The global economy continued its slow crawl during the first quarter of 2013. The endemic debt crisis in the Eurozone reared its head in Cyprus, as a further symptom of the economic problems in the developed world. Developed market central banks continue to pour stimulus into the markets at an unprecedented rate in their continuing attempt to support the recovery. The Bank of Japan's recently announced 'Quantitative and Qualitative Monetary Easing Programme' had an immediate impact on risk assets around the globe.

Locally, weak export demand, buoyant but slowing consumer spending, slow infrastructure development and chronic labour unrest in the mining, transport and agricultural sectors all contributed to a sluggish economy. This, along with a high current account deficit, negatively affected the rand, which was the worst performing emerging market currency over the quarter. During this period, the rand lost 8.1% and 5.3% respectively against the US dollar and the euro.

Developed equity markets rebounded strongly during the quarter. Positively interpreted comments from the US Federal Reserve officials contributed to US equities gaining 10%, propelling the S&P 500 index to a new high. The Japanese equity market was a strong performer, with the Nikkei 225 index gaining 19.3%. European equities gained 5% during the period, underperforming the global market as the events in Cyprus seemed to dampen investor sentiment. The MSCI Emerging Markets index was down 9.7% (in US dollar terms).

Despite deteriorating macroeconomic fundamentals, the South African equity market continued to set new records, with the FTSE/JSE All Share index reaching an all-time high of 40984 in March. Given the debt woes and weak economic activity plaguing developed economies, South Africa has attracted significant foreign investment over the last few years. During the quarter, foreigners bought R3 billion of SA equities and R14.1 billion of SA bonds. Foreign investors now own more than one-third of the local bond market and of the shares trading on the JSE Securities Exchange - an all-time record for both asset classes.

The FTSE/JSE All Share index gained 2.5% over the quarter, with industrials up 6.3%, and financials up 5.9%. Resources (down 6.0%) continued to be weighed down by weakening commodity prices in part from weaker Chinese demand, as their economic growth moderates. However, the weaker rand should provide some support to resources earnings in the short term.

Most commodities relevant to South African miners lost ground in US dollar terms. Gold was down 4.6% and copper lost 7.1%. Platinum, however, was up 3.5%. The oil price (Brent Crude) rose above US$120/barrel for the first time in almost a year, but fell back as the US showed strong inventory figures, ending the quarter 2.2% lower.

The rand's depreciation has placed upward pressure on inflation expectations. The revised Consumer Price Inflation basket has now been implemented and inflation rose to 5.9% at its most recent reading for February. The effects of a weaker rand, rising food prices, rising administered prices such as fuel and electricity and real wage increases are the main upside risks to inflation, which we expect to breach the South African Reserve Bank's target band in mid-2013.

The Kagiso Islamic Equity Fund outperformed the average fund in the ASISA South African Equity General sector for the quarter. This outperformance was driven by strong stock-selection as many of our highest conviction positions were rewarded. The absence of many expensive industrial shares (particularly retailers), which had a poor quarter, also contributed significantly to relative outperformance. Mondi (up 36.5%), AECI (up 27.9%), Sasol (up 12.3%) and Tongaat Hulett (up 7.6%) were strong performers for the fund, while our exposure to BHP Billiton (down 7.8%), MTN (down 6.2%) and Anglo American (down 6.0%) detracted from performance.

Looking ahead, we continue to be cautious given the contradiction between vulnerable global and local economies and a market at all-time highs. Ever-increasing monetary stimulus is continuing to distort local asset prices in certain sectors and the risk of permanent capital losses remains elevated.

The fund continues to be positioned in our best ideas, based on our team's proven bottom-up stock-picking process. Significant hedging provides capital protection in an increasingly expensive market.

The FTSE/JSE All Share Index gained 9.8% during the quarter, ending the year near a record high. In terms of sector performance, Industrials (12.4%) were the largest contributors, followed by Financials (9.9%). Resources (7.3%) recovered as Chinese data improved and the iron ore price rallied. For the year, the FTSE/JSE All Share Index returned 26.7% compared to 2.6% in 2011. Industrials (40.7%) and Financials (38.1%) performed well, with Resources (+3.1%) lagging.
Going into 2013, the macro problems that have hindered growth in developed markets remain in place: the strength of the economic recovery will continue to be hampered by the absence of re-leveraging among consumers, reluctance by businesses to invest amid great uncertainty and intense pressure for fiscal restriction from governments. However, monetary authorities have taken extraordinary actions to promote growth in order to stabilise the global financial system and to try to offset fiscal constraints. It is likely that their efforts will produce mixed results, leading to diverging economic growth rates in these markets.

The 'flavour of the month' syndrome of rewarding companies with perceived resilient earnings bases together with 'safe haven' dividend yields continues. Industrial stocks have been key beneficiaries and sector rotation into resources could be a key feature of 2013. However, volatile commodity prices remain significant barriers to this rotation potential. Our investment process, which focuses on bottom-up stock selection with an emphasis on the analysis of key drivers, did not anticipate the macro tailwinds of monetary easing and record low interest rates and its impact on cross-asset valuations. The current phase of corporates re-leveraging or refinancing borrowings and thereby 'locking in' the benefits of record low interest rates will boost short-term earnings growth with the next and final phase of increased M&A activity using cheap debt yet to play out.

The Kagiso Islamic Equity Fund underperformed the average fund in the Domestic General Equity sector for the quarter due to the lack of exposure to financial shares and our large positions in Lonmin and Tongaat. While our current overweight position in resources shares and underweight position in industrials has affected our short-term performance, we believe it is appropriate to position our clients in deeply undervalued shares in anticipation of strong capital gains and avoid the permanent capital losses we expect in vastly overvalued shares. Implats (up 20.6%), Nampak (up 11.4%) and MTN (up 10.9%) were strong performers for the fund, while our exposure to Anglogold Ashanti (down 10.1%), Tongaat Hulett (down 3.5%) AECI (down 2.5%) and Lonmin (down 2.1%) detracted from performance.

Looking ahead, we remain cautious over prospects for developed economies with high levels of government debt, high levels of unemployment and demographic trends moving slowly against them. On the positive side, we believe that there are strong prospects for companies focused on emerging market consumers, although much of this optimism seems to be priced into South African consumer stocks. We are increasingly finding opportunities in large capitalisation IT stocks in the US with solid balance sheets and resilient cash flow generation abilities.

We remain defensively positioned from an asset allocation point of view, with significant non-equity positions in place. The fund continues to be appropriately positioned in our best domestic and international stock selections, based on our team's proven bottom-up stock picking process.

Portfolio manager
Abdulazeez Davids