Markets received a huge boost on the back of Ben Bernanke's (chairman of the US Federal Reserve) commitment to flood the US and global economies with liquidity by way of a second round of "quantitative easing", (if and when required). The result has been a further drop in global bond yields, emerging market currency strength and explosive equity returns.

Against this backdrop, PSG Optimal Income remains light in bonds as the potential for capital loss continues to increase. Although inflation is not an immediate threat, it looks like we are close to an inflation bottom and any rate cuts from current levels will probably be a risky move by the South African Reserve Bank.

One should be careful not to extrapolate current low levels of interest rates based on the short-term dissipation of inflation fears - South Africa remains a price taker when it comes to hard and soft commodity prices which both have a direct impact on local inflation. In this regard we believe it is an opportune time to start looking at potential inflation hedges such as inflation-linked bonds within the portfolio.

With that being said, interest rates remain low in South Africa, stock ratings are likely to remain well supported, and the yields on lower risk asset classes will remain relatively unattractive. If the rating on stocks remains stable, average growth in company profits will deliver low but positive returns. However, it is worth remembering that domestic interest rates are at 30 year lows.

Monetary policy around the world is extremely accommodative. This inevitably results in pockets of exuberance and hence demand for emerging market equities is currently very healthy. It is our view that the valuations of many domestic industrial stocks are factoring in even lower interest rates. We are not sure what will trigger a change in sentiment, but in the absence of a margin of safety we are cautious on the medium term returns that can be achieved by currently in-favour domestic stocks. Equities seldom deliver positive real returns when interest rates are rising and interest rates are currently low.

Now is not the time to be chasing stocks expecting a re-rating on the back of further ratecuts. Instead, we would advocate careful stock selection and a strong focus on margin of safety which is what is being carried out within the PSG Optimal Income portfolio.

The PSG Alphen Optimal Income Fund will change it's name to PSG Optimal Income Fund, effective from 1 September 2010

Equity markets have enjoyed healthy gains since their lows in March last year. The All Share Index (excluding dividends) has appreciated 44.9% and was up an impressive 63.2% as of the 15th of April (2½ months ago). In dollar terms global equities has done spectacularly well with a 51.2% return however the 38.5% strengthening of the rand has resulted in a neutered 9.8% return for rand investors.

Despite the recent market pullback, local equity remains marginally expensive on a trailing price to earnings multiple of 16.1 and dividend yield of 2.4%. Earnings, however, are expected to rebound which will underpin valuations should prices remain at current levels or drift lower.

The latest bout of market weakness brings the local index to a level last seen 9½ months ago and the MSCI global index to a level last seen 10½ months ago. A major contributing factor to the recent equity market weakness has been the unfolding of the European debt crisis which was triggered by the surfacing of previously unaccounted for Greek debt in November last year. This resulted in the downgrading of Greece's debt which then snowballed into the "2010 Euro Crisis" also known as the "Aegean Contagion" resulting in widening bond yield spreads and risk insurance on credit default swaps for Greece, Portugal and Spain vs. other well positioned European union members such as Germany.

Austerity measures have been put into place to tackle the issue and authorities (although slow to respond) have banded together in terms of providing a "rescue package" however the overriding reality is that growth will be negatively impacted.

Local bonds delivered no return during 2009, however, as growth concerns have resurfaced, yields have taken another leg down (9.3% to 9.1%) on the back of a healthy 5.2% price appreciation on the All Bond Index over the last 6 months. As of late the market is pricing in a probability in excess of 50% for a further rate cut when the monetary policy committee next meet on the 22nd July.

The rand remains volatile but range bound (vs. the US dollar), fluctuating between the levels of R7.25 and R8 over the last year (currently R7.67 per dollar). When compared to the pound and euro, however, the rand has realised sizable gains of 12.9% and 17.3% respectively as a result of waned confidence in the euro zone.

Looking ahead, we will continue to see a recovery in global growth but expectations are being subtly adjusted downwards and this is feeding through to asset prices. Domestic interest rates are at, or close to the bottom and any upward movement in interest rates will likely have a negative impact on stock ratings. This would be no different to anything we have experienced in the past. The only problem is that thus far we have relied mainly on a market rerating for stock performance and very little support has come from earnings growth. When the de-rating arrives we doubt that the earnings cycle will be strong enough to sustain recent stock returns, especially in inflation-adjusted terms. Under these conditions and at this point in the rate cycle, cash becomes an attractive asset despite its low current yields.

The domestic stock market put in a strong performance during March. The FTSE/JSE All Share Index (ALSI) ended March at a 21-month high and a level of 28747. The recovery in stock prices since the lows of just over a year ago that coincided with the banking crisis have been nothing short of astounding - the ALSI is 62% off its lows and a mammoth 137% when expressed in US dollar terms. Recent economic data from around the world has become increasingly positive and further improvement is likely to continue to underpin the rally.

However, given the strong equity market returns it is clear that many stocks are starting to discount a very good earnings outcome over the next few years and risk premiums are in many cases very low. In light of these conditions we have reduced the net equity portion within the fund from the mid-teen levels last year to a current weighting of 5.8% relative to a neutral benchmark weighting of 10%.

Interest rates look to remain low for the following 12 months on the back of an improved inflation outlook over the short term, which has set a positive tone for asset classes trading on yields higher than short-term cash. This includes bonds, with the All Bond Index rallying 4.5% over the last quarter, listed property rallying 6.7% and preference shares up 5.5%. The question is, are current yields compensating investors sufficiently over the longer-term, given the view that we are at the bottom of the interest rate cycle? We would prefer higher yields and as such we can be expected to hold under-weight exposures in bonds, listed property and preference shares through the next phase of rising interest rates.

It is worth reiterating the focus of this fund, which is to deliver tax efficient income for investors with a low tolerance for capital loss. In addition, we are mindful of the need to deliver real returns for investors who do not require income. To achieve this objective we look to structure the portfolio around a strategic benchmark which is comprised of 50% hedged equity, 20% bonds, 5% listed property, 5% preference shares, 10% equity and 10% liquid cash. Over-time these weightings can be expected to deviate from benchmark levels as a result of fluctuating relative valuations between asset classes and opportunities which present themselves from time to time.

This strategy has rewarded unit-holders over the last year with a pre-tax total return of 12.1% and post-tax return of 9.7%. Although returns were enhanced by underlying assets realising capital gains, the pre & post tax yields were also favourable with 8.2% and 5.9% respectively compared to cash's pre & post tax yield of 7.2% and 4.3% (tax rate of 40%). With yields having dropped significantly and valuations on non cash assets having waned somewhat, last year's performance can be regarded as exceptional. Therefore investor expectations of similar returns need to be moderated over the next few years. We do however continue to seek out new opportunities as and when they inevitably present themselves.

Despite the bumpy ride we experienced initially in 2009, Alphen remained very optimistic that the valuation levels in the market towards the end of the first quarter in 2009 would eventually arrest the implosion in equity prices that started in mid- 2008. Needless to say our portfolios were all positioned accordingly and fortunately our clients have enjoyed a stellar year with respect to investment performance. Investors have entered 2010 on a completely different tone. The global media is swamped with positive news about the synchronised global recovery and the resultant uplift in earnings, the complete opposite of 2009 when gloom and doom reigned. Not dissimilar to the euphoria that prevailed in early 2008, China is once again leading the way on the commodities front with its almost insatiable demand for raw materials and consequently, commodity currencies and commodity markets are firmly in vogue. By extension, emerging financial markets have continued with their star performances relative to their developed peers as their economies are in much better shape and likely to stay that way for quite some time. What concerns us this year as against last year however, are the high valuation levels of various markets across the globe. Companies are no longer priced for Armageddon as was the case in late 2008-early 2009, which made stock selection much easier. Earnings yields of many companies are not looking that attractively priced relative to bond yields and cash yields anymore. In 2008, we found companies that that we purchased at or below the value of their assets, now many of these same companies trade at almost double those levels. Our view is that the margin of safety in equities for most of the market has largely disappeared. With this in mind, we firmly believe that once investors start paying for growth, the risk of capital loss increases significantly. Capital preservation for us is a key component of our investment philosophy and we therefore deem it prudent to take money off the table as the market moves higher. We have reduced the equity exposure in the fund to less than 10%. This compares to an equity allocation of 20% which was held in March 2009. Bonds are fairly priced given the level of interest rates in South Africa. A lot has been said about a potential adjustment of the South African Reserve Bank's inflation-targeting mandate, to incorporate other economic factors as well. Thus far it has only been speculation and given the status quo, we maintain our view that interest rates are likely to stay on hold for at least six months, before they start moving up again. The impact of the very aggressive rate cuts between 2008 and 2009 will start impacting the real economy positively in the first half of this year and based on this could act against the performance of longer dated SA bonds. We favour cash over bonds and also continue to look for an entry point into inflation linked bonds. Contrary to the consensus view, we believe that the inflation threat is likely to come from emerging markets such as China and not as a result of rising money supply in developed markets. Although inflation globally thus far has largely been an asset price phenomenon, the most likely inflation risk which South Africa faces could in fact again emerge in soft or agricultural commodities. We are cautious as against being overwhelmingly negative on equities at present and we are aware that markets can indeed move higher in 2010. Our concern is that this could be for the wrong reasons. The extreme stimulus measures that have been implemented in recent years by Central Banks across the globe are likely to overstay their welcome and will be supportive of equity prices. The more realistic growth paths for individual countries will unfortunately only be witnessed with hind sight, once these artificial stimuli disappear. Our objective as always is to own the right stocks for the right reasons and at the right valuations, and to keep some powder dry when mouth watering opportunities come to the fore again; and they will.

Neels van Schaik and Adrian Clayton

PSG have decided to leave the PSG in front of the Alphen funds' names.

Alphen Asset Management have changed the names of all of their funds by removing PSG from the front of their fund names.