Domestic equities gained 13.9% over the past quarter, much in line with global equities but less than their emerging market counterparts. Similar to global equities, domestic equities lost momentum in September gaining a mere 0.3% over the month. The disappointing returns from the All Share Index reflected concerns that equities were overbought in the near term and that valuations had become stretched. Despite the pedestrian returns, leading indicators of economic activity suggest the economy emerged from recession in Q3. The Kagiso PMI surged from 37.9 index points to 48 points over the past quarter, marginally below the breakeven level that indicates expansion and contraction in the manufacturing sector. The quarterly change in the index shows that manufacturing contributed positively to economic growth in the quarter, helping the economy to record positive GDP growth.

Domestic bonds yielded 3.0% in Q3 underperforming both global and emerging market bonds. Market concerns about a 45% to 66% increase in electricity prices over the next 3 years saw the breakeven inflation rate push higher to 6.5% from a low of 6.2% earlier in the quarter. In addition, expectations of increased issuance of government debt to fund the ballooning fiscal deficit, estimated at 8% of GDP, also took its toll on the long end of the bond market late in the quarter. The 12+ year portion of the yield curve returned -0.1% in September, whereas the short end of the curve yielded returns of 0.6%. Although the sovereign risk premium narrowed to 189 basis points from 287 at the start of the quarter, foreigners were net sellers of domestic bonds totaling some R2.7bn. In September, however, selling pressure intensified with foreigners selling some R11.5bn in bonds highlighting the reduced appetite for SA bonds. SA cash yielded 2.0% in Q3, underperforming all other asset classes with the exception of inflation-linked bonds that yielded 1.4%.

Global equities yielded an impressive 13.8% in Rands in Q3, slightly less than the 16.9% yielded by emerging market equities. The relative outperformance from emerging market equities highlighted investor appetite for more risky assets and the belief that emerging markets will recover sooner from recession than their US and European counterparts. Following the stellar gains in equities early in the quarter, equities lost momentum in September gaining a pedestrian 0.4% in Rands. Factors weighing on global equities included worse than expected US ISM manufacturing data and a sharp contraction in the new orders to inventory ratio. Global bonds gained some 3.2% in Q3, well short of the 7.4% yielded by emerging market bonds. Towards the backend of the quarter, global bonds gave up some of their gains declining by 1.1% in September. The negative returns from global bonds were somewhat surprising given that inflationary pressures have abated on the back of a large output gap (the difference between potential and actual GDP) and excess capacity utilization. Furthermore, central bank policy of quantitative easing has succeeded in reducing the long term cost of capital, helping to push yields lower. The SMMI Defensive FoF performed very well during the third quarter. One month performance was in line with cash, which was the best performing local asset class, and performance for the quarter was ahead of the real return target.

The SMMI Defensive FoF benefitted from reasonable equity exposure over the quarter which greatly contributed to the fund achieving its real return target.

Domestic equities were the best performing asset class in Q2 2009, yielding an impressive 8.7% return. Emerging market equities were equally impressive yielding 7.6% in Rands. The relative outperformance from emerging market equities in general highlights the improvement in investor appetite for risk over the quarter. Foreign demand for SA equities was also buoyant with net foreign purchases totaling R19.4bn, up from R15.4bn in Q1. Further catalysts included favourable global equity markets accompanied by further signs of stabilization in the global economy. At the sectoral level, industrials and financials yielded 13.6% and 13.5% respectively, while resources increased a pedestrian 2.7%. The lackluster returns from resource stocks followed a 24.1% appreciation in the Rand/USD exchange rate that offset a 27.8% surge in $-metals prices.

Domestic bonds yielded 0.3% over the past quarter, outperforming both global and emerging market bonds. With more domestic government and parastatal issuance, yields should rise in the year ahead. In addition, downward revisions to GDP growth have also resulted in upward revisions to the fiscal deficit, now widely expected to top 6% of GDP in the 2009/10 fiscal year. Breakeven inflation has also trended higher highlighting the market's expectation that inflation will not drop back to within the 3% to 6% target range this year. It is generally expected that inflation will only fall back to within the target range in H2 2010, lending support to the MPC's June decision to leave rates on hold. SA cash yielded 2.3% over the past quarter, somewhat lower than the 2.7% yielded in Q1. The lower return followed 200 basis points in interest rate cuts with the repo rate declining to 7.5% from 9.5% at the end of Q1. Following the MPC's decision to leave interest rates unchanged at the June MPC meeting, the interest rate cycle appears to be at or near its inflection point. Reasons for the MPC decision included stickiness in inflation fuelled by administered prices (electricity) and above-inflation wage settlements.

Global equities surged over the quarter yielding 19.7% in USD. In Rand terms, the returns were down 3.5% due to a 24.1% appreciation in the Rand/USD exchange rate. Catalysts for the rebound included signs of consolidation in the US housing market, further gains in purchasing manager indices (PMI) as well as a narrowing in corporate bond yields and corporate spreads. Although most confidence and manufacturing indicators trended higher, measures of consumption expenditure and exports continued to decline. In particular, disappointing US payrolls data, a sharp pullback in mortgage refinancing and a surge in global savings rates has raised the possibility that the global economic recovery will take longer than initially expected. Global bonds yielded 2.9% in USD's over the quarter underperforming emerging market bonds that rallied some 10%. The difference in returns highlights the differences in estimated budget deficits between developed and emerging markets as well as the structural differences between these economies. The increase in risk appetite for emerging market assets is reflected in the narrowing in the sovereign risk premium that declined from 636 basis points to 424 basis points over the past quarter.
The SMMI Defensive FoF performance was well ahead of the median return for its category over the second quarter. The absence of international exposure added value from the fund due the strong appreciation of the Rand against the USD. Of the underlying absolute return managers, Coronation was by far the best performer for the quarter. Their high equity exposure added significant value due to equities outperforming all other asset classes. There were no significant changes to either manager allocation or asset allocation over the last quarter.

Asset class returns over the previous quarter were heavily influenced by a shift in sentiment away from the dismal state of the global economy to one of optimism that the world economy was stabilising. Unfortunately for equity markets the change in sentiment came too late to shore up returns for the quarter. Following the sharp sell-off in equity markets in January and February, equity markets did manage to reverse some of these losses in March. The Alsi yielded -4.2% for the first quarter while for the month of March it yielded 11.0%. During the first quarter resources were by far the best-performing sector, yielding 1.7%, while financials and industrials both had negative returns of 8.1% and 9.3% respectively. During March resources and financials both returned in excess of 14% while financials lagged, yielding only 7.0%. Global equities yielded -12.5% in USD for the quarter, while emerging-market equities fared much better with flat returns for the quarter in USD.

The sharp rebound in equity markets in March was driven by a number of economic and financial catalysts. Economic catalysts for the rally included an upturn in China's leading economic indicator and a rebound in Chinese and Japanese purchasing manager indices. Although visibility in the global growth outlook is improving headwinds remain, such as benign consumption expenditure due to rising unemployment, massive declines in export growth especially in Asia and Japan, and still high real yields on corporate bonds and mortgage-backed securities.

Even traditional safe-haven assets such as government bonds failed to yield positive returns as concerns about inflation dogged the bond markets both at home and abroad. Inflation-linked bonds benefited from upward revisions of domestic inflation and strong institutional demand for these assets, while emerging-market assets gained on the back of an increase in risk appetite. With domestic interest rates still attractive, cash outperformed most of the other asset classes. Bonds yielded -5.1% for the quarter and were flat for the month of March. Cash yielded 2.7% for the quarter, lower than in the previous quarter due to the effect of the rate cuts we have seen. Global bonds returned -4.8% in USD, marginally outperforming local bonds in rand terms. 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.

There were no significant changes to the fund construction over the past quarter. On a look-through basis the equity allocation has increased from 37.3% to 38.4%. The SMMI Defensive FoF returned -0.4% for the quarter, with returns coming under pressure due to both equities and bonds performing poorly.

Domestic equities yielded -9.2%% in the fourth quarter, delivering a total return for the year of 23.2%. Although the domestic economy is expected to record GDP growth of around 1.9% in 2009 and some 3.7% in 2010, the risk of growth and earnings disappointments looms large. On a two-year view, however, the earnings outlook looks positive given expected interest rate cuts of some 3% coupled with sharply lower inflation. Furthermore, the potential for an equity market rerating later in 2009 due to improving fundamentals suggests that domestic equities will outperform all other domestic asset classes over the coming two years. Valuing the All Share Index on a forward basis suggests that by historical standards the Index is attractively priced, trading on a forward price-earnings multiple of 9.2X, well below the mean of 12.5X.
At the broad sectoral level a similar conclusion is reached with financials and resources more attractively valued than industrials. SA bonds were the best-performing asset class in the fourth quarter, yielding a return of 11.4%. For the year as a whole, bonds returned 17%, under-performing only global bonds. Relative to equities, the earnings yield differential between equities and bonds supports an overweight equity position at the expense of bonds. SA cash yielded 3.0% over the quarter and delivered a total return of 11.7% for the year.
Global equities performed in line with domestic equities in rand terms over the fourth quarter. For the year as a whole, global equities yielded a rand return of -19%, somewhat better than the 23.2% returned by the All Share Index. With economic recession in the developed world expected to deepen in H1 2009, earnings growth is likely to contract further. Global bonds were the best-performing asset class in 2008, yielding a rand return of 56.6%. Although these returns were aided by a 28.5% depreciation in the rand/USD exchange rate, a flight to quality amid poor economic fundamentals drove these returns. At current yields, bonds are overbought, having priced in much of the bad economic news to come. While bonds are likely to remain overbought in the medium term, yields will push higher once money supply accelerates and the global economy shows decisive signs of a recovery. Although such signs may come only late in the year, other factors may still weigh on bonds. These include the ability of central bankers to sterilise the huge amount of liquidity they have added to the banking system, as well as the financing of the fiscal deficits needed to fund the stimulus packages already approved or in the process of being approved.
There were no significant changes to the fund during the quarter. At an underlying fund level we reduced exposure to the Peregrine Quant Absolute Return portfolio and added this exposure to the Prescient Positive Return portfolio. Given the less volatile nature of the Prescient absolute return process, the exposure was raised to provide better risk-adjusted returns to the portfolio. The fund will still benefit from a recovery in the equity market but will be better insulated against continued market volatility. On a look-through basis the cash levels of the fund have remained constant from the previous quarter end.