There was a broad-based rally across asset classes during the third quarter, with Treasury notes, high yield bonds, equities and commodities appreciating in price.

Global equity markets experienced a continuation in the rally that took hold towards the end of the first quarter. During the three-month period, the MSCI World (Developed Markets) Index rose by 17.45% in dollars. While not as substantial as the market gains seen during the second quarter, this was still a significant return for a quarterly period. After a slight pause in June, the market roared back in July by 8.5%. In August and September, the market rose by 4% in each month. Despite a torrid start to the year, the market is now up almost 25% year to date, having risen in six of the past seven months.

Positive investor sentiment extended to global bond markets as near-zero interest rates on risk-free assets fueled the search for yield. Within the Barclays Capital US Aggregate, the government-quality Treasury and Mortgage-Backed Securities (MBS) indices posted healthy quarterly returns of 2.10% and 2.31% respectively but underperformed the Corporate Bond Index ( up 8.12%) and the Commercial Mortgage-Backed Securities (CMBS) Index (ahead 12.70%).

With its reserve currency status still in question, the US dollar fared poorly during the quarter, depreciating against most currencies, including losing 6.9% to the Japanese yen.

All performance figures are quoted in US dollar terms unless stated otherwise.

The second quarter of 2009 saw global equity markets rise for the first time on a quarterly basis since the third quarter of 2007 - when the credit crisis first started to emerge. For the period, the MSCI World (Developed Markets) Index rose 20.75%[1], making it one of the best quarters in the history of the MSCI World Index, and the best for over 10 years. Even more astonishing was the three month period to the end of May, which saw the MSCI World Index rise by more than 30%! Returning to the quarter itself, April saw the rally which began in late February continue with a monthly return of over 11%, and May was little different to April as the market rose by over 9%. However, in June a period of reflection took place as equity markets fell very slightly, but by less than -0.5%. This potential 'pause for breath', was certainly required given the strength of the rally, on what many have viewed as fairly flimsy support, and evidence of this concern re-emerged during June as the on-going debate about the future direction of the global economy and market continued. Business surveys and real economic data did indicate the world economy is stabilising following precipitous falls in gross domestic product (GDP) in the final quarter of 2008 and first quarter of 2009. Admittedly, there are still many weak points, including the US housing market, where house prices continue to decline against the backdrop of a still elevated inventory level. Analysts are raising concerns that the recent rally has run ahead of the potential global economic recovery. The third quarter earnings season will be closely watched for some guidance on the direction of the markets for the rest of the year. Risk aversion in the fixed income markets continued to subside during the second quarter, as "less bad" data suggested the contraction of economic activity had slowed. Treasuries were out of favour, with the 10-year yield rising 87 basis points to 3.53% and delivering the worst six-month total return (- 8.6%) in over a decade. On balance, positive interpretations of weak data have become more common as investors have regained confidence in the overall functioning of the credit markets. As a consequence, markets have begun to speculate about the end of quantitative easing and the withdrawal of monetary stimulus by the Federal Reserve. In fact, from May 14 to June 8, the yield on the five-year.

[1] All performance figures are quoted in US dollar terms unless stated otherwise.

The first quarter of 2009 was characterised by extreme volatility in equity markets, with a sharp pull-back in January and February followed by an extremely strong recovery in March. Reflecting this, the MSCI World Index was down 12.5% for the quarter, masking a 7.2% recovery in March. Emerging markets fared better - up 0.5% for the quarter and 14.2% up for year to date. Signs of economic stabilisation in the global economy helped lift sentiment in March. Economic catalysts for the rally included an upturn in China's leading economic indicator, a rebound in Chinese and Japanese purchasing manager indices, a V-shaped rebound in ISM new orders, better-than-expected US housing data, buoyancy in mortgage refinancing and ongoing destocking of inventories in most major regions across the world. In the Eurozone, the ZEW expectations index pointed to a recovery in GDP growth later in the year although the coincident index suggested the recession would still deepen in the short term. Although visibility in the global growth outlook is improving, headwinds remain, such as benign consumption expenditure on rising unemployment, massive declines in export growth especially in Asia and Japan, and still high real yields on corporate bonds and mortgage-backed securities.

Financial catalysts also boosted sentiment this quarter. These included quantitative easing in the US, Japan and the UK designed to force down long-term interest rates, unfreezing of credit markets and removal of toxic assets from bank balance sheets. That these measures have had some success is borne out by the declines in nominal borrowing rates, and the beginnings of a narrowing in corporate bond spreads. In the US, the introduction of the TALF programme (Term Asset-backed Securities Lending Facility) saw the Federal Reserve commit some USD300bn to purchases of US Treasuries, a further USD750bn in purchases of mortgage-backed securities and a further USD100bn for purchases of GSE debt. In total, some USD1.15trillion was committed over and above the USD750bn announced under the Tarp programme (Troubled Asset Rescue Package). The UK's quantitative easing programme was less spectacular at GBP75bn, while Japan's spend was a more muted USD100bn.

Although global bonds are generally expensive relative to equities, support for this asset class is still evident given the quantitative easing adopted by the US, UK and Japanese central banks. As a consequence, purchases of government and corporate bonds are expected to keep a lid on yields notwithstanding longer-term concerns of a surge in inflation given the unprecedented rise in the monetary base. Despite the massive jump in the monetary base and relatively buoyant growth in money supply, the slowdown in the velocity of circulation has kept a lid on inflation expectations. Against this background we are neutral on equities for the time being but over the medium term will look to add to equities, while within bonds we favour corporate bonds relative to sovereign bonds.

During the quarter the portfolio was defensively positioned with an underweight equity exposure and a very overweight cash exposure. Bonds were slightly overweight. We are happy with the blend and diversification of the underlying managers and as such no changes where made in this regard.

Deleveraging, correlation and eventual capitulation where all evident in 2008, resulting in a roller-coaster ride for global equities and a stellar performance for bonds. The MSCI World Index ended the year down 42.1% in dollar terms and 22.1% down in the fourth quarter in the wake of the Lehman Brothers' collapse and the recessionary conditions evident across developed markets. Emerging markets fared worse as risk appetite disappeared, and were down 27.9% in the quarter and 54.5% for the year. In sharp contrast, bonds were up 9.7% in the last quarter, bringing the return for the year to 41.8%. Cash returns plummeted as short rates where cut aggressively across the globe in response to recessionary fears. This saw the Fed funds rate cut to 0-0.25% - an all-time low. In addition a $775bn bailout package was also announced by US president-elect Barack Obama. Other central banks followed suit.
These measures triggered an equity rally at the start of the New Year, but this is likely to be a rocky path given the headwinds in the coming quarters. Economic recession in the developed world is expected to deepen, with earnings growth likely to contract further. Given the leads and lags between US earnings and those in the Eurozone, Japan and emerging markets, the outlook for earnings remains depressed.
With corporate spreads also likely to remain at elevated levels at least in the first half of the year, a second-half recovery in US earnings will need to be accompanied by an easing in corporate spreads. A further catalyst will need to be a broad-based turnaround in leading economic indicators, particularly in Purchasing Managers Indices. Any recovery will be driven by huge fiscal expenditure and policy initiatives aimed at normalising the credit markets. Investors expecting a miraculous global economic recovery in 2009 are likely to be sorely disappointed, with many of the challenges evident last year continuing to weigh on markets for most of this year.
Against this background, we sought to reduce risk in the fund and sold out of the Sarasin Global Real Estate Fund during the quarter. This proved to be the correct action as global property fell by 39%. The fund's more than 30% exposure to fixed-interest assets made it fairly defensive and added to the performance of the fund. However, this was offset by the poor equity performance. The fund remains well diversified both in terms of assets and manager selection but we will look for opportunities to add to equities later in the year.