The South African economy realized economic growth of 3.2% during the 2nd quarter driven largely on the back of a recovery in mining output and some acceleration in agricultural output. If the primary sector was excluded, the rest of the economy growth rate slowed during this period. Manufacturing was under pressure due to slowing domestic demand and weak global economies, particularly Europe. Inventory levels to GDP is still at low levels in relation to history at around 12.5% to GDP and manufacturing utilization levels are unlikely to recover strongly in the short term. However, South Africa remains well positioned relative to the developed markets due to a strong balance sheet and its exposure to growth on the African continent. The mining sector has faced significant challenges this year and more so in the 3rd quarter. Lower commodity prices together with the impact of lower production due to strikes will impact its contribution to economic growth during this year. If this industrial action goes on for a prolonged period, the impact on economic growth will be significant. Pressure on exports due to the mining & manufacturing sectors and continued increase in imports is having an impact with our current account deficit widening during the past quarter to -6.4%. Our terms of trade continue to weaken and should trend downwards during the 2nd half. Despite the worsening of the current account deficit and negative news around the mining sector, the South African currency has remained fairly resilient which can be attributed to the net flows of close to R90bn into South African bonds by foreigners year to date. Should these flows turn negative, the currency could weaken substantially from the current levels. Inflationary pressures are expected to rise on the back of the increase in liquid and soft commodity prices and together with slower credit extension consumer spend growth is expected to moderate.

The South African equity market has continued its strong performance in 3Q12, trading relatively close to its record peak. The JSE All Share Index (ALSI) is now trading at a price-to-earnings multiple of 13.7x and a dividend yield of 3.0%. Based on these metrics, the index is fairly valued when compared to its own long-term history. Trailing twelve month resources earnings are still based on iron ore and coal prices which are roughly 25% and 15% higher than spot levels, respectively - indicating downside risk to earnings if current commodity prices and labour unrest persists. Despite the downside risk to earnings, consensus still expects ALSI EPS to grow by 13% over the next year. On the other hand, while headwinds and downside risk to the global economy persist, global equity valuations continue to trade at a discount to their long-term averages. Even though developed sovereigns face budgetary headwinds, high quality global companies have continued to consistently generate strong cash flows and strengthen their balance sheets. Given this dynamic, we continue to maintain a high off-shore allocation which consists of companies that have distinct competitive advantages, healthy balance sheets, strong cash flows and the ability to generate a higher level of sustainable Return On Equity (ROE) through the economic cycle - a strategy which we believe creates long-term shareholder value while minimizing portfolio volatility in the short to medium term.

The South African listed property market has delivered solid returns for the first three quarters of 2012 as investors continue to search for income yield. On the operational front we continue to see outperformance of premium grade properties, especially in the office market. Demand for Retail space from national food and fashion tenants remain strong and the new supply of shopping centres is low in the major cities and nodes. Industrial demand is solid for larger warehouse and logistics space while demand for manufacturing space is lagging. The current Property Unit Trust yield is 7% and the Property Loan Stock yield is 6.8% relative to the SA 10yr bond yield of 7.0% and we expect distribution growth of 5-6% per annum.

Against the backdrop of global stimulatory monetary policy, South African yields will remain lower for longer but there is still a risk of Rand weakness impacting on inflation and there could be upside surprises. Our Income portfolios are well positioned to take advantage of opportunities while remaining focused on the quality of the instruments and the cash flows of the underlying issuers.

The South African economy remains resilient but economic growth expectations are being lowered for the current year. The services sector and domestic SA was positive but growth in retail starting to slow as noted in recent months. Credit extension contracted in April, largest decline since 2008, with bank impairments also rising. This could point to slowing consumer spending for the remainder of this year. The mining sector has been mixed with production under pressure in precious metals while remaining robust in iron ore, coal and manganese. Commodity prices remain below their peak levels with significant declines noted in oil and thermal coal in recent weeks. At current Rand spot commodity prices, the mining sector should deliver decent earnings but at lower levels than 2011. The manufacturing sector realized positive growth during the first quarter but the weak global environment has seen softening starting to come through. South Africa's terms of trade has started to fall from its recent peak in 2011 as weakness in mining has impacted. Any substantial decline to terms of trade in the coming months will weaken the Rand further and impact economic growth. The fall in both liquid (oil, etc) and soft commodities (maize, etc) has eased inflation concerns with inflation anticipated to peak at a lower level this year. A Rand blowout will however drive inflation risks to the upside. Employment remains weak with some net job losses reported in recent months. Public sector remains the major driver of new employment as the likes of Eskom and Transnet spending continue to rise. Our inflexible labour regulations are unlikely to encourage the private sector to invest and hire new employees for future growth with corporate cash balances continuing to rise.

The strong equity market momentum experienced during the first three months of 2012 faded during the second quarter as the All Share index (Alsi) returned only 1.0% for the quarter, taking the total return for 2012 to 7.0%. The Alsi is currently trading at an acceptable price-to-earnings multiple of 12.4 and dividend yield of 3.0%. Based on these valuation metrics compared to the long-term averages, the market looks fairly valued. Upon analysing the current Alsi earnings level, we remain concerned that the current base is high relative to our assessed fair level. The South African market's earnings are sensitive to movements in global commodity prices and during periods of poor economic activity, lower global commodity prices lead to lower forecasted Alsi earnings. This phenomenon once again played itself out during the latter part of the second quarter which resulted in consensus downgrading their one year forward Alsi earnings expectation by 6%. As a result of the downgrades, equity performance was weak over this period.

Given the high earnings base, our equity portfolios remain defensively positioned. We maintain significant positions in consumer staples, non-resource Rand hedges and higher quality, low-cost resource producers. The quality of our equity portfolios remains very high. Based on back-testing results of the historical financial performance of the underlying companies we hold, our long-term average portfolio return on equity (ROE) is well above the long-term average ROE of the major local equity indices. In an uncertain future environment, we believe that higher quality companies are superiorly positioned relative to the average quality company and as a result we believe such superiority will translate into better relative equity performance. Over and above the high quality of our underlying holdings, our portfolio trades at attractive multiples relative to the multiples of the major local equity indices which provide us confidence of generating long-term outperformance.

There are early indications that the A Grade office property market is starting to recover with demand for A Grade space starting to improve but this appears to be at the cost of B Grade space where demand remains weak. Demand for South African Retail property space from national food and fashion tenants remain strong and on average the rental reversions on lease renewals remain positive. Industrial property rental growth is recovering and there is a clear trend in favor of larger warehouse and logistics space while demand for manufacturing space is lagging.

Following the recent moderation in South African inflation, the SARB has indicated that there is no reason for tighter monetary policy until the global economy and the EU in particular shows signs of a sustainable recovery. Although it appears that yields will remain lower for longer there is still a risk of recent Rand weakness not being fully reflected in the current inflation and there could be upside surprises if the Rand weakens further.

South Africa has evolved over the past 20 years with the economy becoming more diversified and being less reliant on historically major sectors such as mining. Importantly major service related sectors such as financial services, real estate and tourism have developed and become meaningful contributors to the economy. Financial services and tourism should continue to realize decent growth over the long term with South Africa's positioning as a financial hub to Africa becoming increasingly more relevant. Shortage of skilled labour in these areas could however hamper our pace of growth in the services sector over the next decade. Effective execution on transport infrastructure projects could help to unlock meaningful economic contributions from both the mining and manufacturing sectors. In the short term, weak demand from our developed world trading partners will impact our economy. Any significant slowdown in China (not anticipated at this stage) will also impact our mining sector and overall exports. The engine of South African economic growth over the past decade, household consumption expenditure, is expected to face some pressure in the short term due to declining real disposable income, high debt levels and high unemployment. Some reprieve will come through increased capital investment from government and public enterprises. South Africa's relatively stable financial situation could allow for more flexibility, both fiscally and through monetary policy should the need arise.

Capital markets have been quite volatile in the wake of continuing sovereign debt concerns in the developed world and hints of slowing emerging market growth. Risk aversion has continued with investors moving into safer assets, resulting in US government bond yields declining to historically low levels during 2011. At the same time, equity markets have pulled back while profitability has remained robust, leaving valuations at relatively attractive levels compared to their long-term averages. Further lending credence to our preference of equity over bonds is our view on inflation. We are of the view that while global inflation is likely to remain under control, it is still expected to be higher than historic levels given the surge in demand for food and oil related items from developing countries. Given this backdrop, we feel an overweight position in equities relative to bonds is necessary for capital preservation and wealth creation over the long-term.

Within equities, the picture is rather mixed on a regional basis. SA equities are currently trading in line with their long-term average P/E whereas global equities are trading at a significant discount to their long-term average valuations. An interesting point to note is that while the dividend yield for the ALSI and the MSCI World is similar at 2.9%, inflation in SA is 3ppts higher than global inflation (OECD) making global dividend yields relatively more attractive. During the current economic environment, we feel companies and markets which offer a high level of sustainable dividend yield are crucial for downside protection and wealth creation over the long-term. Given relative valuations, we remain convinced in our higher than average off-shore equity exposure. Not only does it provide our portfolios with a very valuable hedge against any further rand weakness but the deeply discounted valuations are likely to ensure outperformance over the long-term.

Global equity markets are likely to remain volatile in the near term given fiscal issues in the developed world. We feel investors need to look past the volatility and focus on the long-term objective of capital preservation and wealth creation. Based on current valuations, we feel equities as an asset class offer much higher relative value compared to bonds or cash holdings and should perform relatively well especially during times of high inflation. Within equities, we feel offshore markets are offering very good value relative to their own long-term history as well as when compared to the ALSI - justifying our conviction and higher than average exposure to off-shore equities. While there are obviously risks to the global economy, we remain convinced that our strategy of identifying companies which have strong competitive positions, leading market shares, strong balance sheets and the ability to generate robust cash flows through the economic cycle should ensure long-term outperformance for our portfolios.

South Africa is relatively well placed when compared to its major developed economy peers, with our debt levels and budget deficits looking much healthier. This does provide the government with some financial flexibility as noted with the infrastructure expenditure announced in the budget. While government debt levels will rise, they are not anticipated to go above 40% of GDP over the next 2-3 years. The tough global economic environment will however, constrain economic growth in the short term with our export related sectors anticipated to bear the brunt of this. The mining sector is mixed with production growth in commodities such as iron ore, manganese & coal expected to deliver some volume growth while precious metals appear to be facing production pressures. However, recent weakness in the Chinese economy could put pressure on commodity prices, impacting the mining sectors contribution to GDP negatively. Weakness in the Rand may assist in reducing the impact. The South African consumer appears financially stable with debt levels having declined slightly during the last quarter while debt services costs are close to historical lows and unlikely to increase significantly in the short term. Taking the above factors into account, economic growth for 2012 is therefore anticipated to be lower than last year at around 2.7%.

Global equity markets have had a strong start to the year as positive economic data out of the US and continued liquidity injection in developed markets has reduced risk aversion quite substantially. With investors focusing on riskier assets, we did see US bond yields moving higher from their historically low levels. However, despite that move, equity risk premium has remained at elevated levels relative to their long-term average indicating the relatively superior value being offered by equities relative to bonds. On the domestic equity side, forward earning expectations have been reduced by 15% over the last three months; in line with our thesis that consensus numbers looked relatively high at the beginning of the year and were mostly being driven by higher commodity prices. With the All Share Index now trading at a forward P/E of 11.5x (in line with its long-term average), we feel there is not substantial value in domestic equities and have thus continued to favour a defensive positioning in our portfolios.

Our current portfolio has close to the maximum exposure to for offshore allocation due to the better relative value of developed market equities and property. In South African equities, our portfolio is dominated by attractively priced, low cost commodity producers and high quality consumer staples. The lowest cost mining houses should continue to be profitable in the event of a large correction in commodity prices while the inelastic behaviour inherent in select consumer staple brands remain attractive to us in the current uncertain economic environment. On the global side, earnings downgrades have not been as severe and with the MSCI World Index trading at a forward earnings multiple of 11.8x relative to its long-term average of 17x, the market still seems to be offering value from a long-term perspective. Investors seem to be pricing in a significant cut-back in earnings which we feel is unlikely unless we hit a full blown global recession. Consequently, we continue to believe that global equities are offering much higher relative value compared to their domestic peers and have thus maintained our higher than average exposure to global equities.

The South African economy grew faster than expected during the first quarter of 2011, growing at an annualised rate of around 4.8%. This was largely attributed to the rise in manufacturing output, the increase in non-gold mining contribution from rising prices and increased consumer spending on durable and non-durable goods. While the growth was better than expected, the South African economy does face several challenges in the year ahead. Excluding the motor vehicles and the chemicals segments of the manufacturing sector, the broad part of the manufacturing sector remains under pressure. The continued strength of the Rand and muted global demand does make export related growth challenging while increasing imports have placed pressure on domestic profitability. The mining sector has benefitted significantly from the meteoric rise in China with high commodity prices and rising volumes driving non-gold mining growth over the past year. In the short term, with China aggressively raising interest rates to combat inflation, there is a risk that commodity prices could decline from current levels in the year ahead. After declining significantly over the past 2 years, real fixed capital formation grew this year as public corporations in particular increased capital investment. Consumers spending remained robust with the increase in real disposable income experienced during the past year having been the major driver. High debt levels, particularly among the higher LSM groups, together with increased inflation, will however constain the level of consumption expenditure in the short to medium term.

SA equities have had a decent run over the last two years. However, despite the strong performance, record low interest rates and high inflationary expectations have continued to make equities look attractive as an asset class. Both domestic and global equities seem to be offering more relative value when comparing them to their respective bond markets and money market rates. Equities have historically outperformed bonds and properties during inflationary time periods. Consequently, we continue to favour a high equity exposure within our balanced portfolios. Within equities, there has been a significant divergence in valuations between domestic and global equities. The tide of emerging market (EM) fund flows over the last few years has left valuations in EM (including South Africa) stretched relative to their own history and even more so when compared to developed markets. While global equities have outperformed YTD, they still seem to be offering a lot more relative value compared to South Africa and other emerging markets. We have taken advantage of the underperforming developed market equities to continue increasing our exposure to high quality stocks within developed markets which are trading significantly below their historic valuations. While our higher global equity exposure has hurt us in the short-term because of the stronger rand and the unsustainably high flow of funds into emerging markets, we remain convinced that attractive valuations and the high quality stocks that we hold in our balanced portfolios should allow for longer-term outperformance as economic conditions normalize. Our view is further strengthened by the earnings revisions that have been coming through over the last three months. Earnings growth expectations in emerging markets including South Africa seem to have been unrealistically high - which are now being revised downwards. At the same time, it seems that the health and profitability of the US corporate sector had been underestimated which is now surprising on the upside. These earnings revisions are likely to bode favourably for our balanced portfolios which have a higher than average exposure to global developed market equities.

Our South African and global equity exposure has continued to focus on high quality companies which are market leaders within their respective industries and thus have pricing power to offset inflationary pressures. The strong market position these companies have within the areas they operate in provides them a higher level of sustainable ROE through the economic cycle while providing downside protection during times of increased market volatility or downturns.