Comments from the US Federal Reserve hinting at a possible deceleration of stimulus, concerns around a Chinese slowdown and the weak South African economy were key themes during the quarter. It is still early, but there are signs that a market environment, for which we have been positioned for over a year, is finally coming to pass, with valuations driving this view. US economic activity appears to be improving, but remains significantly below potential. The Eurozone faces significant challenges as it grapples with debt in its periphery and an increasingly negative demographic burden as its population ages. China's growth prospects remain high, but are decelerating as the new leadership undertakes necessary structural reforms and reins in excessive credit extension. The South African economy remains weak and vulnerable. Lacklustre manufacturing, slowing household spending and a struggling mining sector, all contributed to a weak 0.9% GDP growth rate in the first quarter. In addition, the large 'twin deficits', high and rising inflation, falling commodity prices and a credit-driven consumption boom, which is now showing signs of unwinding, are all contributing to a fragile economic outlook. With the exception of Japan, global markets performed poorly in June as news of the Fed's stimulus tapering saw a re-pricing across risky asset classes and bond markets. Yet, despite the sharp sell-off in June, most developed equity markets performed well over the quarter. The local equity market hit a new high in May, but then fell sharply during June to end the quarter down 0.2%. In line with the previous quarter's trend, Industrials (up 6.9%) outperformed the broader market, driven by rand-hedge stocks which were boosted by the depreciating currency. The rand had another difficult quarter, weakening 6.5% against the US dollar and 7.9% against the Euro. Inflation eased to 5.6% at its most recent reading for May. However, inflation is expected to breach the 3% - 6% target band in the second half of this year due to fuel price increases and the lagged impact of the weaker rand. The Kagiso Stable Fund slightly underperformed its benchmark over the quarter after a strong first quarter performance. After contributing to recent outperformance, the fund's commodity ETF exposure and inflation-linked bond holdings, detracted from performance this quarter. Credit exposure in the fund performed well, with credit spreads remaining stable or contracting slightly. The fund's global exposure contributed positively to performance, where the weaker currency and strong stock selection continued to add value. In addition, the fund's defensive asset allocation and protective hedge positions proved beneficial in offsetting some of the volatility observed over the quarter. Looking ahead, while the unwinding of stimulus will be a slow process, the reality is that any slowing (and ultimately reduction) represents a significant change in the flow of liquidity to markets. This will have implications for several asset classes and we will continue to avoid those assets that have benefited disproportionately from quantitative easing over the last few years. We remain defensively positioned from an asset allocation point of view. We have low exposure to property, physical cash and long-duration bonds. Global exposure continues to contribute to currency protection and fund diversification, and significant equity hedging provides capital protection in an increasingly expensive market.

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 Stable Fund continues to reliably deliver on its mandate of outperforming cash deposits, with a very low risk of capital loss. Strong outperformance of 3.6% over its benchmark was achieved for the quarter. This was driven by strong stock selection, inflation-linked bond performance and the effect of the rand's depreciation on the portfolio's global component.

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.

We remain defensively positioned from an asset allocation point of view. The fund continues to be positioned in our best ideas, based on our team's proven bottom-up stock-picking process. Global exposure continues to contribute to currency protection and fund diversification and significant hedging provides capital protection in an increasingly expensive market.

Firm (but marginally slower) growth in emerging economies and relatively flat output in developed economies contributed to lacklustre overall global economic growth in 2012.

Within emerging markets, China remains the key driver of growth despite some deceleration since the double-digit growth rates of 2010. Developed market growth continues to struggle with the US recording average growth of 2% through much of 2012 and Eurozone economic activity remains weak. The peripheral Eurozone economies are still firmly in recession amid debt-fuelled austerity measures and a volatile political climate.

Locally, structural economic problems and weak global conditions continue to constrain prospects for economic growth. South Africa's macro fundamentals are weak and the marginal growth achieved has largely been driven by government and household consumption - largely debt-financed. Yet despite the deteriorating economic environment, South African share prices continue to reach record highs.

The FTSE/JSE All Share Index gained 10.3% 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 a little as Chinese data improved and the iron ore price rallied. For the year, the FTSE/JSE All Share Index returned 26.7%. Industrials (40.7%) and financials (38.1%) performed well, with resources (+3.1%) lagging.

During the fourth quarter, the South African 10-year bond yield fell by 0.2% to 6.78%. Over the year, the All Bond Index returned 16%. Inflation-linked bonds had a stellar performance, returning 19% for the year amidst growing demand for inflation protection and restricted issuance.

Foreigners were net sellers of South African equities worth R3.4bn in 2012, although there were inflows of R5.3bn in December as currency pressures subsided and labour issues appeared to stabilise. Bonds continued to experience significant foreign inflows during the quarter, resulting in a record of R94bn for 2012.

The rand weakened by 1.9% against the US dollar and 4.4% against the euro. The rand depreciated notably in October at a time of severe labour unrest and the downgrading of South Africa's sovereign rating. However, it performed strongly in December, gaining 5.1% against the dollar as concerns about Europe's slowdown eased and the appointment of Cyril Ramaphosa as ANC Deputy President was well received by global markets.

South African consumer price inflation rose during the quarter, driven by higher petrol, electricity and food prices. Inflation remains in the upper region of the South African Reserve Bank's target band, where we expect it to remain in the medium term, with most of the upside pressure stemming from higher food and electricity prices, as well as the knock-on effects of a weaker rand. At its Monetary Policy Committee meeting during the quarter, the Reserve Bank left rates unchanged. The Bank continues to balance weak growth prospects and rising inflationary pressures.

The Kagiso Stable Fund continues to reliably deliver on its mandate of outperforming cash deposits, with a very low risk of capital loss.

Going forward, we remain defensively positioned with high effective rand cash exposure and relatively low effective equity exposure - mostly achieved via hedging. We are underweight property, physical cash and bonds, with a large positioning in inflation-linked bonds. Global exposure continues to contribute to currency protection and fund diversification. The fund continues to be appropriately positioned in our best ideas, based on our team's proven bottom-up stock picking, fixed income and asset allocation processes.

Portfolio manager
Gavin Wood