Global equities disappointed over the quarter, yielding 2% in USDs and -0.5% in rands. The pedestrian returns were due to a sharp rise in credit spreads following the sub-prime blowout and concerns that the credit freeze would drive the US economy into recession. Following the US Fed's 50 basis point rate cut in September, global equities surged towards quarter end. With a further rate cut expected before year end, equities are likely to continue.

Global bonds handsomely outperformed global equities over the quarter, yielding a return of 7.2% in USDs and 4.6% in rands. The rally in bonds was sparked by concerns that the US would head into recession following the fallout in the sub-prime market. The bigger than expected cut in the Fed funds rate also helped push yields lower, as did benign readings of inflation. During the previous quarter we commented that we "await an opportune time to increase the bond weighting". That opportunity did arise and we added to the position in global bonds, but have subsequently reduced the position again.

The current positioning of the fund with an overweight in global equities and a neutral position in global bonds paid off during the quarter. The Global Property Fund showed a welcome recovery and the increased position in bonds added to returns.

Global equities returned 5.8% (in USDs) over the quarter, handsomely outperforming the -1.7% yielded by bonds. The improved visibility in the global growth outlook and the rebound in US leading economic indicators were all generally supportive of equities. While US growth will still fall short of trend growth this year at around 2.2%, the re-synchronisation of the US with the global economy will have positive spin-offs for Japan and the rest of Asia. The normalisation in yield curves, in particular the US, reflects the improved visibility in growth and the risk of higher inflation going forward.

Global bonds were the worst performing asset class over the past quarter, yielding a rand return of -5.1% and a USD return of -1.7%. The broad-based rise in bond yields globally was due to the improved outlook for global growth, coupled with widening credit spreads on the back of debt defaults in the US sub-prime lending market. With US leading indicators of economic activity beating the street and industry surveys of input costs continuing to push higher, inflationary concerns were elevated across the globe. Although we believe the US interest rate cycle has peaked, further interest rate increases are expected from the BOJ and ECB this year, supporting our underweight recommendation in bonds. Furthermore, with the US only likely to start reducing interest rates early next year, we envisage upweighting bonds only later in the year.

The current positioning of the fund with an overweight position in global equities and an underweight position in global bonds, continued to pay off during the quarter. The only significant change during the quarter was to reduce the exposure to global property due to our assessment that the cycle is now quite mature, and while it still offers opportunity and diversification, returns have been harmed by rising bond yields, and a reduction benefited the fund. The cash weighting was increased as a result, and we await an opportune time to increase the bond weighting.

Global equities yielded 2.1% in USD terms over the past quarter, significantly lower than the 8.0% reported during the forth quarter of 2006. The disappointing relative performance can be attributed to slowing earnings growth, mixed economic data releases and heightened market volatility. Although valuation metrics remain positive, with the Fed funds futures supportive of equities, slowing earnings momentum on the back of slowing growth will limit the upside to equities in the year ahead. While this view is at odds with the Greenspan view that the US economy could be headed for recession by year end, SMMI supports the Bernanke view that growth will pick up in H2 as manufacturing recovers.

Given the risks of earnings disappointments and an easing in global liquidity, we recommend caution with regard to aggressively overweighting global equities. Global bonds lagged global equities over the past quarter, yielding a USD return of 1.2%. The quarterly return from bonds was marginally lower than the 1.6% yielded in the forth quarter of 2006, due to higher than expected inflation indicators (US payrollsdata, unit labour costs, average hourly earnings and ISM prices paid indices) and somewhat hawkish comments from the ECB.

Given the risk of further interest rate increases in Asia, Europe and Japan over the course of the year, SMMI still favours a short-term underweight bias to global bonds. In H2, the likelihood that the global interest rate cycle may have peaked should allow investors the opportunity to upweight bonds to a more neutral position. In the year ahead SMMI will continue to favour equities over bonds.

During the quarter the underweight position in global bonds was reduced somewhat. The allocation to property continues to add value. The full weighting in equities and property combined added value, as both asset classes outperformed bonds.

The welcome mollification of global inflationary fears around mid-2006 led to lower bond yields and higher equity prices in the second half of the year. Credit spreads narrowed again after widening in the middle of the year, volatility stabilised and emerging markets recovered strongly along with developed equity markets. All eyes remained on the next step of the US Fed, and the end of US interest rate hikes was heralded by many market commentators. Judging by the latest statement early in the fourth quarter, this expectation appeared to be on track.

However, strong economic performance in many major areas around the globe during the last quarter has served to shift expectations again, and longterm interest rates rose towards the end of the quarter and into the new year, albeit not back to the June peak. The question of "whether" rather than "when" the US interest rate cycle will peak in 2007 is once again being asked. If the anticipated global economic slowdown in 2007 is more muted than expected, the outlook for global equities remains positive, but stronger growth and the accompanying interest rate adjustments may introduce more risk to global bond yields. During 2006 global equities outperformed bonds strongly. We expect equities to outperform bonds in 2007 as well, but perhaps not to the extent seen in 2006 (20% for equities versus 7% for bonds in US$).

The exposure to equities was increased from a neutral stance to a higher weighting, which added to performance. In addition, the equity portfolio was converted into a global equity fund (the Sanlam Universal Equity Fund) and an MSCI tracker fund. This provides broad equity exposure within a balanced mandate in a cost-efficient manner. Within the equity portion, two new managers were added in the Sanlam Universal Equity Fund, namely Payden and Rygel (who follows a top-down approach) and Principal Global Investors, a core manager with a value bias. Bond exposure was reduced. The portfolio continued to benefit handsomely from the inclusion of a property fund (Sarasin) and a flexible asset allocation fund (Foord).