The major theme for the third quarter of this year was the sub-prime "crisis" that broke in mid-August, causing serious downward volatility. The recovery in the equity market at the headline All Share Index level was impressive, but it was contained to just a handful of shares as the broad breadth of the market rebound was modest, particularly on the local side of the financial and industrial sectors.

We were fortunate to be well positioned from an exposure point of view during the volatile period during August. At the low point of the equity sell-off our funds performed relatively well, but they did not rebound as aggressively as the All Share Index. This is because the recovery was largely confined to Anglo and Billiton, which made successful stock picking difficult over this very short-term period. We continue to be shy of these two heavyweights on valuation concerns. For example, Billiton is currently trading at over 8X NAV with a ROE of 51%. These lofty valuation metrics are clearly unsustainable and we will revisit its case once more realistic valuations appear.

Other areas in the equity stock picks that battled over the quarter were banks and technology. We believe that these areas are cheap and will continue to build exposure.

We were not active in bonds over the quarter, which proved to be a sound decision as bonds, thanks to a recovery in late September, just outperformed cash over the quarter. However, within the cash area we were quite active, extending the duration by investing heavily in 1- and 2-year NCDs. The logic of these investments is that we are now, in all likelihood, at the top of the interest rate cycle.

In the light of our success in stock picking we are unlikely to tamper much with the equity exposure. An area that we are likely to focus on more is listed property and bonds. Given any meaningful opportunity, i.e. weakness, and all else being equal, we will add to these asset classes. Patience and an understanding of value will be our key inputs in this decision.

The major theme for the second quarter of this year was the continued upward trend of equities in stark contrast to a negative return over the same period for bonds. Equities as measured by the All Share Index returned 4.3%, which, on its own, is about in line with long-term expectations. However, the really impressive feature was that it was on top of a stellar first quarter of 10.4%m, which has resulted in a return of 15.1% for the first six months of the year. Bonds, on the other hand, were the laggards, producing a negative -1.7% return over the quarter as measured by the All Bond Index. For the year to date, bonds have produced a marginal negative return of -0.1%. Listed property eked out a small return of 0.3% over the three months but, as the first quarter was particularly strong for this sector, the six-month return was 16.1%.

In summary, the key feature for the local financial markets over the quarter was the sharp deterioration in the outlook for domestic inflation and the upgrade to global economic growth.

We did not make any conscious asset allocation decisions over the quarter to change the equity exposure. Instead we focused on a disciplined approach of selling or trimming any share that looked fully valued and bought some shares that looked as if there was meaningful upside potential. The net outcome of this approach resulted in our exposure being what we would consider to be fully invested in equities.

We continued to avoid bonds, which proved to be good decision as we avoided the big sell-off in June. As mentioned above it was the unexpected bad inflation numbers and, more importantly, the outlook for inflation that caused the bonds to sell off. The question now is whether they have priced in all the bad news or whether there is an opportunity to buy at more attractive levels. We believe that we can wait a while, as the peak in inflation is uncertain in terms of extent and timing.

Listed property also derated over the quarter in sympathy with the rise in bond yields. While the fundamentals remain attractive, we are less convinced about the valuation story. Our portfolios are now very light in this asset class as we reduced our holdings early in May, so we were fortunate to avoid the sell-off. As with bonds the next move is to increase exposure, but it is all about being patient and waiting for better value to emerge.

Given our success in stock picking we are unlikely to tamper much with the equity exposure. An area that we are likely to focus on more is listed property and bonds. Given any meaningful opportunity, i.e. weakness, we will, all else being equal, add to these asset classes. Patience and an understanding of value will be our key inputs in this decision.

Considering only the headline returns from equities for the first quarter of this year they look impressive enough, with the All Share Index producing a return of 10.4%. But this masked huge volatility at the end of February where equities fell just under 10% in total and then recovered strongly during the latter part of March. The All Bond Index under performed cash over the quarter and produced a return of 1.6% compared with the 2.3% of equities. The star performer was the Listed Property sector, which returned 15.7% over the quarter. Another feature during the quarter was that the SARB decided to leave interest rates on hold. The challenge now for the portfolios is to carefully pick through the data and noise in an attempt to determine whether there is still genuine value within equities, which have been the main engine of returns over the past 4 years.

The momentum in the equity run early in the quarter pushed our exposure above our longer-term strategic level. During February, before the volatility started, we embarked on a disciplined programme to reduce exposure. The logic of this move had more to do with risk management than with any prescient notion that the markets would have a bumpy ride. The challenge as far as equity exposure is concerned is that if one examines the outlook for growth (earnings and dividends) and compare these yields to real long bonds, then equities, as an asset class, remains attractive. In other words, real interest rates when compared to growth rates still favour equities above all the fixed income asset classes. The greatest risk to both these asset classes is that global liquidity could unexpectedly dry up. This fact, together with the uncertainty in the domestic interest rate outlook (recent spike in the oil price), has caused us to move closer to our longer-term exposure level.

Although bonds had a positive quarter the returns were less than those on cash. The slope of the yield curve remained negative throughout the period, indicating that the long end is still comfortable about the future inflation expectations. So all in all it was a dull quarter for the bond market in terms of returns, but what the yield is signaling is more important; i.e. a positive inflation outlook. We remained out of bonds over the quarter, favouring listed property as a proxy. We did not add further to listed properties during the quarter. Solid value, in general, has now been lost as the sector is trading around fair value. We will have to be patient in this area before we can increase our exposure.

We concluded the previous quarterly by saying that "… we believe that 2007 should be a challenging year as the solid value underpin has largely disappeared, making volatility a likely scenario". This is indeed what has transpired so far this year. However, the returns generated by equities have exceeded expectations. This further heightens the risk for more volatility from equities for the year ahead. We are therefore comfortable with a more neutral stance towards equities.

An area that we are likely to focus more on is listed property. Given any opportunity; i.e. weakness, and all else being equal, we will add to this asset class. To add to bonds we would prefer to see further weakness so as to increase the probability that bonds will outperform cash over the next 12 months.

Undoubtedly the main feature of the fourth quarter was the exceptionally strong performance virtually across the board. The All Share Index gained 11.8% over the quarter, with the All Bond Index rising a very creditable 5.6% over the same period. With respect to the currencies, the rand appreciated by 11.0% against the US$ and 6.2% and 6.4% against the UK£ and the € respectively. The performance outcome was made to be even more interesting as it was achieved against a backdrop of rising short-term interest rates, which featured additional rate hikes in October and December of 50 points each. The total since the first rate hike in June is now 200 points. At first glance, it appears that the setback that the markets experienced in May and June were nothing more than a financially induced correction rather than a fundamentally driven one as the underlying macro-economic variables remain sound.

Exposure to equities was increased by around 4% during the quarter due to some stock picking in some smaller-cap value situations. Within equities we continue to believe that the financial and industrial sector should remain the core of the portfolio in the foreseeable future. With respect to commodities in general, we are not overly bearish on the demand side of the equation, but we do see more supply in many metals coming on stream this year, which should depress prices. This input, viewed in conjunction with very rich valuation levels of the resource shares, gives us the conviction to stick to our view of remaining underweight resources.

The domestic bond market was characterised by two important developments during the final quarter of 2006. Firstly, the market rallied strongly with the yield to maturity on the benchmark 10-year bond falling by some 81 basis points to close the year at 7.80%. Secondly, the longer end of the yield curve rallied considerably more than the shorter end. Curve inversion was a major theme, which investors had to identify early on. The inverted yield curve generally serves as a powerful signal that the rally in the domestic bond market could continue. Whether this will happen will depend mostly on the outlook for domestic inflation, the rand, and the outlook for domestic monetary and fiscal policy.

We added a further 3% to listed properties during the quarter. In hindsight we should have been more aggressive as this sector had a very strong quarter, returning 19%. Solid value, in general, has now been lost as the sector is currently trading around fair value. We will have to be patient in this area before we can start increasing our exposure. Given the strong rise in the equity markets over the fourth quarter, and with the increase in additional exposure, we feel comfortable with the weighting to equities at present. There is a fine line, in our opinion, between what the markets are discounting and what the macro-economy should deliver. While we are optimistic about the local economy on a three-year view, we believe that the equity market has moved ahead of itself in the short term.

We therefore are likely to use any weakness as an opportunity to increase our exposure. Our nominal bonds exposure is zero at the moment and we would prefer to see a sell-off in bonds before we make a substantial investment in this area. The logic behind this thinking is that given the slope of the yield curve, cash on a risk-adjusted basis is relatively more attractive. All in all we believe that 2007 should be a challenging year as the solid value underpin has largely disappeared, making volatility a likely scenario.