South African financial shares have been sold down in line with global financials. However, the outlook here has not deteriorated as much as in the USA, UK or Europe. In the short-term, however, international fund flows could weaken the rand in line with other emerging market currencies in their search for "safety".

This could put pressure on inflation and keep interest rates high for longer, which could bring GDP growth down.

We will provide more detail on what is happening in the market with next month's commentary.

June continued where May left off - a nightmare month. The rand weakened by almost 4%, the JSE fell 5% while the Dow Jones fell by a whopping 10%.

Surprisingly, SA banks declined less than their global peers (US, UK, Indian, Brazilian banks for example declining between 10% and 30% while SA banks declined by only 10%).

This reflects both the fact that SA banks have booked substantial falls year-to-date, and that the environment in SA is much healthier than in the US and UK.

SA banks are better capitalised and have significantly lower bad debt risk. Also, on the positive side is the 2010 World Cup construction activity and our positive fiscal situation, which allows the government to stimulate the economy.

The negatives in SA are the political uncertainty and (short term) the severe slowdown expected in consumer spending caused by high fuel, food and (future) electricity costs, which will keep interest rates high.

The fund had a poor month due to the 19% decline in Old Mutual's share price (totally overdone in our opinion) and the large price declines in small-cap stocks (Sasfin and Capitec). However, our increased holding in African Bank held up well, but still declined by 4%.

We reduced the funds exposure to the Life Insurers sector as we fear increased lapse ratios and that the JSE (one of the outperforming stock exchanges in 2008) will fall once resource shares start declining.

The fund is positioned to benefit from a weaker rand and our view that micro-lenders are the best positioned to weather the period of high interest rates and bad debts.

March saw the South African financial sector being hard hit again, making the quarter a terrible one for financial shares.

Old Mutual, Firstrand, African Bank saw declines of 19%+ during the quarter. The three best performing shares during the month were Sanlam (+2%), Liberty (-3%) and Investec (-4%).

At this stage, shares globally and in South Africa look oversold and undervalued. Whereas the global picture is still deteriorating (falling house prices in the UK/USA/Ireland/Spain) and default rates are increasing, the timely increases in interest rates by the SARB will cause increased bad debts and slower loan growth (aided by Eskom's failure to deliver enough electricity), structurally South Africa's banks, corporates and consumers are much healthier than their western peers.

Hence, earnings will decline during 2008. However, the economy will recover in 2009 and if one looks through the weak 2008 environment, bank and insurer valuations are attractive.

Weighing heavier on our financials until 2009 is the political uncertainty and this could keep foreign investors away, and along with the effect of lower commodity prices, keep the rand under pressure, which in turn keeps inflation and interest rates high.

We changed our portfolio in January to reflect the possibility of the above scenario. During March we increased our holding in Standard Bank (well positioned to benefit from global risk averseness with ICBC behind them), Liberty Life (which became too cheap) and reduced our large Investec holding as the price came back during March.

Financial, and specifically bank shares, were sold aggressively during December, causing a dismal end to a year that started the first 10 months quite well.

The fund outperformed due to its large holdings in Santam, Sasfin and also Sanlam, African Bank and Capitec (up 59%, 56% and 24%, 15% and 14% respectively for the 12 months) while our large holding in Liberty Life and Liberty Holdings also helped (+9%).

The bank sector and specifically Investec (-24%), Absa and Firstrand (-11%) were the worst performers in the sector (besides Liberty International (-24%) to which we had no exposure).

Banks started underperforming in October as certainty grew that the SARB would increase interest rates more than the initial 3 - 4 hikes. As intended, the last few (and possibly one more hike) will slow down loan growth and increase bad debt levels.

Bank shares also seem to be bearing the brunt of selling by international fund managers withdrawing from emerging markets and more specifically South Africa due to the increased uncertainty about the future of economic policy.

While bank shares are not yet as undervalued as the extreme valuations seen in 2003, I think they have overreacted to the higher interest rates and represent good value again.