Risky assets experienced a strong recovery during the quarter. The global equity markets rebounded sharply, with the MSCI World rising 21% in dollar terms. The recovery in emerging equity markets in dollar terms was even more pronounced, with the MSCI Emerging Markets index soaring 34.8%. Some of this return stemmed from the firmer emerging market currencies. The rand was one of the strongest performing emerging market currencies over the quarter. The JSE All Share index delivered an 8.6% return in rand terms.

Global credit spreads recovered from extremely oversold levels, while industrial commodity and oil prices increased dramatically. For example, oil gained 50% in US dollars. The fears of an extensive recession, or even depression, priced into these risky assets appear to have subsided. Global deflationary fears have also waned, with US government bond 10 year yields weakening to 3.5%. The Barclays/Lehman's global bond index returned 4.93% in dollars for the quarter.

Asset allocation
Local equities: We have had an overweight equities position since the fourth quarter of 2008. Given the recent rally in our market, we have reduced the magnitude of our overweight position marginally. When the equity market was at its low point in November last year and again in March this year, the upside to fair value (calculated by summing our equity analyst valuations) was close to 30%. Given the recent rally in the market, the upside on this basis is now 10% to 15%. Over a three year period, however, we still believe equities will do better than cash and bonds, taking into account the additional return required due to the higher risk implied by investing in equities. Using either our own earnings forecast or consensus earnings forecasts, the price:earnings multiple for the market, one year from now, could be just above 12.
An argument could be made that equities are not as cheap as they appear since the real (inflation-adjusted) earnings of the SA listed companies are currently still well above the long-term trend. However, the domestic economy has opened up since the early nineties and it is not unreasonable to expect higher real growth rates than those experienced during the eighties. Ultimately, there is a strong link between real long-term growth in gross domestic product (GDP) and real earnings growth.
Local bonds: We currently have a neutral allocation to domestic bonds, as the current nominal yield on offer in relation to the long-term inflation target seems fair.
Inflation-linked bonds: When we went overweight inflation-linked bonds in February and early March this year, the real yields on offer from government inflation-linked bonds were between 3.2% and 3.5% for medium term R197 bonds maturing in 2023. The yields on the medium-term bonds have rerated substantially to levels below 2.6% at the beginning of May, while both the short-dated and very long-dated inflation-linked bonds were trading around 2.25% real - a level we consider to be expensive relative to alternative investment options. As a result, we reduced our overweight position. We do, however, retain an overweight position in inflation-linked bonds because they do provide diversification and protection against unexpected inflation, especially in the light of the monetary policies being followed by the developed market central banks. The remaining overweight position comprises mainly corporate bonds.
Local listed property: We retained our neutral position to property even though the current valuation of property on an absolute basis relative to bonds remains somewhat attractive. However, relative to developed markets SA listed property appears expensive.
Global equities: We retained our overweight position in global equity markets with a preference for Europe where valuations are more attractive.
Global bonds: We retained our neutral position to global bonds. Even though the real return obtainable from sovereign bonds does appear more attractive now, we do still prefer corporate bonds to sovereign bonds. The additional yield or spread obtainable from a diversified portfolio of corporate bonds implies a default rate that is high relative to what has been experienced historically.

Risks and opportunities ahead
Developed market governments and central banks have been engaged in unprecedented stimulus policies. The jury is still out on what effect these will have on economic growth and long term inflation. Given this, we aim to be overweight assets where the current valuation discounts a worst case scenario.

Market review
Global and local equity markets declined steeply for the first two months of the quarter before rebounding in March and ending the quarter down 11.8% and 4.2% respectively, Emerging markets outperformed during the quarter, while negative sentiment prevailed in the developed world stock markets. Offshore bonds also had a disappointing quarter, with yields rising in the face of increased issuance and less foreign buying. At home, SA equities followed their offshore counterparts lower and local bonds yields traced the upward movement in global government bonds.

What SIM did
Local equities: Overweight. After the further fall in equity prices, local equities are now priced quite attractively. The market's forward rating is well below its long- term average and on a fundamental intrinsic valuation the market offers significant value. Local bonds: Neutral. Long bonds yields are offering decent real returns should inflation drop to well within the SARB target range. However, inflation-linked bonds offer similar returns without any inflation risk so we have moved to an overweight position in inflation-linked bonds. Local property: Small Overweight. Listed property continues to offer value. However, vacancies are very low and, as the economy surprises to the downside, vacancy risk rises. Global equities: Overweight. Global markets have de-rated further. Price-to-book valuations are between 1 and 1.5 for the developed markets and thus we added slightly to our overweight position. Global bonds: Neutral. Global sovereign bonds are currently offering fair real returns based on the long-term implied inflation assumptions of the US and European central banks.

SIM strategy
There is a risk that global inflation could rise well above average in the medium to long term. Inflation is a function of money supply and the velocity (or amount of transactions) of money. Due to the financial crisis, the velocity of money has dropped substantially but money supply is increasing rapidly. Central banks are printing money to buy some of the burgeoning government debt issues, as well as distressed corporate debt, thus increasing money supply. As a consequence, the velocity of money will increase again when the global economy recovers, which could have serious inflationary implications, unless the central banks react quickly by destroying the money they have printed. Moreover, given the increase in government debt, future governments might not be adverse to inflation, as this would help to inflate them out of their debt problem. Long bonds are one of the most risky asset classes in times of unexpected inflation, as they only pay a fixed nominal yield. Currently the US government and inflation-linked bond market is pricing relatively low long run inflation of 1.5%. But if the capitalist system survives and functions properly from here, we believe equities are likely to outperform bonds.

Market review
The FTSE/JSE All Share Index lost -9.2% during another tumultuous fourth quarter, as economic news from developed economies confirmed that the globe was entering recession and emerging market growth indicators continued to deteriorate. Resources (-12.9%) and Financials (-11.4%) led the ALSI down, while Industrials (-4.1%) were relatively unscathed. A clear defensive style-bias emerged looking at cross-sector performance, as non-cyclical sectors outperformed. Global equity markets also had a rough quarter with the S&P500 losing 22.4% and MSCI World falling 21.7% in US dollars. The Federal Reserve lowered the target funds rate from 2% to 'between 0% and 0.25%'. Indicators of a sharply slowing global economy came thick and fast, the stand-out probably being a steep drop in US employment. Official measures to protect the financial sector continued and US automakers also sought public sector support. Meanwhile fiscal policy stepped up a gear in a number of countries. In South Africa, the SARB cut the repo rate by 50 basis points to 11.50% at its MPC meeting in December on easing inflation pressures. Local bonds had a strong quarter, returning a healthy 11.3% for the period. Listed property was also a feature, producing 8.5% for the quarter. These returns were in response to a strong belief that the repo rate is likely to be cut meaningfully during 2009.

What we did over the quarter
In general we had a quiet quarter in terms of making any significant changes to the portfolio. Within equities our stance was not to take big stock bets as the shortterm outlook and sentiment remains highly problematical. At an exposure level, for the same reasons, we sold some equities over the quarter to be underweight. Some exposure was added to bonds which proved to be sound move although in hindsight we should have much more aggressive in this area.

Major performance value adders and detractors
The position that added the most value over the quarter came from our low weighting to equities relative to what we believe the benchmark is. Within equities, our low exposure to resources paid off but our key detractor was that we did not have a large enough holding in the food and retailer sector, which produced a stunning 16.2% return over the quarter. In general, the major detractor of value over the quarter was our relatively low weighting to the all interest rate-sensitive assets.

Investment Strategy going forward
We maintain that the ultimate fallout of the US-led financial crisis will be a sustained period of below-trend global economic growth for at least the next two to three years, with the key question now: is this correctly priced into the equity markets? There is no doubt that there are pockets of value emerging within the equity markets so the only challenge, given that we are sensitive to avoiding capital loss (making the time horizon much shorter), is when the value will begin to be unlocked. Regrettably, it is impossible to predict this dimension so we believe it would be prudent to take advantage of our low weighting to equities and to start to add some more exposure cautiously. We believe that bonds have more than fully discounted all the positive inflation and short-term interest rate movements and are now expensive. Given our low weight to this asset class we are likely to be buyers on any material weakness.