The 3rd quarter of 2008 proved to be an extremely volatile quarter that was dominated by the global credit crisis and volatile equity markets. Generally speaking, the global credit crisis proved to be positive for developed fixed income markets with central banks lowering interest rates late in the 3rd quarter (the opposite was true for most risky asset classes). The focus shifted away from inflation towards a lower global growth scenario. The domestic fixed interest market had a major recovery during the quarter; the R157 benchmark bond yield decreased from 10.72% at 30 June to 8.86% at quarter end.

The return of positive sentiment was on the back of a re-weighting of the inflation basket for 2009 which will see inflation 1-1.5% lower that anticipated. Slowing economic growth and softening commodity prices also led to a more positive inflation outlook. The All Bond Index returned 12.6% for the quarter with cash at 2.9% and inflation-linked bonds at -1.4%. The expected lower future inflation had a negative impact on inflation-linked bonds with real yields increasing by an average 70bps. Property stocks clawed back some of the losses earlier in the year and returned 23.1% for the quarter, but still negative for the year at -11.9%.

During the quarter we increased the nominal bond exposure by 12.3% to 30.8%; this switch was done out of cash. Currently we prefer a barbell strategy where the portfolio invests in longer-dated (1-and 2 year) cash instruments and longer-dated nominal bonds. We expect an improved inflation outlook for next year with rate cuts early in 2009. This should be supportive of the bond and property market over the next 6 months.

The final quarter of 2007 was quite volatile overall. On the domestic front high inflation remained a concern, while in international markets the sub-prime debt crisis and weak US housing market left investors nervous heading into 2008. Domestic inflation remained high with the November CPI reading coming in at 8.4%. During 2007 the repo-rate was increased by 2% from 9% at the end of 2006 to 11% by the end of 2007.

During the 4th quarter the bond market weakened with the R157 yield moving 0.24% higher to 8.5%. As expected under these conditions, the 0-3 yr area of the yield curve outperformed all other areas of the domestic yield curve. During the quarter inflation-linked bonds strengthened, especially the longer-dated R197 and R202 which moved down about 0.3% in real yield. For the quarter cash returned 2.5%, ILB's 5.4% and bonds 0.9%. For the calendar year 2007 cash returned 9.4%, ILB's 9.2% and bonds 4.2%. After a strong 3rd quarter, property returned -0.4% for Q4; the total return for 2007 was 26.5%

During the quarter, bond exposure was increased by 7.2% to 32.5% into market weakness. Cash and property exposure were reduced by 6.7% and 0.4% respectively. Profit was taken on some of the property holdings during the quarter. Although market volatility remains high we expect the bond market to look through the peak in inflation with lower inflation expected in the second half of 2008; this should support bonds over the next 6 months.