The JSE All Share Index (ALSI) ended a miserable quarter in lackluster fashion, posting its worst monthly performance for 2011, declining 3.6%. This compared poorly to the MSCI World and MSCI Emerging Market Indices that returned 6.0% and -0.9% respectively. The SA bond market (ALBI) declined 2.1% for the month of September. Concerns about global growth and the lack of an effective policy response to the sovereign crisis in Europe, have undermined market confidence.

For the quarter, the ALSI recorded a 5.8% decline. MSCI World equities were flat in rand terms and the MSCI Emerging Market Index dropped 7.2%. The ALBI returned 2.8% for the quarter.

Concerns about global growth and the worsening debt crisis in Europe are top of mind. Numerous global growth indicators point to further downside in global economic activity, which will be hard to arrest without major policy stimulus. This prompted the Federal Reserve's "Operation Twist", a bold attempt to drive down long-term interest rates and stimulate the faltering US economy. Equities were also rattled by the Fed's bleak comments; "Growth remains slow. Recent indicators point to continuing weakness in overall labour market conditions and the unemployment rate remains elevated." This assessment is consistent with the latest report from the International Monetary Fund (IMF). The IMF reduced its forecast for economic growth in the US this year to 1.5%, down from their June estimate (2.5%). The outlook in the eurozone is no better, with limited visibility surrounding the sovereign debt woes, and confusion regarding the mechanism to solve the crisis and contain the damage.

In the developing world, the IMF expects economic growth to remain robust, albeit with increased risks. China, the world's second-largest economy, is forecast to grow 9.5% this year (according to the IMF). China's economic resilience is critical for the world! A nightmare scenario is a "hard-landing" in China, which would almost certainly lead to a global recession and a sharp decline in asset prices.

Emerging markets and their currencies were particularly badly hit in September as risk appetite faltered. The rand was weaker against the US dollar, depreciating approximately 15% for the month. The deterioration in the global economy means further downside risk to local growth. Weak external demand, coupled with indebted consumers, rising energy prices, infrastructure constraints and concerns over policy have all weighed on domestic growth. Despite this, the Reserve Bank's Monetary Policy Committee opted to leave the repo rate unchanged at their September meeting given the upward climb in inflation (both the CPI and PPI readings for August were above expectations).

There is little room for complacency for investors. There is a growing realisation that developed economies are in the midst of a prolonged period of sluggish growth. At best, we expect a faltering but gradual recovery in economic growth supported by low interest rates, liquidity injections and currency adjustment where these are possible. Markets are also likely to be characterised by elevated volatility. Given this, we continue to favour high quality companies with growing cash generative businesses that are trading at reasonable valuations

Last week saw Greece approve austerity measures, required in order to ensure another tranche of bail-out loans as the country faced imminent debt defaults. Markets in Europe seemed, for a while, to be taking their cue from Greek bond and equity markets as the roller coaster ride that was the debt crisis unfolded. The European banking sector was particularly affected, as was the local banking sector, as fears of contagion spread to our markets. SA banking shares took a beating, despite local banks not having any appreciable direct exposure to Greek debt. The JSE Banks' sector ended the quarter down 1% having reached a peak of 3% and a trough of -5% during the quarter.

We have detected a rising level of alarm regarding the requirement for investment advisers to write the Level 1 Regulatory exams, as required under the Financial Advisory and Intermediary Service Act. Likely to be hardest hit are independent brokers and tied agents that operate predominantly in the mass market.

On the banking side, early indications of an increasing appetite to grant credit came in the form of an announcement by Standard Bank that it would grant business and personal loans of over R50 billion this year. This was welcome news as the prospects of balance sheet led growth in the sector were looking quite slim.

One area that has received much attention over the past year has been the possibility of all the big SA banks expanding their footprint into Africa. Standard Bank has a head start in this respect with FirstRand a close second. During the quarter, however, that expansion strategy took a step back as FirstRand Bank announced that they had terminated talks with Sterling Bank Plc, a small retail bank in Nigeria. However, FirstRand made it clear that it still sees Nigeria as key in its Africa strategy and that they continue to evaluate opportunities in that market.

This quarter saw Vodacom (VOD) report sterling results. We were encouraged by a strong increase (22%) in free cash flow with future cash flow prospects looking strong as the group increased its payout ratio to at least 70% of headline earnings. Group net debt declined by R2.7 billion to R9.5 billion, an excellent performance given the share buy backs seen during the year. VOD was the biggest contributor to the performance of the portfolio, being up 9.4% over the quarter. VOD's dividend yield is currently 5.5%, a generous premium to the market yield of 2.56%.

In March, the three main domestic asset class returns were: Equities = 0.52%, bonds = 0.49% and cash = 0.47%. Reliable monthly total returns for all three asset classes go back to November 1985 (bonds being the limiting class here). In those 304 months, the dispersion of returns in March 2011 set an all time record for being the lowest. Not a productive month for strategists and asset allocators.

Japan
The awful destruction caused first by the earthquake and then more catastrophically by the tsunami drew comparisons with the Kobe earthquake in 1995. That measured 7.2 on the Richter scale; March's earthquake measured 9.0. The seismic energy released by an earthquake scales with the 3/2 power. So, the destructive power of the Fukushima earthquake versus the Kobe earthquake was: = (10(9.0 -7.2))(3 / 2) = 501 times more powerful. At the time of the Kobe earthquake, Japan made up 30% of world stock market capitalization (down from a peak of over 50% during the Japanese stock market bubble). Today it makes up around 10%, much more in line with its share of world GDP. There was subsequently a 25% drawdown on the Nikkei 225 index. At the time of writing, the Nikkei is just 5% lower than the day of the recent earthquake. We surmise that the lower impact on the stock market from a more powerful earthquake is due mainly to the substantially lower starting valuation (PE multiple) this time around.


Selected company news
FirstRand (held):FirstRand reported interim results to December 2010. These were the first results since the significant restructuring in which FirstRand unbundled Momentum and disposed of its holding in Outsurance. Given the torrid times that the group experienced two years ago, it was heartening to see indications of a return to form, with some divisions' earnings close to previous peak values. Gross advances, revenues and non-interest income were all up, with normalised earnings (on a pro forma basis) up 20%. The credit loss ratio reduced from 1.52% to 0.92% and dividends per share were up 25%. FirstRand also reported the highest Return on Equity in the banking sector, at 18.7%. This is comfortably above its cost of equity.

Standard Bank (held):Standard Bank reported disappointing full year results to 31 December 2010. Headline earnings declined 4%. The group bad debt ratio did decrease (from 1.6% to 1.04%) but this was negated by a very disappointing performance in the international operations with an increase in bad debts in certain of the European and Asian businesses. Increased expenditureinthe African operations contributed to a 9% increase in operating expenses, resulting in an unsatisfactory increase in the cost to income ratio.

Old Mutual (held): Old Mutual reported good results with improved disclosure, especially with respect to the generation of cash within the group. Concerns about Old Mutual being able to meet its debt reduction targets subsided. Gratifyingly, Old Mutual increased the dividends paid to 4p per share from 1.5p, at a 4x cover. The FGD surplus increased from its low of £900m in Q109 to £2.1bn. Sales, net client cash flows and new business margins improved. The US businesses remains an area of major concern as asset management experienced significant net outflows. The US life business is in the process of being sold, with indications recently received that regulatory approval has been received in the State of Maryland.

BHPBilliton (held): With Iron ore, copper and oil prices persistently high, cash has been pouring into the BHP Billiton coffers apace. The brains trust at the company has wasted no time in finding homes for this largesse, as the following recent announcements illustrate: A further US$554 Million Investment at the Escondida copper mine, a US$400 million expansion at Hunter Valley Energy Coal in New South Wales, three metallurgical coal projects in the Queensland amounting to US$2.5 billion and approval of US$6.6 billion of capex at the Western Australia Iron Ore operations. This comes in addition to the company's US$4.75 billion entry into the US Shale gas market and a US$10bn expanded share buyback program, both announced in February.

A very good month
The past month was one of those that give credence to the oft repeated adage that investment success is related to time in the market rather than timing the market. Heading into December the market did not appear particularly cheap, nor was there anything happening which might have alerted one to the impending 6.2% advance in the equity market. The fact that this unpredictable move represents a third of the total return of 19.0% for the year underlines, in our opinion, the folly of trying to anticipate market movements.

Small market capitalisation shares
During our review of the past year's performance it was interesting to note that the Small-Cap Index outperformed the Top 40 Index by the fairly wide margin of 7% during 2010. We have for some time been of the opinion that the best value on offer is to be found among the small-and mid-cap shares. The portfolio consequently has had a reasonably large exposure to companies in this classification for a while, particularly within the industrial sector, and has benefitted handsomely from this stancerecently. In particular, our holdings in Illiad Africa, Invicta Holdings, EOH and Lewis Stores have lately contributed significantly toour performance. Given the still relatively low valuations of a number of good quality small cap companies, it will not be a huge surprise should2011 turn out to be another good year for the little guys.

Bonds
After a strong third quarter, in the fourth quarter bonds worked hard to justify their reputation as the boring asset class and the All Bond Index barely changed in the past three months, but did deliver a very healthy return in excess of 14% for the year. The Orthogonal Investments GIPS composite fared considerably better. Since inception of bond management at Orthogonal (31 August 2007), our composite has beaten the All Bond Index by an annualised 1.85%.

The outlook for 2011
Bonds The 10-year government bond yields of 8.2% hardly inspire excitement, but contextualised, they are less concerning. That is 4.7% above the prevailing level of inflation. Since the inception of independent monetary policy and the end of the unlamented period of prescribed assets, namely late 1989, the All Bond Index has outperformed inflation by 7.2% a year. Clearly, that is not on the cards for the next few years, but risk-adjusted and allowing for the globally low interest rate environment, a prospective real return from government bonds in excess of 4% ought to be quite acceptable. Let's hope the actuaries have factored lower returns to their pension fund surplus estimations. Another reason to tolerate yields of only about 8% stems from the opportunity set. Cash is yielding just 5.25%. In fact, expressed as a ratio, ten year yields exceed the BA rate by the second highest amount since 1989. We have demonstrated that this metric has been a reliable indicator of the subsequent relative performance of bonds over cash.

Equities
"I am neither clever enough nor foolhardy enough to make forecasts." -Martin Wolf, Associate Editor of the Financial Times. At this time of year it is commonly expected of asset managers to make profound sounding predictions about what will most likely happen in the year ahead. In our experience this is a sometimes amusing, but almost always futile exercise. We have consequently conditioned ourselves to live with the shame of admitting our inadequacy in the hallowed field of crystal ball gazing. The fact of the matter is that no one knows what will happen, but, while we all know that, the false comfort provided by pretending that we do remains a difficult addiction to break. In our opinion, the best one can do is to objectively assess prevailing valuation levels and try to draw some conclusions from this. Looking at the prevailing valuation of the equity market (PE = 17.2x; DY = 2.2%) against the backdrop of its long-term history (PE = 11.9x; DY = 4.5%) one is led to the inescapable conclusion that a significant recovery in corporate earnings has already been priced in. On both measures, current valuations are more than one standard deviation on the expensive side of the long-term average. Factoring in the consensus analyst expectations for dividend (17%) and earnings (30%) growth during the next 12 months renders valuations (PE = 13.2x; DY = 2.6%) that remain decidedly on the expensive side of their long-term averages. This implies that investors are either already discounting more than one year's earnings growth or believe that the consensusistoo conservative. Given the severity of the recession that we are recovering from this might prove to be a not unreasonable expectation, but thereis no escaping the conclusion that 2011 had better deliver robust earnings growth if we are to experience positive equity returns.