The euphoria continues
The equity market rally continued unabated during September and investors experienced the strongest third quarter rally in ten years. Emerging markets delivered a total return of 21% for the third quarter while the developed markets gained 17.6%.

The performance differential between Emerging Markets and Developed Markets continued to widen, year to date, with a region like Latin America delivering 81% so far this year.

The rand remains the second best performing currency globally this year relative to the US dollar with a gain of 25%. This has clearly detracted significantly from year-to-date total returns in rands. What is interesting to note though, is the rand's performance is not out of sync with that of other commodityexporting economies, considering that the Australian dollar and the New Zealand dollar are the third and fourth best performing currencies, having appreciated by 25.3% and 23.3% respectively.

Risk taking has increased significantly during the last few months and the business and Consumer Confidence Index has recovered from its low of 25 in February this year to its current levels of 53 - still off its high of 112 reached in 2007. The volatility index is still sitting at pre-Lehman Brother levels and credit spreads have narrowed across the debt spectrum.
Commodity prices as reflected by the Economist Metals Index which has rallied 22% between June and the beginning of September, after which it has drifted backwards to end the third quarter with a return of 15%. This index has recovered roughly 70% off its lows reached at the end of February this year.

Global leading indicators are pointing to a recovery back to marginally positive economic growth in the not-so-distant future. This recovery will largely be driven by a very low base off which the developed economies will recover as the restocking cycle evolves.

The future of the unemployed and their impact on the US economic recovery remains the key question and unfortunately only time will tell how this unfolds. More than seven million jobs have been lost during this economic downturn and the unemployment rate is sitting at almost 10%. The more complete measure of unemployment - including people that have been out of a job for more than six months - is sitting close to 20%.

The recovery in employment always lags the recovery in the broader economy and the key for firms would be to ascertain how sustainable the recovery actually is. The recovery in the US economy remains dependent on the financial condition of the US consumer. A jobless recovery with concomitant pressures on income growth could therefore result in a very slow recovery over the next few years. Given the state of consumers' balance sheets and the impact of the wealth destruction on psyche, we view the US government's effort to revive the economy with more debt as a rather futile exercise.

This is unlikely to derail the equity markets in the short term as low interest rates and unattractive returns on interest bearing asset classes such as cash and US Treasuries is forcing investors into more risky asset classes

Outlook for the remainder of 2009
The market low reached in March 2009 was pricing in a catastrophic outcome, however, it was not a view we were willing sharers of. The S&P500 price relative to its ten year average earnings reached a level reflective of a very depressed view of sustainable growth in profits (although not quite as severe as the levels reached in the 1930s and 1970s). In addition a wave of liquidity was in the process of being systematically dumped onto the world economy by central banks of both developed and emerging markets.

The recent market rally, therefore, has been valuation and liquidity fuelled; the ideal concoction for spectacular dollar based returns. Developed markets have subsequently delivered a total return of 42% over the second and third quarter of 2009.

We are getting more cautious on equities given the returns we have seen thus far and also the optimism that has crept back into the market. Equity prices seldom go up in a straight line and given our priority of preserving capital, we prefer to take a 'sell' cue when valuations portray a high risk of permanent capital and/or very low future returns.

The S&P500 is trading 17% above its twelve month moving average. Historically sharp rallies such as this have been unsustainable and resulted in very poor multi-year returns.

The problem arises when comparing valuations between asset classes. Cash yields are currently very low. Bond returns globally have been poor since March, as the catastrophe that was implied in a 2% US Treasury yield did not unfold. The US long bond yield has subsequently increased back to 3.5% and the market's focus has shifted towards funding concerns of sky-rocketing budget deficits. Investors are starting to demand higher interest rates to fund the twelve digit deficits of various developed countries. We think these concerns are valid and the margin of safety in US Treasuries are very low.

We believe that equities can deliver competitive returns relative to other asset classes, but it becomes very important which managers you own. Investment managers with a value based process, long track records of prudent capital allocation and good stock selection will add tremendous value in the type of markets we expect going forward. We would be looking to allocate more of your capital to such managers.

Furthermore, we would be looking to allocate some capital to alternative asset classes such that have shown low correlations with other asset classes over long periods of time.

As we know, a rising tide lifts all boates and therefore as sentiment and hype subsides, we believe fundamental based investment managers, will once again deliver superior returns. We are confident that our own investment process can help in the selection of such managers.

June has been a slightly disappointing month for world equity markets with small declines of -0.4% and -1.5% for developed and developing markets (in USD) respectively. However, second quarter (Q2) and first half (H1) returns have been significantly better for developed markets with +21% (Q2) and +6.8% (H1). Emerging markets returns have been even better returning +33.6% (Q2) and +34.3% (H1).

Although the markets may appear to have stabilised somewhat, most asset managers are hesitant to say that we have definitely seen the bottom. The stability in the markets is reflected in the VIX Volatility Index which fell as low as 25% near the end of June - a level which has not been seen since before Lehman Brothers filed for bankruptcy on 15 September 2008.

The recovery in the oil price also reflects investor's more positive sentiment with Brent crude reaching an eight month high of US$70 at the end of June.

The real economy unfortunately is not as positive as the markets and continues to decline. June is the 18th consecutive monthly decline in the US, with the unemployment rate rising marginally to 9.5% from 9.4% in May. Even though the market was expecting 9.6%, this is still the highest unemployment rate recorded in the US since 1983, and will get worse in the shorter-term.

Employment data, however, is a lagging economic indicator. Importantly, the weekly jobless claims look better, and some key US leading indicators (US ISM manufacturing index) have improved in the past few months, suggesting that the economy is moving past the worst of the decline.

The big question is: Have the markets run away with themselves over the short-term, given the continued worsening of the economy, albeit at a slowing pace?

We believe the market has run very hard over the short-term and given the rapidly reduced value gaps based on normalised earnings, the market in general is vulnerable to a correction. In this regard, during June, we lowered our equity allocation from our neutral weighting of 50% to 40%.

Having said this, however, we acknowledge that the immeasurable element of sentiment will determine the direction of the market over the near-term and consequently, we will look to reintroduce equity exposure into any market weakness.

During June US treasury yields peaked with the 10-year US Government bond reaching 3.95% with markets becoming complacent towards risk, bond yields obviously rose but in June, risk appetite has waned somewhat and treasury yields are gain migrating down (end June at 3.5%).

For June the rand was the third best performing currency that we monitored against the dollar, it remains the best performing for Q2 and H1 2009, the appreciation has been 22.1% and 21.5% respectively. As a result, the 3 month rand based returns of global assets have been very poor despite the strong global equity markets and relatively stable global bond markets. In rand terms, global equities have delivered a return of - 2.45%, global bonds -17.04% and global cash ranging between -19% to -7%.

Therefore, the typical flexible/balanced fund has declined by -5.5% (Morningstar average ZA Foreign AA Flexible Sector) over this period, with the more conservatively funds worse off due to their higher cash holdings.

Our star equity performers over Q2 have been the Ashburton Asia Pacific and Ashburton European funds returning 8.2% and 0.3% in rands respectively.

As stated above, we have reduced our equity weighting by 10% to 40% which has been fortuitous, although over the long-term we remain convinced that stocks will prove the asset class of choice for investors. The fund's global government bond exposure remains at under-weight levels in favour of selective holdings in higher yielding assets. From a capital preservation perspective, the cash holding remains over-weight despite low yields. Unit holders have the benefit of exposure to a wide range of currencies via Investec GSF Managed Currency team who are seeking to add value in the short-dated fixed income space.

Over the last month, equity markets have rallied finishing between 7% and 17% up across the globe. The start of the year however was very poor with global equity markets selling off aggressively. As a result, returns for the quarter (Q109) have been disappointing. The only index posting a positive return was the MSCI Emerging Market Index which ended 0.52% up. The JSE All Share Index has fared relatively well with a loss of only -4.7%. Of the major indices, the Dax was the poorest performer down -19.8% for the quarter followed by the Cac 40 (-17.6%) and the Nikkei down -16.0%. The Toronto 300 experienced a minor loss of -6.0% vs. the S&P 500 (-11.7%) which performed in-line with the MSCI Global Index (-11.8%).

After the last quarter's (Q408) powerful rally in global bonds (+11.2%), fortunes have waned leaving the Global Bond Index down -4.8% for the quarter despite the 2.4% March up-tick. Emerging market bonds posted a healthy 2.5% return for the quarter in contrast to Japanese bonds (last year's strong performer) which ended down - 6.2%, UK bonds down -3.1% and the South African All Bond Index down -5.6%. US Bonds also ended the quarter weaker, down a marginal -1.4%.

Global asset returns continue to be heavily influenced by global currency translations which remain volatile. Over the 6 year period (2002 to 2008) the US$ Index experienced a 7.5% annualised decline, however during the height of the latest financial crisis the dollar staged a powerful comeback.

During the latest 8 month period the dollar has gained 40% vs. the pound (erasing the 6 years of losses), appreciated 18% against the euro and made substantial gains of between 20% and 40% against all other global currencies. The two exceptional currencies are the Chinese yuan (which has tracked the dollar since July 08) and the Japanese yen which has continued to make choppy gains against the dollar.

Holdings which have fared well during these difficult market conditions are: the Sarasin EquiSar CI Dollar Fund which out-performed global equities over the last quarter. Other holdings which fared well during the last 3 months of dollar strength and poor global bonds markets include the Investec GSF Managed Currency and Investec GSF Global High Income Bond Funds.

The PSG Alphen Foreign Flexible Fund of Funds portfolio remains neutrally positioned with a global equity exposure of 48% (increased from the 32% level in July last year). We remain overweight cash at a level of 36% vs. the strategic level of 15% and under-weight bonds 16% vs. the strategic level of 35%.

We continue to look for underlying managers who we believe offer the prospect of out-performing the market over the medium to long-term. In addition we continue to seek opportunities to add value through marginal tactical asset allocation tilts around our strategic benchmark levels.

Alphen Multi-Management

Stages to this economic fall-out were always likely to unfold, albeit that they would not necessarily follow a highly predictable path.

In past notes we mentioned that bursting asset bubbles would precipitate deleveraging, extreme investor pessimism, credit squeezes, collaborative government re-flation exercises, higher unemployment levels, escalating corporate bankruptcies and thereafter a protracted period of below trend economic growth.

As expected many of these phases or cycles occur concurrently but 'leads' and 'lags' across varying markets and varying asset classes are inevitable. Presently, as an example of asset class performance divergences, property remains under negative price pressure with month on month declines particularly in the residential space. On the other-hand, equity markets fell heavily in 2008 and although we have been left with a high degree of volatility, monthly declines have waned and global markets are well off the lows that were posted in late 2008. Fortunately, until now, we have yet to test these again.

As far as the credit squeeze is concerned, here too debt markets are slowly loosening-up and whilst still being abnormal, are showing signs of a modest recovery. The Lehman-type credit squeeze is now notably absent from daily headlines and a new focus on unemployment and corporate failures is evident. The credit issue can, however, resurface at any point in time and the importance of credit as the cornerstone to every-day business operations, to international trade and to the overall smooth functioning of an economy cannot be overestimated. This is why liquidity injections were the first tool used by central banks in an attempt to rehabilitate markets.

As mentioned above, rising unemployment and corporate bankruptcies are the new market focus; in our opinion these concerns were likely to represent the latter half of the economic collapse. Along with this, we have seen an implosion in global industrial production and severe collapses in US and European retail sales, Japanese machinery orders, Asian shipping orders, Chinese vehicle sales and many other important economic indicators. The credit and asset crisis is now firmly embedded within the real economy and affecting everyday business activity and the economic well-being of millions around the world. Predicting the bottom of the economic fall-out is impossible, but it is worth mentioning that the speed and voracity of the declines in economic activity could assist in creating a base earlier than later and we are already seeing tentative signs that certain OECD leading indicators are bottoming or even turning higher.

Our funds had an excellent December buoyed by rising markets in all geographic regions. Certain of our underlying equity managers came close to producing double digit returns in the month assisted by the Dax which gained 13.6%, the Nikkei 10.1% and emerging markets 7.6% in dollar terms.

Further pound weakness (the pound fell 26.5% against the dollar in 2008, it was the worst performing developed market currency and one of the worst overall performers for the year) meant that returns in sterling terms even exceeded those of the dollar, implying an exceptional month for sterling investors invested in non UK investment locations.

An interesting angle to the equity gains in December was that bond markets rallied simultaneously. Considering bonds have been the deflation proxy trade and equities are not normally regarded as beneficiaries of deflation, this coincident rally might have been purely a relief rally on the part of equities off an extremely low base. Alternatively, if equities maintain momentum, deflation perceptions will likely be faltering, this should cause bonds to sell-off. The point is that the further collective rallying of these two asset classes is improbable as the economic tailwinds of the one are the headwinds of the other - namely a global economic slowdown and concomitant deflation.

Looking back at the year, equities performed shockingly with the MSCI Global Index down 42% in dollar terms and 20% in sterling terms. Developed markets held-up better than emerging markets which fell heavily in sync with other risky or cyclical asset classes such as commodities. Corporate debt also had a terrible year as the prospects for failures forced yields higher. Government bonds on the other hand, supposedly the safe-haven and deflation proxy trade provided staggering returns in 2008. These returns were predominantly driven by the gains from developed markets, particularly the 14.3% and 28% returns enjoyed in US and Japanese government debt.

At Alphen, we are well aware of poor market sentiment as well as a very bleak economic back-drop; these factors are conspiring to negate equity returns. Increasing global liquidity, which conventionally would push markets higher, is presently not filtering its way to consumers and is instead being trapped at banks. Whilst liquidity tailwinds are building, they are not firmly in place and thus not presently propelling markets.

Against this, equity valuations are incredibly low and given enough time, should provide for outstanding returns; also, it is easy to argue that the collapse seen in economic indicators has been so violent that we are at or near the trough and a bottoming cannot be far off. Currently we view positive and negative factors as equally poised.

In response to this tricky environment, we have decided to maintain equity exposure at benchmark levels but have introduced a new manager that we hope will offer upside should markets rally. We have remained underweight bonds and overweight cash and feel comfortable with this at present but will be watching for any serious market weakness to raise equity exposure. We are unlikely to accumulate bonds without meaningful gains in yields and cash remains a poor return, but default asset class in a world short of alternatives.



Mark Seymour