Market review
Risk assets maintained their upward trajectory during the third quarter, thanks largely to continued support from central banks. European Central Bank President Mario Draghi's commitment to do "whatever it takes" has removed some of the near-term tail risks in the euro zone. The resumption of open-ended quantitative easing by the US Federal Reserve also bolstered markets. Economic data generally remained weak, especially in Europe and China. However, there were fewer data releases that disappointed forecasters, encouraging investors to anticipate more positive news.

Portfolio review
The fund experienced a reasonably good quarter, helped in particular by returns from emerging market bond and currency markets. Corporate bond positions also added to performance over the period.

Portfolio activity
Core government bond yields traded in a range towards historically low levels during the quarter. Peripheral yield spreads narrowed somewhat on potential European Central Bank support, while emerging market bonds were also stronger, and credit spreads narrowed. The US dollar generally weakened, with emerging currencies performing especially strongly, and there was a more modest recovery in the euro. Within developed markets, exposure to UK inflation-linked bonds was reduced on concerns that the calculation of the retail price index (RPI) was likely to be revised, reducing its rate of increase. This was offset by closing a short position in Canadian bonds, which had moved to price in less dovish policy from the Bank of Canada. The portfolio remained overweight the US dollar, but the underweight position in euros was reduced on a removal of near-term downside risks and replaced with a larger underweight position in the Australian dollar and Swedish krona. In emerging markets, we bought bonds in Poland on economic weakness, Malaysia on the potential for a rate cut, and Mexico and Hungary on cheaper valuations. Bonds were sold in Thailand, South Korea and South Africa to take profits after recent strength - in the latter, negative ratings dynamics also played a part. Exposure was also reduced in Russia on higher interest rates. Currency exposure was increased in the Thai baht, Hungarian forint and Turkish lira on improving balance of payments positions, and in the Taiwanese dollar and Israeli shekel following underperformance. Exposure to the Chinese renminbi was reduced on weak growth, and to the Czech koruna and the Korean won on central bank policy. Within credit, corporate bond exposure was reduced into the rally. The portfolio took profits on bonds issued by Total and Elster, which had rallied strongly after its acquisition by Melrose. The portfolio added exposure to bonds issued by Mubadala on what was a very attractive yield spread, despite the implicit backing of the Emirate of Abu Dhabi. It also added to Verizon, on a switch out of Comcast, which had looked expensive; Ardagh Glass 2017s, on a switch out of the 2016 maturity to pick up yield spread, and Everything Everywhere, on a switch out of SES Global, which had outperformed strongly. Additionally, the portfolio participated in a number of high quality new issues over the quarter that are offering attractive yield premiums, such as Linde, State Bank of India and Vale.

Portfolio positioning
Our central view remains that the global economy is likely to continue at a sluggish pace, with growth held back by the debt overhang, but supported by loose monetary policy. Around this trend, however, we expect markets to remain nervous, veering between worry over a variety of potential downside risks and hope that policymakers can 'keep the show on the road'. Central bank policy should continue to provide support to financial markets for some time, especially if growth shows more signs of stabilising - which is possible as we move into 2013. Certainly, few risk assets appear to be significantly overbought, despite the rally seen in recent months. That said, we believe it is sensible to sell into further market strength. Monetary policy has addressed the symptoms of the crisis, but not the underlying causes. In Europe, the periphery remains in recession, with poor fiscal dynamics and evidence of ongoing capital flight. In China, the economy has shown few signs of responding to modest stimulus. Elsewhere, growth continues to run at, or below, trend. Unless growth picks up, this rally is likely to run out of steam and, even if it recovers, a prolonged bull market seems highly unlikely. Problems in Greece and Spain have not gone away, but rather have been pushed aside by the ECB's bravado, and could resurface, especially if Spain drags its heels in applying for support. In addition, it seems probable that the approach of a possible fiscal cliff will hold investors back into year end. As such, we remain cautious of the latest 'sugar rush' rally. We continue to see good value in a number of emerging bond and currency markets. In particular, a backdrop of aggressively easy monetary policy in the developed world should support developing market exchange rates. We view short positions in commodity currencies as a good hedge against better opportunities elsewhere, given their relatively expensive valuations and the poor performance of bulk commodity prices.

Market review
Economic data disappointed in most regions during the reporting period, which undermined investor risk appetite. Risk aversion was further compounded by a worsening of the sovereign funding crisis in Europe, as Spanish government bond yields rose to new levels against Germany. Core government bonds rallied sharply as investors sought 'safe-haven' exposure, before reversing some of these gains during June. Emerging market government bonds also rallied on weaker data and lower oil prices, which created room for interest rate cuts.

Portfolio review
The portfolio gave back some performance in the second quarter of 2012. Both credit spreads and emerging market currencies sold off quite sharply in the first 2 months of the period, before recovering a portion of their lost ground in the final month. Positioning within emerging market currency exposure also hurt returns, while exposure to emerging bond markets added to performance.

Portfolio activity
Corporate bonds and emerging market currencies sold off sharply over the quarter. The portfolio was partly hedged against both moves, but not completely so. These hedges were reduced into the weakness, allowing the portfolio to have some benefit from the rally late in the quarter. Sentiment improved towards the end of the period, thanks to a more successful European summit than anticipated, and on renewed expectations of additional quantitative easing. The portfolio maintained a fairly flat duration to major bond markets, but participated in the strength of emerging bond markets. The US dollar generally rallied against the euro, which helped performance. However, other currencies were more mixed, with a number of Asian currency positions hurting returns. The portfolio reduced the underweight position in euros modestly towards the end of the quarter, in expectation of a bounce from oversold levels.

Portfolio positioning
The euro zone is in the midst of three interlinked crises: a banking crisis, a fiscal crisis and an economic crisis. The latest EU summit appears to have made progress in addressing the first, has provided a lifeline for the second, but has done little to solve the last. The agreement to use euro-area bailout funds to recapitalise banks directly is a positive step forward, because it has the potential to break the toxic feedback loop between peripheral sovereigns and their domestic banking sectors. The broader mutualisation of debt is still a stumbling block. However, the potential to use the European Financial Stability Facility/European Stability Mechanism to support government bonds in the secondary market has been reaffirmed, without the need for additional conditions. This may buy much-needed time to make progress on setting out the steps towards greater fiscal union. Given the reliance on the limited resources of these bailout mechanisms, it is unclear how successful this strategy will be. Unfortunately, the summit had little to offer to address the worsening growth dynamics across the continent. Macroeconomic policy is still focused on too much stick and not enough carrot. The combination of austerity, diminishing credit availability and deteriorating confidence is weighing heavily on activity, especially in the periphery. On balance, it appears that some progress has been made towards a more sustainable monetary union, but not enough for us to believe that the risks have disappeared. As a result, we continue to hold more risk-averse positions than normal and to adopt a tactically contrarian trading stance, selling exposure into rising markets and buying back exposure into falling markets. Our caution also reflects widespread economic weakness outside Europe. There has been a close relationship between data surprises and risk asset performance since the credit crisis. Recent economic releases suggest that markets are vulnerable to the downside. Some improvement in activity seems likely later this year, helped by lower oil prices and policy stimulus, but the third quarter may continue to disappoint. We continue to see value in corporate bonds and emerging market currencies. Both appear to price in decent risk premiums, which should reward holders over time. Core government bond markets remain very expensive, but are supported for now by monetary policy and risk aversion. We are still positive towards the dollar on improved competitiveness and optimism that the deleveraging process in the US is well advanced. We continue to hold a negative view on the euro on fundamental grounds. We also see the yen as increasingly unattractive, being expensive and with declining balance of payments support.

Market review
Economic data was generally better than expected in the first quarter, with the US economy leading the charge. This and the second European longterm refinancing operation helped to boost risk appetite and saw credit spreads rally and emerging market bonds and currencies recover from last year's weakness. Core government bonds stayed well supported until March, helped by dovish central bank rhetoric. However, they eventually reacted to the stronger data, with US Treasuries reaching the upper end of their 6-month yield. Dovish comments from US Federal Reserve Chairman, Ben Bernanke, helped to reverse some of this weakness. Core European yields generally remained well anchored, with data much weaker and renewed concerns about the sustainability of austerity resurfacing into quarter-end. Inflation-linked bonds outperformed as inflation expectations rose on higher oil prices.

Portfolio review
The portfolio returned -2.4% in rand terms over the quarter. Corporate bonds and emerging market debt performed well, helped by additional European policy easing and better than expected US data. Interest rate positions were aided by a short position in US Treasuries, an overweight exposure to Norwegian and Australian bonds, as well as higher breakeven inflation expectations in Europe and the UK. Currency returns were driven primarily by weakness in the yen and Australian dollar, where the portfolio was short versus the US dollar, and a recovery in emerging currencies.

Portfolio activity
Market strength during the quarter was used to reduce exposure to credit and emerging market bond and currency markets. The portfolio took profits on a short position in Treasuries before re-selling them into the market bounce. The US dollar reversed some of its gains as investors reduced euro short positions. The portfolio used this sell-off to rebuild long dollar exposure, especially against the euro and the Australian dollar. The weakest currency was the yen, where loose policy and widening interest rate differentials led to a sharp sell-off.


Portfolio positioning
Leading indicators suggest that global growth should run at or slightly below trend over the next 6-12 months, with the US economy leading and Europe lagging. The recession in Europe appears to have worsened slightly, and the outlook for China has yet to stabilise. A gradual pick-up in Chinese activity in the months ahead remains probable, but there are clearly risks to this view. Core developed government bond markets remain overvalued, with Treasuries especially mispriced. With little evidence of a near-term turnaround in activity measures in the euro area, bunds are expected to remain supported. Despite the rise in breakeven inflation expectations, we continue to see relative good value in inflation-linked bonds, especially in the UK. In emerging markets, valuations remain close to fair value. Credit valuations have continued to deteriorate and are now much closer to fair value than at the beginning of the year. We continue to take profits.

The outlook for the euro remains negative, given an expectation of renewed concerns surrounding peripheral euro-area stresses and weak economic activity. We are also bearish on the Australian dollar, which remains one of the most overvalued currencies. Soft Chinese data, growing concerns about the non-resource economy in Australia and shifting global risk appetite have added to downside risks. Overall, our strategic asset allocation scores remain positive towards risk assets. Risk events, however, could resurface, especially in the euro area. This and a backdrop of fewer positive data surprises have prompted us to take a tactically more guarded stance. The potential for synchronised corrections across risk assets remains a concern, favouring a more cautious approach for now, and supports judicious profit-taking after good performances across asset classes over the past quarter.

Market review

The final quarter of 2011 continued to be dominated by the euro-zone crisis, with two inter-governmental summits and aggressive European Central Bank (ECB) policy action. Fears that the crisis would spark a double-dip recession saw several central banks reduce interest rates, including Australia, Norway and, indeed, the ECB, which reversed its increases of earlier in the year. Those central banks with no room to reduce rates further either created more central bank money or shifted balance sheet positions around in the hope of stimulating demand. Economic data, however, generally surprised to the upside, albeit from fairly depressed levels, especially in Europe.

Despite significant volatility, financial markets were fairly directionless, with risk assets rallying in October, giving up ground in November, and then ending the year on a moderately positive note.

Portfolio review

Performance was fairly flat over the quarter, with a modest recovery in corporate bonds and emerging market debt boosting returns. Interest rate and currency positions detracted from performance.

Portfolio activity

We used strength at the beginning of the period to reduce exposure to credit and emerging market debt, and to raise duration. The portfolio also increased exposure to higher-quality developed government bonds and reduced cash, given concerns in the bank funding markets. This included adding exposure to Norwegian government bonds and UK Treasury bills.

In currency markets, the portfolio reduced exposure to the euro in favour of the US dollar and added back some exposure to cheap emerging currencies by reducing exposure to more expensive commodity currencies.

Portfolio positioning

As we begin 2012, the euro-area crisis remains unresolved and seems likely to continue to be a key driver of markets for the foreseeable future. ECB action at the end of last year has delivered some relief for markets by providing term funding in unlimited size for European banks. While this may also help to support short-dated peripheral government bond issuance, it does not provide a permanent solution to the funding pressures. For now, Euro zone governments appear to be sticking with a policy of buying time, but it is unclear how long this strategy can be sustained without the market forcing more decisive action. There are plenty of near-term pressure points, including negotiations on the next Greek package and the likelihood of sovereign downgrades against the backdrop of substantial debt issuance.

Fortunately, financial markets are already priced for a difficult environment and should deliver reasonable returns, so long as a messy break-up of the euro can be avoided. In addition, growth is generally holding up better than feared, especially in the US, which helps to support risk appetite.

We continue to see good value in corporate bonds and retain a reasonable exposure, although this is partly hedged. Current yields versus government bonds point to decent excess returns over the next few years. Default rates remain low, but the market is priced to withstand recessionary conditions for companies. Recent data reinforces our view that a global recession can be avoided, although some countries will experience a contraction.

By contrast, we see little value in most government bond markets. We continue to avoid peripheral sovereigns. Core markets are priced for exceptionally loose monetary policy to persist for the foreseeable future, which, although likely, offers limited scope for further declines in yields. Indeed, some rise towards fair value seems likely without a global recession or a worsening of the euro crisis. We will look to reduce duration as opportunities arise. We prefer inflation-linked bonds, given the extent to which disinflation is priced into the market, and hold a core position in the US and UK.

The dollar may continue to gain against the euro, given the existential drag on the latter, coupled with policy loosening by the ECB. Dollar positioning, however, is starting to get a little stretched and so we are reluctant to chase this trend too aggressively, although we are comfortable with a moderate underweight. We continue to prefer cheap currencies in the emerging world with better fundamentals, partly hedged by selling the expensive currencies of the developed commodity producers.

Given the heightened level of uncertainty, we are likely to run less risk than normal and will not be swayed by excessive market optimism or pessimism.