility stocks. The global bond holdings performed in line with the index.

The message from the Federal Reserve is now clearly hawkish, and markets have responded by raising their forecast for interest rates above the likely peak of 5.5%. There are now clearer indications of a slow-down in US growth, but this needs to take its course if the persistent but, so far, mild uptrend in inflation is to be reversed. The best signal of when the Fed

has done enough will be given by a clear peak in bond yields. In Japan and Europe, there are some signs of growth faltering, but the best assumption is that these are incorrect and that growth is robust. The Asian central banks are raising rates as well as the European Central Bank, ad Japan may follow in the next few months. A recession in the US is very unlikely, and even if growth drops to zero, it is hard to see global growth falling below 2%. This means that commodity prices are likely to remain firm and the next down-leg in bond yields is likely to be limited. Corporate earnings are likely to slow, but remain positive. When the US economic slowdown becomes embedded, the Federal Reserve can be expected to stop raising rates, and both equity and bond markets should respond positively.

Equities had ceased to be good value relative to bonds, but the recent fall has re-established good absolute and relative value, assuming that bond yields are near a peak. We expect markets to consolidate over the summer, but to return to their up-trend later in the year.

The MSCI World index returning 2.2% in Dollar terms in March and 6.7% in the quarter, despite a dull February. In local currencies, the S&P 500 returned 1.2% (4.2% in the quarter), the MSCI Europe, excluding the UK, 3.1% (9.7%) and the UK's All Share index 3.8% (8.1%). The Japanese Topix index returned 4.6% (5.3%) and the MSCI Emerging Markets Free Index 1.4% (9.7%). Smaller companies out-performed in the month, except in the UK, and everywhere in the quarter.

The Dollar rose 1% against Sterling and 1.8% against the Yen but fell 1.5% against the Euro (down 1%, down 2.6% and flat in the quarter). Bond markets were weak with 10 year government bond yields rising to 4.78% in the US, to 3.78% in Europe, to 4.4% in the UK and to 1.69% in Japan. The Citigroup Global Bond index produced a return of -1.2% in Dollars in the month and -0.4% in the quarter.

The Federal Reserve raised US rates to 4.75% and is expected to raise them to 5%-5.25% in the current quarter. Rates were kept at 2½% in Europe, at 4.5% in the UK and at zero in Japan, but the Japanese authorities indicated a more restrictive monetary policy.

Oil prices rose above $65 per barrel, the gold price reached a new high at $590 per ounce in early April, and other commodity prices were also strong.

As a result, the Benchmark index returned 0.8% in the month and 3.9% in the quarter. The fund returned 2.1% and 6.3%, while the average fund in the sector returned 0.9% and 3.9% respectively. The global equity had a strong month and quarter, returning 3.9% and 10.6%. The global bond fund returned -1.0% and -0.6% respectively. These performances together accounted for 1.1%of the fund's out-performance in the month and 2.2% of it in the quarter, while asset allocation contributed 0.2% in each period. This was the result of the modestly over-weight position in equities, the under-weight position in bonds, and holdings in specialist funds.
Rising US interest rates have had little impact on US growth, but will probably be raised until they do. In Japan and Europe, growth is picking up sharply, and monetary policy is responding. For much of last year, falling bond yields cancelled out the effects of rising interest rates, but, more recently, they have moved in the same direction.

When the US economic slowdown becomes evident, the Federal Reserve can be expected to stop raising rates, and both equity and bond markets should respond positively.

The combination of firm equity markets and rising bond yields means that equities are no longer such good value relative to bonds, and this may result in a market consolidation. Earnings growth continues to be strong, and the modest reductions in forecasts for 2006 are more than counter-acted by the increases in those for 2007.

Exposure of the fund to equity markets remains at slightly above the benchmark index, while exposure to bonds remains low and there are significant holdings in cash. We are ready to raise bond holdings at the appropriate time, while our modestly overweight position in equities reflects our confidence in the continuation of the long-term uptrend, in the ability of the underlying funds to out-perform, and in specialist opportunities in the market: for example, Japan, gold and pharmaceuticals.