Over the month, economic data continued to disappoint consensus forecasts. Slowing activity was most visible in the US housing market, but there was also evidence that a de-stocking cycle has begun across the global manufacturing sector.

Markets continued to price in rate cuts in the US & Canada and fewer rate increases in other economies. This helped Treasuries and Canadian bond yields to rally. Other markets generally followed suit, but to a lesser extent. In Europe, shorter-dated bonds struggled to perform. This was also the case in the other Anglo Saxon markets; the UK; Australia & New Zealand where yields trade below cash rates and the risk of further interest rate rises remains.

We had increased bond exposure after the back up in yields in the first half of the year and this helped performance.

Currency markets were much less directional. The Dollar's failure to sell-off despite rising economic pessimism was notable as was a general preference for higher yielding currencies over lower yielders.

Looking ahead, the global economy has clearly entered a period of slower growth, but we believe that this is unlikely to be either particularly pronounced or prolonged. Certainly US housing is very weak, but we see 4 reasons why activity is more likely to recover next year than slow further. Firstly global monetary policy has been tightened, but from very easy levels and is not yet tight. Secondly, growth is no longer as reliant on the US as in previous cycles. Thirdly, consumers are still experiencing good job and income growth which will tend to support demand. Finally, the recent rally in bond yields and particularly oil prices will support consumption.

On balance, therefore we think that bond markets and especially short dated bonds have gone too far in re-pricing interest rate expectations. As a result we will look to cut bond exposure again on any fall in yields.

Yields rose and the US dollar fell in the first half of the quarter against the backdrop of a gradual tightening of global monetary conditions. However, in mid-May as the market began to fear that Ben Bernanke, the new Federal Reserve Chairman, would be forced to overtighten to maintain credibility. Against a backdrop of rising inflation expectations, some deterioration in actual reported inflation, and somewhat weaker growth numbers, the markets scrutinised Bernanke's every word to try and find some hint of where the Fed might stop raising short term interest rates. To some extent, Bernanke was guilty of making himself the focus of market interest by seeming to give contradictory guidance. In his testimony to Congress in May, he appeared confident that the economy would slow back to a trend growth level and thus gave the impression that the Fed was about to pause in its policy of raising interest rates by a quarter of a percent at every meeting. He then flatly denied that this had been his intention during a dinner-time conversation with a financial journalist. The uncertainty that this created led to a pick up in volatility and saw stock markets fall by over 5%. This financial market volatility carried over into early June as US inflation indicators continued to surprise on the upside. Yields on benchmark 10 year Treasuries ranged between 4.95% and 5.25% before ending broadly unchanged at around 5.15%.

While the US outlook is complicated by growing signs of a slowing in the rate of growth, the case for a significant hike in rates by the European Central Bank is looking clearer. Against this background, currency markets also traded in a volatile range. The dollar was initially undermined by the fact that a pause in US interest rates would attract fewer capital flows and that global growth leadership was transferring away from the USA to Europe and Japan. The dollar fell to almost 1.30 against the euro and 109 against the yen before Bernanke's more hawkish comments saw US interest rate expectations rise and thereby support the currency. Despite growing evidence of above-trend demand growth in the euro area, the ECB maintained a measured pace of tightening at its early June meeting where it lifted its benchmark repo rate by 0.25% to 2.75%. Nevertheless, the continued strength of business surveys has led to increasingly hawkish comments from a number of national Central Bank governors. In our view monetary tightening could accelerate from the current pattern of 0.25% per quarter to perhaps a move every two months. This scenario gained some support from the ECB's decision to break with its normal summer tradition of having a telephone conference in August and instead scheduling a full meeting with press conference. Emerging market currencies generally weakened, with some previously strongly performing markets such as

Brazil, Mexico and Turkey correcting sharply as speculative investors cut positions. At this stage in the global business cycle when spare capacity and labour is gradually being used up and inflationary risks exist, central bankers are likely to continue to raise interest until growth slows down. Given the tightening to date, the probability of a slowdown in the next 6 to 12 months is building, but there is little evidence to suggest that it has already begun. Bond yields should ultimately benefit from a policy-induced slowdown, but will continue to rise until it is imminent and will only rally substantially if growth slows enough to make easier monetary policy possible. For now we remain tactically negative on duration, but recognise that we are probably approaching reasonable buying levels. A softening of global activity is likely to be led by the US and rates should peak there first.

As such we are relatively constructive on US Treasuries, especially versus markets, such as Europe and Japan, where growth momentum and policy settings imply scope for significant further tightening. Sweden, within Europe, looks reasonably attractive given a fairly steep yield curve for the interest rate increases that we expect. The next move in the US is likely to involve a somewhat steeper curve, but not until monetary policy is more clearly on hold. We continue to expect an environment of tightening global credit conditions will leave currencies with significant current account deficits vulnerable to weakness. This theme implies further underperformance for the Australian and New Zealand Dollars as well as some emerging currencies. Currencies that should benefit include the yen, the Swedish krone and the Swiss franc, but all of these and especially the yen will be prone to bouts of profit-taking given their low interest rates. This suggests the need for some tactical trading to protect returns. Overall the dollar also looks somewhat vulnerable, but has been supported in the short-term by position-squaring and the hawkish nature of the Fed. Both of these should begin to wane and we anticipate renewed dollar weakness in the coming months. Riskier markets, such as high yield and emerging markets are likely to see yields drift higher and prices fall, given less abundant credit and growing cyclical risks, especially with valuations offering limited protection.

The US economy moved ahead at a steady clip during the fourth quarter, shaking off the deleterious effect of the summer's hurricanes. Although inflation data generally improved and showed little evidence of higher energy prices passing through to the consumer, the Fed continued on its path of raising interest rates at a measured pace. Short rates rose to 4.25% by year-end but the bond market latched onto comments contained in the minutes of the November FOMC meeting. The wording of some comments seemed to suggest that the Fed might be close to the end of its monetary tightening cycle, with some members worrying that "risks of going too far with the tightening process could also eventually emerge". This lead the Treasury market to recover from earlier weakness in the quarter and 10 year yields ended the period broadly unchanged at 4.4%. The US Dollar strengthened moderately over the quarter, with the widening in interest rate differentials, firm economy and inflows related to the Homeland Investment Act all proving supportive. The currency rose by about 1% against both the Euro and 4% against the Yen.

The fund remains defensively positioned in terms of duration but has recently reduced its exposure to the US Dollar in favour of Euro and Yen.

The Dollar has benefited from positive cyclical factors over the past year, above all strong growth and rising interest rates. Over the medium term these cyclical factors are expected to be overridden by the longer term structural problems that the Greenback faces. Indeed, interest rate and growth differentials with the rest of the world are now starting to move in favour of the Euro and Yen even though, for the time being they remain Dollar supportive. We are looking to reduce our Dollar exposure further within the Fund. Bonds offer poor value given strong global growth and oil-related inflation pressures and the Fund remains significantly underweight.