The third quarter was bleak for equity markets, with the MSCI Europe Index losing 20.7% in dollar terms - the weakest quarter since the third quarter of 2002. Most of the damage was done in September, with the MSCI Europe declining by over 15% in that month alone. European equity markets essentially moved sideways in July and August in euro terms, but the dollar's recovery converted this into a negative return for dollar-based investors. In September events in the US dominated investors' attention as first the US government seized control of the two largest mortgage finance companies Fannie Mae and Freddie Mac and then Lehman Brothers filed for bankruptcy. Merrill Lynch agreed to sell itself to Bank of America, America International Group was effectively nationalized, and Washington Mutual was seized by regulators in the biggest US bank failure in history.

In the end the House of Representatives failed to approve Hank Paulson's $700 billion bail-out plan, sending markets plunging across the board. In continental Europe the governments of Belgium, the Netherlands and Luxembourg were forced to bail out Fortis, and in the UK Lloyds TSB is taking over HBOS and the Bradford and Bingley Bank was nationalised. Understandably, financials were hard hit, down 17%, but they were not the worst-performing sector. This honour was reserved for the Materials sector, which declined by 41%, while the Energy sector fell by 30.7% over the quarter (oil prices fell by 28%). Unsurprisingly, in this environment defensives fared better, with consumer staples and health care falling by a more modest 8% each.

Equity markets continued to be driven by familiar macro-influences in the second quarter. Recent economic data were at best mixed, though on balance the evidence points to a continued deceleration in activity across the developed regions. Coinciding with this is a period of significant acceleration in inflation, driven mainly by food and energy prices (dated Brent touched $139 in June and went on to peak at $145 in early July). Central banks are thus still in a difficult position, unable (or unwilling) to reduce interest rates significantly (if at all in the case of the ECB) to stimulate economic activity because inflation is still exceeding target levels. Markets are consequently concerned that the consensus case of a contraction in the first half of '08 followed by an improvement in the second half, is looking optimistic and that there is a real risk that the downturn could be more severe and protracted than anticipated.

The STOXX Europe ($) initially staged a modest recovery from the first-quarter close, gaining 5.5% by mid-May but then falling by 10.8% to record an overall decline of 5.85% for the second quarter of 2008. In dollar terms the best-performing sector was once again basic resources, returning 15%, narrowly beating the 14.6% of oil and gas. This has really been the story for the year to date as well. The market has become extremely narrow with only one sector (basic resources) providing a positive return and the next-best relative sector performances coming from energy and commodity price strength beneficiaries.

Returns from the rest of the market have been dismal. The worst performing sectors were banks (-17.4%) and autos and parts (-18.7%). Banks continued to be hit by a stream of poor news flow ranging from UBS's additional CHF19bn write-down and recapitalisation to the Royal Bank of Scotland's deeply discounted rights issue (the largest rights issue in UK corporate history). Autos were squeezed by higher input prices (steel, rubber, oil), less competitive currency and falling consumer demand. The UK fell by 2.23% and the Eurozone by 7.74%, while emerging Europe rose by 5.72%.

At least 85% of the assets of this fund should be held in developed Pan-European stock markets (UK an the Continent) at all times. At least 75% of the fund must be invested in equities at all times. Up to 20% of the value of the fund may be invested in other collective investment schemes.

The fund has changed sector from Foreign Equity General to Foreign Equity Varied Specialist

The background for financial markets in the first quarter of 2008 was one of continued uncertainty. A spate of worrying economic news from the US and Europe fuelled fears of a recession in the US and lower growth for the rest of the OECD and key emerging markets, such as China. Combined with this was, and still is, the fear of commodity price inflation feeding through into core CPI inflation. Inflation is already running above target in the UK and the European Central Bank expects it to remain high in the Eurozone. This has led both the ECB and Bank of England to be less enthusiastic in reducing their official rates than the Fed, the BoE reducing rates by 0.25% in February and the ECB not at all. This lack of policy reflation by was not well received by the markets, especially as the credit squeeze continues unabated in the UK.

The Stoxx Europe ($) fell by 9% in the first quarter of 2008; however, equity markets traded with significant levels of volatility at market, sector and stock levels throughout this period. In dollar terms the best-performing sector, basic resources, returned 0.43% and was the only sector to post a positive return. Booming resource prices and significant levels of bid activity and rumour in this sector helped in no small amount. The worst performing sector, telecoms, fell by 16.3%. Some aggressive price competition in the US and a poorly received bid by sector heavyweight Deutsch Telecom for Hellenic Telekom in Greece led to a sustained bout of profit taking in the sector. The UK fell by 9.56%, the Eurozone by 8.33% and Emerging Europe by 13.26%.

The portfolio has performed relatively well and there have been no changes to its construction.

Global equities continued to come under pressure from the ongoing fallout of the sub-prime crisis and the subsequent decline in investors' risk appetite. The UK market, which is dominated by financial stocks, was down 2.9% in dollar terms as it became apparent that the widespread paralysis affecting money markets and interbank lending threatened to turn a financial crisis into a global economic downturn. In response to this and deteriorating economic data the Bank of England cut its base interest rate from 5.75% to 5.5%. This brought the performance for the UK market to 4.7% for the year in dollar terms.

The Eurozone fared better, with the DJ Euro Stoxx ($) up 1.6% for the quarter supported by strong performance from Germany, which was up 5%.These markets returned 16.3% and 32.5% respectively for 2007. Last year's gains were supported by strong economic growth, corporate restructuring and takeover activity. This performance is unlikely to be repeated as economic growth is starting to slow while inflation has jumped way above the 2% targeted rate, leaving the ECB with little room to manoeuvre. The continued strong euro and high oil prices have exacerbated the situation.

Emerging Europe had a strong quarter and was up 13.3% but with a wide spread of returns across regions. Poland, the biggest holding in the Aviva Convergence Fund, delivered 1.73% while the Czech Republic, 14.3% of the fund, returned 14.9%. Cyprus, which constitutes 18.9% of the fund, rose by 9.2% for the quarter. Varying fundamentals across this region should continue to provide good diversification to the more developed markets and as such this region is likely to continue to outperform in 2008.

Overall the blend of funds is working well and offers investors a well-diversified portfolio covering both developed and emerging markets in the region. As such no significant changes where implemented during the quarter.