Market review
The third quarter was dominated by the subprime housing crisis in the United States, widespread credit concerns and the growth prospects of the US economy. The general reluctance of banks to lend to each other was not confined to the US, and global banks saw a severe squeeze in liquidity. A full-blown implosion of the US credit market was narrowly averted when the US Federal Reserve (the Fed) first cut the rate at which it lends to commercial banks and later the benchmark federal funds rate, from 5.25% to 4.75%. Amid the turmoil, global equity markets ended the quarter well in positive territory to reach record highs; bouncing off their intra quarter (August) lows. The MSCI World Index gained 2.5% in US dollar terms over the quarter. The MSCI Emerging Market Index extended its positive performance (up 14.5% in US dollars) over the quarter, mainly on the back of a very strong performance out of Asia (up 19%).

Global events reflected in the SA market, causing bonds and the currency to weaken and equities to sell off as risk appetite waned and uncertainty with regard to the global outlook grew. However, the bears seemed to lose the battle yet again as US Federal Reserve governor, Ben Bernanke, provided some monetary relief. Equities recovered strongly from their August lows, gaining 6.7% over the quarter. The local market was led higher by resources (up 13.5%) and industrials (up 3.3%). Financials, which were caught up in global credit concerns were down 1.6% over the quarter. Bond and property yields pushed lower and the currency gained strongly against a falling dollar. Over the quarter the All Bond Index was 3.4% higher, listed property rose by 9.5% and cash (as measured by the STeFI) earned a return of 2.3%.

Fund performance
The Investec Managed Fund performed well over the quarter. The fund returned 4%, delivering a top quartile performance. The fund benefited from an overweight position in equities. During the quarter we bought protection to provide a cushion in the event that equities fell. It is not often that volatilities are this low, making protection attractive. This protection served us well during the sell-off in the subprime crisis in August.

The international allocation continues to add value. We keep the number of holdings confined to six or seven. This area of the portfolio is vulnerable to a stronger rand and we need to select companies which can outperform in rand terms, even if the rand is strong. We have holdings in Rio TInto, Barrick Gold, Pepsico and Peabody Energy.

Within the resource sector our holdings in Billiton, Sasol and Kumba Iron Ore helped. Our weightings in Aveng and KWV also contributed positively. Billiton has strongly outperformed Standard Bank this year. We continue to like both companies, which are of a high quality and have good earnings revisions.

Our lack of property shares detracted from performance. Despite rising bond yields, listed South African property shares delivered good returns. However, the slowing consumer environment will impact on returns from this asset class. With financials in the red over the quarter, the fewer financials one had the better. However, given the attractive valuation levels, we feel some exposure here is prudent.

Portfolio activity
The fund's exposure to resource shares was reduced through the sale of precious metal shares. We increased our weighting in the telecommunications sector, on the back of firm upgrades for MTN. Murray and Roberts were added to the portfolio as the earnings upgrades were simply too good to ignore. We raised the funds by selling our holding in Bidvest. Earnings upgrades became scarcer on the back of declining motor car sales and input cost pressure. The fund sold out of Sappi, as the weakness in the US dollar, is bringing price increases in their underlying markets into question.

We also bought Pepsico and Peabody on the back of upgrades. Peabody has given us good exposure to the coal industry. Our weighting in African Bank was increased. We believe that the market is underestimating the capital that can be released from combining African Bank and Ellerines.

Market outlook and portfolio positioning
Emerging markets are trading at 18.5 times earnings compared to 16.8 times earnings for the MSCI World Index. The price to book multiple also exceeds that of developed markets at three times compared to 2.7 times. This is not such serious a concern as developing market growth is outpacing developed market growth. It is the composition of the valuations, which causes us to worry. Our view is that the Chinese mainland stock market is experiencing a bubble. Bubbles burst at some point but the economic impact and timing are hard to predict. When the Saudi market halved from a price earnings ratio (PE) of 61 times in February 2006, there was not much economic impact.

South Africa's valuation levels are far more favourable. The Johannesburg Stock Exchange's All Share Index is on 15.5 times trailing earnings and earnings growth is 40%, but likely to slow from here. In the event of a fallout in the Chinese market our resource counters will probably sell off, as will shares with a high correlation to emerging markets in general. However, unless this translates into an economic slowdown in China, the effect on our stock market will probably be temporary, as valuation levels and earnings growth will be supportive.

With the cut in interest rates over the quarter we are now seeing downward revisions in consumer related shares. We are underweight this area of the portfolio. The fund is overweight fixed investment related shares, which are on the receiving end of increased government spending and earnings upgrades. However, we now believe that the inflation outlook is likely to improve next year, as base effects come to the fore. We are selective buyers of interest rate sensitive companies.

Market review
The domestic inflation outlook has deteriorated over the quarter. Rising yields globally and domestic inflation concerns resulted in the local government debt curve increasing sharply. Over the quarter the benchmark R153 and R157 peaked at 9.15% and 8.58% respectively. The All Bond Index lost 1.7% over the three months ended June. We expect CPIX inflation to remain firmly above the targeted inflation band until year-end. This is likely to force the South African Reserve Bank (SARB) to tighten rates further. However, early signs of some moderation of consumption led growth, coupled with a potentially negative impact of the recently implemented National Credit Act are likely to moderate the SARB's stance on the extent of further tightening. Rising bond yields and deteriorating inflation expectations put pressure on domestic listed property. The sector was up marginally over the quarter (0.3%) but remains firmly in the black year to date at 16.1%.

After a strong first quarter, domestic equity market returns moderated slightly over the past three months. The FTSE/JSE Index gained 4.3% since the end of March. The market was driven higher by general mining (up 12.5%), oil and gas (up 9.9%), construction (up 9.9%) and life insurance (up 6.9%). Interest rate sensitive counters, in particular banks were down 6.9% and retailers lost 6.7%. This reminded investors of a similar occurrence last year, when diminishing global risk appetite coupled with higher domestic borrowing costs, caused a massive sell-off in domestic oriented sectors.

We remain positive, yet cautious, on our equity outlook over the next few quarters. Increasing volatility and fluctuations in sentiment should not deflect from a global and domestic backdrop that remains supportive of continued earnings growth and above average equity ratings.

Fund performance
The Investec Managed Fund delivered a top quartile performance over the quarter, returning 4.3%. This is in line with the FTSE/JSE All Share Index's return despite the fact that the fund has a maximum equity allocation of 75%. The benefits from being able to select stocks in international markets are thus evident.

The fund benefited from an overweight position in equities, with offshore equity near the maximum of 15%, and onshore equity about 62% through the quarter. While our asset allocation to equities is full, we did buy protection, which was relatively cheap during the quarter, to provide a cushion in the event that equities fell. It is not often that volatilities are this low, making protection attractive.

The international allocation added substantially over the quarter, with shares such as Yanzhou Coal, which rose from HKD8 to HKD11.94 over the quarter. The rand strengthened by 3.4% over the quarter. However, the JSE did not outperform and hence our stock selection made up for rand strength. We were overweight resource shares, with a big overweight position in oil stocks through holdings in Sasol, Exxon and Chevron. Our underweight bet in property finally paid off as the SA listed property returned 0.3% over the quarter. The best local equity performers were Raubex, Sappi, Santam and Aveng.

We had a marginally overweight position in banking shares, which detracted from performance. While the macroeconomics do not favour banks at the moment with rising inflation and interest rates, they are cheap and earnings revisions are still favourable. Hence we believe this position is justified.

Portfolio activity
The fund remained overweight equities and underweight bonds. We were fully invested offshore and continued to have no exposure to property. Our sector allocation remained overweight resource shares. However, we reduced our exposure to gold stocks, took some profit on much loved platinum counters and bought more oil shares. We slightly reduced our weighting in banks by selling Absa, which had outperformed its peers, but has more local interest rate exposure risk. SA Breweries, which had underperformed for a long period was added to the portfolio. SAB remains an exceptionally good business and revisions were turning positive. The fund bought Chevron to gain more oil exposure and Fording Coal for exposure to the coal sector, where prices are starting to rise as China turns into a net importer for the first time. We also added Hitachi and Komatsu as undervalued plays on the resource cycle.

Market outlook and portfolio positioning
Global demand remains firm despite the slowdown in the US housing sector. Indeed, the sell off in the US bond market over the quarter is testament to this. Locally, we need to see inflation return to the target range of 3% - 6%. We have long felt that inflation is a concern locally and that the market was taking too benevolent a view on inflation and we remain concerned. Within our equity selection we will continue to focus on those counters receiving earnings upgrades. This leads to our current overweight positions in mining houses and fixed expenditure related shares.

The equity market has returned 36.9% over the last twelve months and the investment environment is likely to become more challenging. The price earnings ratio on the JSE is 16 times which is not excessive. However, emerging market valuations are not attractive relative to developed markets. The return on equity is now the same, but is declining in the case of emerging markets and rising for developed markets. Price to book ratios are slightly higher for emerging markets. We believe that excess returns now lie in the developed markets, by and large.

The biggest risk to the portfolio will be if the South African local shares outperform their emerging and developed market counterparts. This would probably happen if the inflation rate surprised substantially on the downside. We remain overweight resource counters, which should be beneficiaries of firm global demand, are reasonably valued and have positive earnings revisions. The fund is underweight local consumer shares, particularly those companies running debtors books, where we feel the consumer could surprise on the downside. We remain overweight oil shares, which are out of favour but where the revisions are starting to come through and valuations are supportive.

Market review
Equity markets were volatile over the first quarter. During January and most of February equities were stronger. However, concern over the US housing market and the deterioration in the macro-economic backdrop put global stocks under pressure. By mid March most markets were 5% to 10% down from their earlier highs but by month end, equity markets had bounced back. The MSCI World Index gained 2.6 %( in US dollar terms) over the quarter. Local equities continued to reach new highs over the first two months of the year. However, the JSE saw heightened volatility in March. Local equities declined very sharply but as global risk aversion eased, stocks recovered strongly. The FTSE/JSE All Share Index gained 10.4% over the quarter and the 12 month return was 37.6%. For the quarter, resources were up 15.2%, financials 6.5% and industrials 5.6%. Cash (as measured by the STeFi index) earned a return of 2.1% over the quarter, against the All Bond Index return of 1.6%. The rand weakened by 4.1% against the US dollar and 4.6% against the euro over this period.

Fund performance
The portfolio recovered some poise in March, earning a return of 5.2% over the quarter. We were underweight equities going into the quarter, but used sell-offs presented at the end of February and early March to increase the equity weighting. Our underweight position in bonds was positive. This asset class significantly underperformed equities. Cash also outperformed bonds. Market participants are finally starting to focus on the outlook for inflation and not just the favourable supply dynamics in the bond market, with the government effectively running a budget surplus. Within the equity portfolio our overweight position in resource counters helped returns, whilst our underweight position in telecommunication counters hurt. We increased the resource weighting over the quarter, as positive earnings revisions started to come through on the back of higher commodity prices. Our very low weighting in fixed-interest bonds and short duration position contributed positively. The portfolio has no weighting in SA property shares which returned 15.7% over the first three months of the year. This clearly hurt. However, with bond yields showing some weakness, we believe it is unlikely that property shares will outperform equities from this point.

Portfolio activity
We increased the equity weighting into the weakness that presented itself at the start of March. Sectorally, we also increased our resource weighting, taking the allocation, in the main from the industrial sector. The weighting in financials remained broadly constant. Our view is that the favourable bottom up dynamics are offset by top down risks such as further interest rate hikes and regulation. We significantly increased our holdings in Billiton and Anglo American, where we felt that commodity prices were responding to the ongoing growth in China, whilst the shares were reflecting the weakness in the US housing market. The resilience of commodity prices has started to be reflected in earnings upgrades and the shares have responded positively to this Large cap shares have significantly underperformed their mid and small cap counterparts and Billiton was simply too cheap - given its growth prospects. Our exposure to fixed investment was increased by taking positions in South Ocean Holdings and Raubex as well as raising our Aveng exposure to 3%. We have a large exposure to Harmony on the basis that we expect the rand gold price to rise, which should impact positively on earnings. We were disappointed with the last quarter's results and have trimmed a few on the back of negative earnings revisions. Aflease Gold continues to perform well, as do some other mining juniors such as Peru Copper.

Market outlook
We believe that large cap shares around the world are priced too cheaply relative to their small and mid cap counterparts. The JSE is no exception. We look for firm commodity prices to drive the large cap shares and for mining counters to continue to do well. Our view is that the risk to the currency lies on the weaker side, as a high amount of funding is necessary to cover the current account deficit. We believe the rand has been very weak given the level of precious metal prices. The oil price at close to 70 US dollars per barrel is currently not causing much concern to equity markets globally but this could change. In addition, rising food price inflation globally could trigger a sell-off in risk assets. We also feel that oil shares are not reflecting the current oil price and that there could be an opportunity in this regard. We added to our Sasol weighting recently. The largest risk to the portfolio from a macro-economic perspective is a very strong rand. To the extent that this reflects firm commodity prices we have some protection. Unexpected upside surprises in inflation globally will impact on the portfolio negatively. Our largest risk in relative performance terms lies in the locally listed global plays continuing to underperform. The emerging market bull favours small and mid caps. We are long large cap shares and resource counters. Our non resource rand hedge holdings give us protection against a weaker rand.

Market Highlights
December was once again a strong month on the JSE with banks leading the charge with a 9.5% return. We added to our banks exposure. Whilst our lower weighting hurt in December, we believe that a switch out of resources and into financials could well last over the medium term. We were consequently buyers of Standard Bank and First Rand during the period. Despite our view that the rand will trade weaker, banking shares could perform better as they should generate above market earnings growth on below market ratings this year. There is less earnings downgrade risk in the banking sector than in the resource sector.
Basic materials were flat during the month. We have a low exposure to copper through minimal weightings in Anglo American and Billiton. We do however have exposure to gold and platinum as we feel it is only prudent in the face of weakening commodity prices to have some protection against a fall in the currency.

Emerging markets, in general, had a very strong month, with the Chinese market, for instance, returning 45% over the last two months. This level of exuberance is of concern to us and we remain cautious on the SA market.

Bonds returned a highly respectable 4.2% in December. With the rand appreciating by 2.3% and the JSE outperforming the developed markets, we struggled in a relative sense.

Outlook
2007 could well prove to be trickier for the markets than the proceeding three years. The historic price earnings multiple on the All Share Index is at the top of its ten year band at close to 17 times. We have reduced our equity weighting to 65% from a full 75%. Unfortunately this proved to be a bit early. Having said that we still believe that equities will provide a real return, albeit non spectacular. We believe that non commodity rand hedge shares could do well as well as counters likely to benefit from firmer pricing such as the food retailers.

Strategy
We have added to our banks and position in food retailers, whilst trimming some shares that have performed well. We took profits in both Naspers and Barloworld. We are overweight non resource rand hedges as we fell this is prudent in the face of emerging market exuberance and nervous commodity prices.

We will be looking to increase our exposure to foreign markets. The oil price has been a very key driver of emerging markets over the past few years. It allows the major emerging markets (with South Africa a noticeable exception) to run current account surpluses. Any sustained fall it the oil price could have interesting implications for the flow of funds between emerging and developed markets.