Domestic equities outperformed all other asset classes over the past quarter, yielding a rand return of 6.7%. Within the emerging-markets universe, however, SA equities underperformed the composite index that rose by some 10.7%. The composition of the SA returns was once again biased towards resources stocks, which were up 13.5% over the quarter. Industrials and financials yielded lower returns, with the INDI 25 up 4.5% and the FINI 15 down 2.2%. Factors weighing on the financials included the likelihood of a further interest rate increase at the October MPC meeting following upward revisions of CPIX inflation. It was only towards the end of the quarter that the market started discounting the possibility of no rate hike.

SA bonds succumbed to worse than expected inflation data and a 50 basis point increase in the repo rate over the past quarter. As a consequence, bonds delivered a return of 3.3%, with some 2.3% of these returns coming in the month of September. The turnaround in September was due to lower global bond yields following the Fed's rate cut decision and the expectation that the MPC would hold off on raising interest rates at the October meeting.

There were no major changes to the fund, which continues to provide a stable and low risk-return profile. Absolute return managers had a tough quarter given the turbulent markets and the slightly higher inflation rate, which they are now using in the calculation of their targets, and this is reflected in the shorter-term behaviour of the fund. However, the longer-term performance is ahead of target.

Domestic equities outperformed all other asset classes over the past quarter, yielding a rand return of 4.3%. Within the emerging-market universe, however, SA equities underperformed the 10.3% returned by the composite index. The composition of the SA returns was once again biased towards resource stocks, which were up 6.8% over the quarter. Industrials and financials yielded lower returns, with the INDI 25 up 4.3% and the FINI 15 down 2.4%. A rise in the repo rate and the pending introduction of the National Credit Act in July all weighed on the financial sector in particular. Factors underpinning the resource counters included improved visibility in the global growth outlook - fuelling gains in industrial metals prices and global bond yields - and ongoing foreign investor appetite for these counters. Net foreign purchases of domestic equities totalled some R22.4bn over the quarter, marginally ahead of the R20.6bn purchased in the first quarter of the year. Although foreign demand remains strong, domestic equity market valuations are becoming stretched.

SA bonds succumbed to worse-than-expected inflation data and a 50 basis point increase in the repo rate over the past quarter. With inflationary pressures likely to remain elevated over the next three quarters, a further 50 basis point increase in interest rates is priced in for August. Although an August rate hike is already priced into the money market, the drag that the National Credit Act will have on private sector credit demand, in particular mortgage advances, suggests that August will be the peak in the current interest rate cycle. Against this backdrop the ALBI yielded a return of -1.6% over the past quarter, outperforming the -5.1% returned by global bonds.

No manager changes were effected during the quarter. Managers maintained a high cash weighting and a low weighting in bonds, with a conservative weighting to equities, in line with the fund's risk profile.

Local equities were the best-performing asset class during the quarter with total returns of 10.4%, mirroring the 11.8% gain reported in the forth quarter of 2006. Unlike the previous quarter, the composition of returns was biased towards resource counters rather than financial and industrial stocks.

This was underpinned by Chinese import demand and an improvement in domestic valuations following the year-end reporting of heavyweight commodity stocks. SA bonds yielded 1.6% over the past quarter, well short of the 5.5% returned in the forth quarter of 2006. Domestic bonds underperformed cash, supporting the consensus view of our underlying managers. With inflation concerns weighing on the bond market - the result of a surge in Safex food prices and higher fuel prices - the risk of an interest rate increase has risen steadily over the quarter.

Furthermore, with the lower 2007/8 funding requirement no longer a stimulus for bonds, the risks to the bond market are weighted to the upside. Against this backdrop local equities remain the preferred asset class, particularly taking into account the earnings yield differential between the two asset classes. Going forward, slowing earnings momentum and a reduction in global liquidity will limit gains, however.

Overall we are still happy with our manager selection and exposures and no changes were made to these during the quarter.

Local markets ended the year on a high with the ALSI returning more than 4% in December as domestic-oriented counters were boosted by a strengthening currency. 2006 was a year of contrasting halves from a broad sector point of view. The first half of the year saw the resources sector dominate the market on the back on continued strength in the commodity cycle. Financials and industrials recovered strongly in the second half of the year, significantly outperforming resources. Overall, the ALSI returned more than 40% for the year, making 2006 a very prosperous year for investors in the equity market.

The SARB raised the repo rate by 50bps four times in 2006. Bonds performed poorly in the rising interest rate environment, returning just over 5% for 2006 and ending the year as the worst-performing asset class. The yield on the R153 government bond started the year at 7.3% and ended the year at 8.16%.

Internationally, 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.

The Sanlam Defensive FoF invests with a combination of leading positive-return funds and there have been no significant changes to the portfolio over the last quarter. The fund remains defensively positioned in the light of increased market volatility in equities and fixed interest. The fund performed well ahead of its real return target of CPIX + 4% for 2006 and continues to deliver on its objectives.

The fund maintains exposure to a diversified mix of absolute return managers, strategies and asset classes. It is ideal for investors seeking capital protection and inflation-beating returns over the long term, but who lack the knowledge, time and skill to select and monitor the various available absolute return funds, strategies and investment managers