World equity markets enjoyed one of their strongest quarterly performances for decades, buoyed by unequivocal evidence that government intervention has succeeded in turning the recessionary tide. House prices in developed markets appear to be stabilising, and the metal price rose on very strong Chinese demand. Consumer confidence, however, remained muted as unemployment increased and individuals reduced their massive indebtedness levels.

The SA economy is expected to have contracted further in the third quarter, though at a slower pace than in the previous quarters. Employment losses have been significant, and together with losses in tax revenue is putting government finances under significant pressure. But SA equity followed international markets higher, partly due to lower risk aversion from international investors and the subsequent demand for emerging market equity. Bond yields were firmer due to the stronger rand, but kept in check by the increasing issuances to fund government’s deficit.

The allocation to equity was increased during the quarter, partly due to selective purchases of companies we like, but also due to a reduction in the short future position in the portfolio. The effective allocation to equity, taking into account theinternational portfolio as well, has increased to 30% during the quarter. The focus, however, remains on quality companies with conservative funding structures and solid balance sheets. We have stayed away from investing in poorer quality companies where the prices have fallen significantly during the preceding six months, especially where question marks around the sustainability of their business models remain.

The interest-bearing portion of the portfolio has been expanded to include a portion of quality, high-yielding short-term corporate debt instruments.

Growth assets returned to the fore in Q2 as investors started to discount the probability of recent positive economic data releases translating into a permanent improvement in the global economy. Pessimism and speculation about the end of capitalism was replaced by thoughts of "green shoots" at the first signs of a change in direction of leading indicators (never mind that the indicators in many cases still point to a worsening global environment).

We draw a distinction between a permanent change in the direction of the global economy and a technical rebound in global economic activity due to a temporary inventory rebound. We do, therefore, not share this euphoria and remain conservatively positioned. In fact, government's support, which has seen the developed world's budget deficits balloon to unprecedented levels, has probably only delayed debasing to a "new normal".

The fund's asset allocation reflects our conservative approach in the current uncertain environment. The "attractive" historic PEs of many companies does not accurately reflect the risks posed by many equity investments, due to a weak earnings outlook. We still favour quality companies with manageable gearing and strong management teams.

A large portion of the fund's interest bearing assets are still invested in cash, where the certainty of capital is preferredover the short term to the potentially higher yields offered by bonds, but where capital is at risk if yield rise. The weak macro-economic environment will put a lot of strain on the government finances and borrowings are likely to increase over the next two plus years.

Developed world markets fell during the quarter despite a significant March recovery on optimism that US plans to restore bank balance sheets could work. Bond markets meanwhile declined as yields rose, following investor concern that the massive deficit financing and burgeoning Government debt issuances will be inflationary over the long term. Interest rates in global developed economies were cut to virtually zero, and UK and USA central banks resorted unprecedentedly to money printing to encourage bank lending. Investor demand for safe haven assets pushed up the price for gold, and the US dollar.

The local share market fell during the first two months of the quarter, but a significant bear market rally in March eased some of the early quarter pains. Short-term interest rates declined by 2% during the quarter, while bond yields rose significantly. Overall economic growth in SA contracted in Q4 2008, and a similar trend into Q1 2009 is likely, driven by decreasing consumer demand and a severe manufacturing recession. However, the decline in the SA economy will be relatively muted as a result of the increased contribution from government, as well as further entrenchment of the infrastructure development program.

The South African and global markets remain in a bear market. Bear markets through the years have experienced significant rallies, and nothing we have experienced in the current environment has led us to believe that the rally in March is anything but a rally in a bear market. While sentiment may have improved in March, very little has changed in terms of the ability of corporates to improve their margins or return to profitability. Volatility will remain elevated, both in market prices but also in investor sentiment.

Cash has been increased in the portfolio through a reduction in the equity position. While yields in the money market are declining as interest rates are reduced, the safety in cash more than compensates investors for the potential of further significant declines in the equity market. It is further anticipated that the foreign allocation will be increased, especially given the recent strength of the local currency.

A volatile and emotional 2008 has come to an end with the FTSE ALSI ending December up 1.5%, but down 9% for the last quarter of the year. With a total loss of -23.3%, 2008 was one of the worst years on record for the local bourse. The local bond market in contrast, produced a positive return of 17% for the year, of which 11.3% was generated in the fourth quarter alone. The local currency depreciated against the US dollar and euro by 29% and 24% respectively, but was flat against sterling.

The Nedgroup Investments Stable Fund has an objective of producing returns of CPIX + 4% over rolling 3-year periods, while at the same time attempting to preserve capital for clients over the short term. It is pleasing to note that the fund produced a positive return of 7.5% after fees in the past year, despite 2008 having been characterised by historically high volatility and deeply negative global equity market returns.

We have maintained a large allocation to cash in the portfolio. Global and local share markets remain in a bear market phase and despite much lower share markets relative to a year ago, prices may continue to decline. However, rallies within this bear market can be expected and we will take advantage of these opportunities to rebalance the portfolio.

While we expect the bleak global economic and share market outlook to persist in 2009 due to poor earnings expectations, we have nevertheless increased the equity exposure within the foreign asset component of the portfolio. Although it is too early to expect a significant positive contribution from these changes, the outlook over the longer term is very appealing.