The FTSE JSE All Share Index posted a total return of -5.8% for the third quarter of 2011. Of the industry groups, Technology (5.0%) was the top performer with Health Care (2.5%) in second position. Basic Materials (-10.8%) was the worst performer, followed by Oil & Gas (-6.0%), Industrials and Telecoms (both -4.6%). Gold posted a total return of 19.5% in the September quarter, after posting -13.0% in the second quarter. The developed market debt juggernaut gathered further momentum in the third quarter, with European policymakers continuing to defer the inevitable. On reflection, the past decade can be broken up into three distinct phases:

uPhase 1, starting from the end of 1999 to 2007, saw a major build up in household and financial sector debt in the US and several European economies.

uThe second phase, lasting from the start of the subprime crisis to early 2010, saw intense private sector deleveraging combined with a surge in government sector debt. In effect, as the private sector was paying back debt, the government was taking on new debt in order to prop up aggregate demand.

uThe third phase - the one in which we currently find ourselves - has seen a slowdown in the pace of private sector deleveraging but an acceleration in the pace of fiscal consolidation. The non-recurrence of further economic stimulus in developed markets has exacerbated the risk of a renewed global recession (the feared double-dip) and threatens to unwind the recovery that commenced in April 2009.

Equity markets appear disappointed and frustrated by the ineffectiveness of Fed policy at a time of heightened economic and financial risks. It is even debatable whether the twist policy will help or hurt the economy. 'Operation Twist' creates no new stimulus as the Fed balance sheet will stay steady, but it flattens the yield curve. This could hurt banks which are already under stress. Furthermore, the political impasse has seriously undermined the Obama administration's ability to address the underlying problems inherent in the US economy. In addition, the horror story in Europe continues.

The advice given by the US to turn the European Financial Stability Fund (EFSF) into a bank is correct as it would allow the EFSF to draw in private sector savings as well as lever up the size of the fund on the European Central Bank's balance sheet. This is the only way to substantially enlarge the rescue fund, making it a credible source of funding to stem the debt crisis.

The extreme volatility in stock prices is symptomatic of the degree of uncertainty and risk inherent in market valuations currently and also underlines the importance of a sound investment philosophy, a robust bottom-up investment process and a regular top-down quarterly review to generate long-term outperformance for our clients.

The second quarter of 2011 saw a significant reversal of fortune for emerging markets: developed markets outperformed emerging markets and the domestic market. Increased tightening policies in China, coupled with continued European austerity and Greek tales of woe, increased investors' jitters towards emerging markets, instead preferring the perceived relative safety of developed markets. The US appears to be a safe haven, with a weak dollar and loose monetary policy acting as powerful magnets for investor's capital. The US strategy of growing their way out of debt appears to be slowly gathering momentum - but could easily be stymied if the US$ start strengthening again.

It became apparent that the all-important Chinese contribution to the global recovery was not without risk: authorities began to aggressively tighten monetary policy in response to rising inflation which will slow down their economy.

Emerging markets had only a mildly negative quarter, with gains in the first two months largely offsetting a sharp drop in June. In total return dollar terms the MSCI Emerging Markets Index was down 1% for the quarter and the MSCI China Index down 1.7%. Developed markets benefited from an element of safe haven buying and fared a lot better with the S&P 500 up 0.1%, the FTSE 100 up 1.7%, the Nikkei 224 up 3.3% and the DAX 30 up 7%.

Local inflation readings have surprised on the upside with the May CPI reading at 4.6% year on year and food inflation the primary contributor at 6.6% year on year. The pick-up in food inflation was expected and was due to the lagged feed-through of high global agricultural commodity prices. South Africa's recent food inflation pick-up has been relatively mild compared to those of other countries, as we have been shielded by a strong currency and a favourable maize crop surplus. We see higher South African inflation risk going into 2012 as these advantageous factors roll off.

We are cautious about developed economies that face long-term challenges in the form of high unemployment, high government debt levels and negative demographic trends. In the short- to medium-term these economies will have to grapple with the inevitable withdrawal of stimulus and the implementation of austerity plans. As a consequence we remain convinced that the current correction in developed markets is yet to run its course and expect further volatility on global stock markets.

We continue to avoid domestic-focussed, cyclical industrial companies that have benefitted from the strong structural forces of lower domestic interest rates and lower domestic inflation over the last 10 years (the magnitude of which is unlikely to be repeated over the next 10 years). Many of these companies are trading at ratings that suggest the earnings growth achieved over the last 10 years will be repeated - we do not share this view. We currently favour companies with strong balance sheets and high franchise value, with strong cash flow generating abilities that trade at normalised ratings well below the current market rating and therefore allows us to preserve and grow our investors' capital in volatile market conditions.

Portfolio manager
Abdulazeez Davids

The Kagiso Islamic Equity Fund returned 2. 4% for the quarter and 20.7% for the 12-month period to 31 March 2011, outperforming the peer mean benchmark by 7.4% over the 12-month period. It is furthermore pleasing to note that since its inception on 13 July 2009, the fund has achieved a cumulative return of 50.5% to 31 March 2011.

Global events at the beginning of March (Japan earthquake and tsunami; Middle East upheavals) dominated world markets in the first quarter of 2011, with nervous investors selling off equities as a knee-jerk reaction. However, equity markets quickly rebounded and are now trading at levels similar to before the financial crisis in 2008. Commodity prices, specifically oil prices, rose sharply in anticipation of constrained supply and expectations of increased demand from Japanese rebuilding efforts. Domestically, the first quarter saw a big recovery in corporate earnings, mainly as a result of a strong recovery (60%) in resources earnings. However, this growth rate in earnings is not likely to recur, given the outlook for the key earnings drivers. Despite the earnings recovery, domestic valuations are still very high relative to long-term averages and many stocks are trading close to their all-time highs.

We have expressed our caution on the domestic equity market's valuation in previous communications, noting that earnings multiples are too high relative to what we think a fair multiple for our domestic market should be. We further caution investors that South African companies, especially industrial companies, have experienced an almost 100% growth in earnings between 2004 and 2009 and this growth in earnings is unlikely to recur over the next five years. A 'stimulus package' of substantial cuts in interest rates, lower inflation, strong nominal GDP growth and a weaker currency propelled earnings to unprecedented levels. The current economic environment of multi-decade low interest rates, and relatively benign inflation is unlikely to persist. In our research and portfolio construction process we are highly cognisant of not rewarding companies for past earnings performance that was entirely fortuitous and not the result of a genuine competitive advantage or management skill. Whilst this could be perceived as conservatism, it has enabled us to successfully avoid recent corporate earnings disasters and thus protect the value of our clients' investments. 150.56

Portfolio Manager
Abdulazeez Davids

The South African and global equity markets continued to recover from the 2008 meltdown in 2010, with developed market liquidity providing strong stimulus to global markets, especially emerging markets. The relentless pursuit of growth-adjusted yields in emerging markets to compensate for meagre yields in developed markets have resulted in investors totally ignoring and discounting economic and political fundamentals in these emerging markets.

Developed market funds, driven by the greed and the expectations of superior risk-adjusted returns from emerging markets, have contributed to 2010 being a record year for emerging market inflows. Emerging market valuations have consequently risen to near record highs as a wall of money chases limited opportunities. The warning signals for emerging markets are clear: are we likely to see a repeat of 1998, when immediately after emerging markets posted record gains, the emerging markets bubble burst and it took six years to recover?

The strong focus on emerging markets did not pass South Africa unnoticed in 2010. With a fairly liquid and developed equity and foreign exchange market, South Africa can be regarded as a suitable proxy of emerging markets and the local market benefitted from increased foreign participation, most notably in the industrial sector. Whilst foreigners have been very wary of the impact of a strong currency on South African resources stocks and are generally shying away from all financial stocks, industrial stocks have been a key beneficiary of this re-acquaintance by foreigners. Consequently, industrials valuations are at record highs, with cyclical and consumer focussed stocks key beneficiaries. The combination of rising share prices and potentially declining profits is therefore expected to exacerbate the valuation gap relative to fair value for domestic stocks. Unfortunately, consensus earnings growth forecasts have yet to adjust for the stronger rand environment and as such appear very optimistic.

The Kagiso Islamic Equity Fund returned 10.1% for the quarter and 22.2% for the calendar year 2010, outperforming the peer mean benchmark by 3.9% over the twelve month period. It is furthermore pleasing to note that since its inception on 13 July 2009, the fund has achieved an annualised return of 29.4%, outperforming the benchmark by 3.2% over the period. The fund remains defensively positioned away from overpriced domestic cyclical industrial and selected resources shares in favour of our investment team's best investment opportunities, utilising our proprietary research process.We remain confident that the current fund positioning is appropriate to generate sustainable long-term returns for investors.

Portfolio manager Abdulazeez Davids