The FTSE JSE All Share Index posted a total return of -5.8% for the third quarter of 2011. Of the industry groups, Technology (5.0%) was the top performer with Health Care (2.5%) in second position. Basic Materials (-10.8%) was the worst performer, followed by Oil & Gas (-6.0%), Industrials and Telecoms (both -4.6%). Gold posted a total return of 19.5% in the September quarter, after posting -13.0% in the second quarter. The developed market debt juggernaut gathered further momentum in the third quarter, with European policymakers continuing to defer the inevitable. On reflection, the past decade can be broken up into three distinct phases:

.Phase 1, starting from the end of 1999 to 2007, saw a major build up in household and financial sector debt in the US and several European economies.

.The second phase, lasting from the start of the subprime crisis to early 2010, saw intense private sector deleveraging combined with a surge in government sector debt. In effect, as the private sector was paying back debt, the government was taking on new debt in order to prop up aggregate demand.

.The third phase - the one in which we currently find ourselves - has seen a slowdown in the pace of private sector deleveraging but an acceleration in the pace of fiscal consolidation. The non-recurrence of further economic stimulus in developed markets has exacerbated the risk of a renewed global recession (the feared double-dip) and threatens to unwind the recovery that commenced in April 2009.

Equity markets appear disappointed and frustrated by the ineffectiveness of Fed policy at a time of heightened economic and financial risks. It is even debatable whether the twist policy will help or hurt the economy. ‘Operation Twist’ creates no new stimulus as the Fed balance sheet will stay steady, but it flattens the yield curve. This could hurt banks which are already under stress. Furthermore, the political impasse has seriously undermined the Obama administration’s ability to address the underlying problems inherent in the US economy. In addition, the horror story in Europe continues.

The advice given by the US to turn the European Financial Stability Fund (EFSF) into a bank is correct as it would allow the EFSF to draw in private sector savings as well as lever up the size of the fund on the European Central Bank’s balance sheet. This is the only way to substantially enlarge the rescue fund, making it a credible source of funding to stem the debt crisis.

The extreme volatility in stock prices is symptomatic of the degree of uncertainty and risk inherent in market valuations currently and also underlines the importance of a sound investment philosophy, a robust bottom-up investment process and a regular top-down quarterly review to generate long-term outperformance for our clients.

The second quarter of 2011 saw a significant reversal of fortune for emerging markets: developed markets outperformed emerging markets and the domestic market. Increased tightening policies in China, coupled with continued European austerity and Greek tales of woe, increased investors' jitters towards emerging markets, instead preferring the perceived relative safety of developed markets. The US appears to be a safe haven, with a weak dollar and loose monetary policy acting as powerful magnets for investor's capital. The US strategy of growing their way out of debt appears to be slowly gathering momentum - but could easily be stymied if the US$ start strengthening again.

It became apparent that the all-important Chinese contribution to the global recovery was not without risk: authorities began to aggressively tighten monetary policy in response to rising inflation which will slow down their economy.

Emerging markets had only a mildly negative quarter, with gains in the first two months largely offsetting a sharp drop in June. In total return dollar terms the MSCI Emerging Markets Index was down 1% for the quarter and the MSCI China Index down 1.7%. Developed markets benefited from an element of safe haven buying and fared a lot better with the S&P 500 up 0.1%, the FTSE 100 up 1.7%, the Nikkei 224 up 3.3% and the DAX 30 up 7%.

Local inflation readings have surprised on the upside with the May CPI reading at 4.6% year on year and food inflation the primary contributor at 6.6% year on year. The pick-up in food inflation was expected and was due to the lagged feed-through of high global agricultural commodity prices. South Africa's recent food inflation pick-up has been relatively mild compared to those of other countries, as we have been shielded by a strong currency and a favourable maize crop surplus. We see higher South African inflation risk going into 2012 as these advantageous factors roll off.

We are cautious about developed economies that face long-term challenges in the form of high unemployment, high government debt levels and negative demographic trends. In the short- to medium-term these economies will have to grapple with the inevitable withdrawal of stimulus and the implementation of austerity plans. As a consequence we remain convinced that the current correction in developed markets is yet to run its course and expect further volatility on global stock markets.

We continue to avoid domestic-focussed, cyclical industrial companies that have benefitted from the strong structural forces of lower domestic interest rates and lower domestic inflation over the last 10 years (the magnitude of which is unlikely to be repeated over the next 10 years). Many of these companies are trading at ratings that suggest the earnings growth achieved over the last 10 years will be repeated - we do not share this view. We currently favour companies with strong balance sheets and high franchise value, with strong cash flow generating abilities that trade at normalised ratings well below the current market rating and therefore allows us to preserve and grow our investors' capital in volatile market conditions.

Portfolio manager
Abdulazeez Davids