Monetary policy has entered different phases globally. The biggest shift has been in the US where interest rates were put on hold at 5.25% during the quarter. This was in sharp contrast to the 0.25% increases implemented at every Fed meeting since June 2004. International equity and bond markets responded to lower oil prices and the waning expectation of further rate hikes and inflation, particularly in the US, by steadily climbing throughout the quarter. Emerging markets kept pace with the MSCI World Index for the past quarter after a sharp retreat earlier in the year and have outshone developed markets for the past 12 months. As far as developed markets were concerned, Europe continued to fare well, followed by solid numbers from the US. The UK market showed muted returns and Japan performed in line with the MSCI World Index. However, returns were generally positive and, given the weaker SA exchange rate, local investors with foreign equity holdings fared better offshore than at home.

The key risks to the global equity markets include a renewed build-up of inflationary fears and a significant economic slowdown as opposed to the hopedfor soft landing. We maintain a fairly neutral position in equities, with a slight preference towards developed markets and larger-cap shares at present. The position in large-cap shares was increased during the quarter.

The other significant change during the quarter was to adopt a neutral stance in bonds, from a previously underweight position, which benefited the fund. The position in property also continued to add value, as well as offered diversification benefits. In the cash portion of the portfolio we have favoured the euro and Sterling.

Further tightening in liquidity, rising risk aversion and credibility issues surrounding the new governor of the Fed fuelled investor uncertainty, leading to a sharp pullback in global equity and bond markets towards quarter-end. The swing in sentiment was largely lead by growing concerns that the Fed would continue hiking rates beyond the 5.25%, their highest level in 5 years. This was due to the more hawkish tone of the Fed's recent statement. Other central banks followed suit, with the European Central Bank hiking rates by another 25bp while the quantitative easing in monetary policy in Japan has come to an end. In contrast, rates remained on hold in the UK where growth concerns dominate.

Although the MSCI World Index declined by only 1.1% in dollar terms, this masks diverse equity returns with emerging markets particularly hard hit in the flight from risky assets. In developed markets, Japanese equities fared badly with a 9.1% drop in dollar terms as the quantitative easing in monetary policy drew to a close. The US weathered the storm better with the S&P 500 Index down only 1.9%. The European markets were positive in dollar terms due to a strong euro.

Following a brief rally during the quarter global bond yields kicked up on the back of the rise in short rates, producing negative returns. In the US rates rose by 30bp to reach 5.19% by the end of the quarter. Similar rises where seen in Europe and Japan.
Shifts in interest rate expectations between the US and Eurozone resulted in sharp gyrations in the dollar. The dollar declined by 6% against the euro to 1.29 before staging a recovery on the back of the rate hike to end the quarter at 1.27. This trend was also reflected against the yen.

With the equity market less heated, conditions have actually improved with global valuations at attractive levels. Overall, at this stage we would caution on turning too bearish on equities but rather to see the recent pullback as a sign of a maturing bull market. Bonds are starting to look interesting given the recent pullback and opportunities to add will be considered where appropriate.

The fund remains conservatively positioned. During the quarter we diversified the fund's assets by adding global property exposure through the highly regarded Sarasin CI Global Property Fund.

Despite a more volatile start to the year, world equity markets ended the quarter on a positive note, with several indices reaching five-year highs (such as the US and UK markets). Developed markets, while still outshone by emerging equity markets in general, delivered a solid performance. The German equity market reached an all-time high in March.

Global bonds generally produced negative returns, with interest rates reflecting the first signs of liquidity tightening seen in years.

This took place against a backdrop of continued growth in corporate profits, a higher oil price and surging precious metal prices. Other commodities, notably the softer ones such as agricultural commodities, put in a more muted performance, moving sideways throughout the quarter, while base-metal prices soared. Softer commodities have however started the second quarter on a more positive note.

There are a few reasons to be cautious at this point when reviewing the outlook for global markets. We have probably seen the low point in global interest rates for some time to come. This is likely to place a dampener on both equity and bond markets. The good earnings season recently experienced, particularly in the US, may be the best we’re going to see this year relative to expectations. While equity market valuations remain reasonable given expectations for growth, there is not much room for disappointment. Lower than expected earnings numbers are unlikely just to be shrugged off. Finally, while a small measure of risk aversion returned to the minds of investors at the start of 2006, the appetite for risk generally remains high, bringing with it increased levels of speculation and corporate activity.

The fund has maintained a moderate exposure to equities. During the past quarter exposure to a high-alpha equity manager with higher exposure to developing markets was added to the fund. A flexible bond mandate was also added in order to facilitate the tactical allocation between global bonds and cash.

After a welcome retreat in the early part of the fourth quarter, global equity markets continued their positive trend throughout the rest of the year. Investors continued to direct funds towards areas perceived to offer better growth prospects. As a result, emerging markets continued to outperform developed markets, a trend now in place for over four years. The Morgan Stanley Emerging Markets Free Index out-performed the general global index by nearly 4% over the quarter. Among developed markets Japan continued to perform well. The Nikkei Dow Index was up 13% (in US$) over the quarter, almost 10% more than world markets in general.

As we enter the first quarter of 2006, talk of the US Federal Reserve nearing a peak in short-term rates in the US has been the catalyst that has propelled markets higher in the first trading days of the new year. However, current economic data from the US suggests there is no immediate reason for the Fed to stop raising rates. Bond rates internationally have behaved well, with the long-feared sell-off in US bonds not materialising… as yet.

Sounds too good to be true? There are some risks. Earnings growth has been good and multiples are reasonable given current interest rates. There is uncertainty as to how far the Fed will raise rates. If one assumes that the US economy will continue to grow in 2006, even if this is at a slower pace than in 2005, the equity market looks relatively attractive. We do not know how the Fed will act, but one could surmise that they will not want to be responsible for causing a recession. In Japan, the risk of their government making a policy mistake that can spoil the long-awaited recovery remains real. However, the prospects for world growth, in general, continue to be good for the longer term and any temporary setback could be regarded as a tactical buying opportunity.

The strength of the dollar in 2005 surprised many investors. The consensus view is that the greenback will depreciate once interest rates in the US have peaked.

Unfortunately, consensus is rarely proved right in financial markets. It is likely that the lack of a credible alternative to the dollar has assisted the rally in the gold price in 2005. To conclude, we see a positive outlook for world growth and reasonable value in world markets given the current level of interest rates.

This fund has enjoyed the benefits of being nearly two-thirds invested in global equities. In order to manage the risks inherent in global investment markets, we recently added a global asset allocation fund. This means that the manager of that underlying fund will actively take tactical asset allocation decisions that should benefit the fund, without the overall fund having to implement switches between funds in different asset classes.