Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%.

Amid the turmoil, global equity markets ended the quarter well in positive territory to reach record highs, bouncing off their intra quarter (August) lows. The MSCI World Index gained 2.5% in US dollar terms over the quarter. The MSCI Emerging Market Index extended its positive performance (up 14.5% in US dollars) over the quarter, mainly on the back of a very strong performance out of Asia (up 19%).

Domestically, we witnessed a modest slowdown in growth and evidence of somewhat weaker consumer spending, particularly evident in the motor vehicle retail sector. Rising inflation, mostly on the back of sharply higher food prices, and a pick-up in inflation expectations were met by a further interest rate hike in August.

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief.

Equities recovered strongly from their August lows, gaining 6.7% over the quarter. The local market was led higher by resources (up 13.5%) and industrials (up 3.3%). Financials, which were caught up in global credit concerns were down 1.6% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The strong upward trend in inflation as measured by the CPIX is showing few signs of abating. Tight capacity and continued demand for a wide range of goods and services in the local economy are heightening these pressures. Over the year to September the Investec Absolute Balanced Fund earned a return of 10.4%, more than 4% above CPIX. The third quarter was shaping up to be a tough one for market exposure, given market volatility in August. However, action by the Federal Reserve has prevented a sustained market downturn, for now. Over the quarter the fund returned 2.1%.

Portfolio activity
The overweight position in Billiton relative to Anglos helped performance tremendously. It provided a small element of "market" exposure, but also exposure to the strongly performing bulk commodities of iron ore and coal. Impala, Sasol and SABMiller also contributed to the fund's performance. Banks' performance (and in fact all financials) lagged the market considerably over the quarter. However, single digit forward market multiples and overweight positions in Standard Bank and RMB Holdings allow for strong future performance from these levels.

Portfolio positioning and market outlook
The tug of war between a housing related US slowdown and relief from lower short-term interest rates provides for a mixed market outlook. If equity markets run too strongly on the basis of the interest rate action and the earnings outlook deteriorates, stocks could become vulnerable to a further downward correction.

We continue to believe that US consumer spending, which makes up 20% of global Gross Domestic Product (GDP), has downside risk. Consumers' contribution from the BRIC countries (Brazil, Russia, India and China) amounts to 15%.

It would be an unusual event for a sharp US slowdown to leave global equity markets relatively unscathed. The net equity weighting has been kept at 10%, with cash continuing to offer very competitive real returns to equities.

Market review
Global economic data over the quarter has remained firm. Estimates of second quarter US GDP range between 3% and 4%, largely on the back of strong industrial output. The recent resurgence of the US economy coupled with steady growth in Europe and Japan bodes well for the growth outlook for the second half of the year.

Against a backdrop of steady global expansion and some inflationary concerns, monetary policy risk remains to the upside. Global bond markets sold off aggressively during the quarter, reflecting rising demand for capital and higher real yields. The European Central Bank's tightening bias pushed the euro to reach a series of record highs against the yen while at the same time climbing to two year highs against the US dollar. The rand strengthened against major currencies over the quarter, in line with both commodity and emerging market currencies. Commodities remain generally well supported. The two main drivers of global inflation, oil and food continue to push higher. Metal prices were moderately weaker but remain well supported by supply constraints and robust growth.

The domestic inflation outlook has deteriorated over the quarter. Rising yields globally and domestic inflation concerns resulted in the local government debt curve increasing sharply. Over the quarter the benchmark R153 and R157 peaked at 9.15% and 8.58% respectively. The All Bond Index lost 1.7% over the three months ended June. We expect CPIX inflation to remain firmly above the targeted inflation band until year end. This is likely to force the South African Reserve Bank (SARB) to tighten rates further. However, early signs of some moderation of consumption led growth, coupled with a potentially negative impact of the recently implemented National Credit Act are likely to moderate the SARB's stance on the extent of further tightening. Rising bond yields and deteriorating inflation expectations put pressure on domestic listed property. The sector was up marginally over the quarter (0.3%) but remains firmly in the black year to date at 16.1%.

After a strong first quarter, domestic equity market returns moderated slightly over the past three months. The FTSE/JSE Index gained 4.3% since the end of March. The market was driven higher by general mining (up 12.5%), oil and gas (up 9.9%), construction (up 9.9%) and life insurance (up 6.9%). Interest rate sensitive counters, in particular banks were down 6.9% and retailers lost 6.7%. This reminded investors of a similar occurrence last year, when diminishing global risk appetite coupled with higher domestic borrowing costs, caused a massive sell-off in domestic oriented sectors.

We remain positive, yet cautious, on our equity outlook over the next few quarters. Increasing volatility and fluctuations in sentiment should not deflect from a global and domestic backdrop that remains supportive of continued earnings growth and above average equity ratings.

Fund performance
The steady performance of the Investec Absolute Balanced Fund continued with the fund beating cash returns over the six months ended June. Fund volatility continues to be exceptionally low, around 2% per annum, with the returns now exceeding 9% on a twelve-month basis. Particularly pleasing was the positive performance for the month of June, where the overall market was negative. Over the quarter the fund returned 2%.

Portfolio activity
The fund has switched the entire holding in Lonmin into Impala Platinum, taking profits on a position that has yielded good returns. We closed out the underweight position in Billiton, preferring the stock relative to Anglos, on a growth and valuation basis, and now hold a positive position. Although these stocks carry large index weights, the net exposures on a fund basis are small.

One of the largest positions in the fund is Distell, which owns and sells the second biggest cream liqueur globally. The organic growth in the business for the next few years is impressive. It is 30% owned by SAB and yet trades at a 25% discount on a rating basis. Overall, risks remain tightly controlled, and we continue to anticipate steady returns, even if more volatile times unfold in the next six months.

Market outlook
Cash returns continue to look attractive at levels close to 10%. Our expectation would be to deliver outperformance over this level given judicious stock selection.

Market review
The JSE saw heightened volatility in March. Local equities declined very sharply but as global risk aversion eased, stocks bounced back strongly. By month end the JSE had broken convincingly through its earlier February highs. The FTSE/JSE All Share Index returned 6.4% in March. This rally raised the first quarter return to 10.4% and the 12 month return to 37.6%. Resource stocks returned 11.1% on the month, massively outperforming the Financial and Industrial Index, which came in with a pedestrian 3%. For the quarter, resources were up 15.2%, financials 6.5% and industrials 5.6%. The bond market had a difficult month, losing 0.4%, which trimmed the quarterly return to a meagre 1.6%. Cash (as measured by the STeFi index) earned a return of 2.1% over the quarter, outperforming bonds. In the run up to the national budget, bonds priced in so much good news that they became vulnerable to any signs that the rate cycle might not have reached its peak. Credit and trade data suggested that the imbalances in the SA economy might be unusually tenacious. This was enough to convince investors that the monetary authorities might have to keep their finger on the interest rate trigger for a while longer. The rand weakened by 4.1% against the US dollar and 4.6% against the euro over the quarter.

Fund performance & portfolio activity
The first quarter generated respectable returns for the Investec Absolute Balanced Fund, given its low risk orientation. The fund returned 2.7% over this period. We have added some resource exposure to the fund, by increasing the Sappi weighting and also introducing African Rainbow Minerals (ARI) to the fund. We continue to be neutral on a sector basis. Our view is that Sappi's earnings recovery will be boosted by the change in coated fine paper prices, thanks to anti-dumping measures introduced by the US. The poor share price performance seen over the past seven years could very well be at its end. ARI has a diversified commodity exposure to platinum, coal, nickel, ferrous metals and gold. The share is undervalued in respect of its growing position in these commodities as the projects ramp up to full production. We trimmed positions in Kagiso Media and Reunert, which have performed very well, to fund these purchases.

Market outlook
We continue to expect more volatility in the markets into 2007, with extremely high risk appetites exhibited across the world. This is reflected in high asset valuations across commodities, debt instruments, currencies and emerging equity markets. Investing in Zimbabwe, an obvious candidate of poor human rights, is now declared sexy by prospective investors. History has shown that such greed cannot and will not last indefinitely. We continue to invest with these risks in mind. The chart below depicts record high commodity prices and equity markets with extremely low volatility. These conditions have led to a rampant appetite for risk.

2006 was the toughest year in the fund's three year history. Many people will be wondering why this was, particularly as the returns were achieved with the backdrop of another good year for the equity market, and this bears some explanation:
I. The fund had very little equity net exposure to capture the underlying market trend
II. Some stock picks did not perform for the first 9 months of the year.
III.Realised returns on equity cash, derived from the sale of index equity futures, were below that of equivalent cash returns

To address each of these factors listed above, with regard to the first, we were a bit early in expressing caution on the level of the equity market, but we have subsequently allowed an increase in the net equity weighting to 10%, concentrated in shares that do not bear full global equity market risk.

Relating to the second factor regarding stock picks, we have seen in the last two months of the year many of the stock picks perform far better, with positive weightings in Naspers, Remgro and Stanbic adding quite strongly, where the negative bets on Liberty Intl and Anglo also contributing. It is worthwhile remembering that underperformance of these stocks to the ALSI 40, generates positive returns.

We cannot do much about the derivative pricing, but the underlying rising trend in short term interest rates is very encouraging and will directly benefit the fund.

2007 will probably prove a tougher environment for the underlying market trend relative to the conditions in 2006 for five key reasons:
I. The US economy is visibly softening and the demand for many commodities is waning. We have seen negative trends developing in oil and copper, two key commodities that have wide industrial and consumer usage.
II. Interest rates are continuing to rise internationally, and also in SA, which typically leads to a more muted and volatile return response from equities.
III. The overall SA equity market valuation (current Price-to-earnings ratio of 17.1x) is consistent only with high single digit returns per annum for the next couple of years, or a real return of 3-4%.
IV. Earnings momentum will be more subdued as the market digests above normal profitability and more difficult macro conditions.
V. A high degree of complacency exists amongst investors with risk appetite very high.