The third quarter of 2007 saw fear creeping into the market. The fall-out from the US sub-prime housing woes led to credit markets freezing, risky assets selling-off and volatility increasing markedly. Central Banks around the world moved swiftly to inject liquidity into the system and equity markets have managed to rally strongly after being pacified by the Fed's decision to cut rates. The Fed's bold move has been led by ever-weakening US economic data that is pointing to a sharp housing-induced slowdown and the possibility of a recession in the US cannot be ruled out.

Rate cuts have had the effect of weakening the US dollar, and with the rest of the world, particularly emerging markets, still growing strongly, commodity prices, particularly the precious metals, have surged in recent weeks with the gold price making new highs well in excess of $700. This has led to very sharp increases in the share prices of the Resource counters with the likes of BHP Billiton and Impala Platinum approximately 40% higher than their mid-August lows.

At the same time as commodity counters have been surging, stocks focused on the domestic economy have been weak. Domestic stocks have been weighed down by rising interest rates, foreign selling and sector rotation in favour of Resources. The JSE has shrugged off the sluggish performance by domestic stocks to register new all time highs at the time of writing. This performance has been driven by a handful of heavyweight commodity counters. Market breadth has thus deteriorated significantly.

Bonds continue to be driven by a hawkish outlook for interest rates, given the recent inflation figures with yields sustaining the 8.3% level, although September saw a very strong performance on the bond market with the All Bond Index gaining more than 2%. US bonds have had a very strong quarter between June and September and have lent some support to the domestic bond market. Although the domestic inflation level is off its 12 month high, CPIX remains above 6%, the upper band of the Reserve Bank's target. Credit extension, though still uncomfortably high, may have peaked, while retail sales across most categories is showing clearly decelerating trends. Although this bodes well for the medium term interest rate outlook, we do not foresee interest rate cuts in the foreseeable future. The fact however that we are nearing the peak in the interest rate cycle does imply that bond returns should be getting more competitive relative to equities.

Although there is a directional relationship between equity returns and changes in the prime lending rates, there is no strong correlation between equities and rates, whereas bonds traditionally respond much quicker to changes in interest rates. The rating of equities is more responsive to changes in economic activity, which occurs as a result of interest rate movements. The economy usually responds to changing interest rates with a 12 month to 18-month lag. What makes the South African situation particularly interesting is the current development of counter economic forces. On the one hand the SARB is attempting to slow the economy down by implementing a tightening interest rate cycle, but on the other hand, the domestic Fiscus is funding a monumental government-led investment cycle. This is in addition to the spending, which is taking place for 2010. Consequently, we see interest rates having less affect on the economy than would have been the case in the past and JSE domestic earnings could be stronger for longer. This should allow domestic orientated equities to perform relatively well and in our opinion makes equities still more attractive than bonds.

Based on our views above, the Alphen funds have moved back to our benchmark weighting in equities for our slightly more aggressive funds and within touching distance of our equity benchmarks for the more conservative funds. This we did during mid-August. As a result of the slightly higher equity weightings in our funds, our cash weightings have declined and are nearing benchmark levels.

Once again the last quarter saw strong returns on the JSE (4.3%), with sturdy performances across the board although performance tables in recent weeks have been dominated by heavy weight resource counters. Annualising the second quarter's return data shows a normalising trend in equity performance, even though year-to-date returns are still sitting in the region of 15%. Bonds showed a negative return (-1.7%) for the three months to June, while the year-to-date return has been flat. Cash returns remain relatively attractive, with June's numbers increasing to 0.80% on the back of the recent interest rate hike. We believe that cash will be a strong competitor relative to other asset classes for the remainder of the calendar year.

Domestic bonds continued to be plagued by inflation fears and commensurate pressures on interest rates. The inflation picture has deteriorated in the last few months although the market has anticipated these price pressures as reflected in the bond sell off since May 2007. Breakeven inflation has also increased to 5.7% over the same period and based on the short-term outlook, risks remain on the upside. Inflation is likely to peak in early 2008 and the base effect will see inflation coming down fairly quickly to around halfway within the inflation band (4.5%). The Reserve Bank should therefore be looking through the inflation bump and considering that these price pressure catalysts, such as refining margins and food and oil prices are externally driven, the MPC should have space to pause on the interest rate hikes. Bear in mind that inflation expectations are the key factor to manage and ongoing hawkish rhetoric by the SARB will keep inflation in the spotlight. Bonds are therefore starting to look more interesting, especially when the scarcity value is taken into account. The problem comes when you compare bonds to cash though, as a rally back to about 7.5% is required for bonds to yield the same return as cash on a 12 month view. We still prefer cash.
We maintain our view that equity returns will be muted for the rest of calendar year 2007 and in the long run will normalise in line with historical returns.

We are cognizant of the fact that South Africa is going through quite a unique phase in terms of the upwards mobility of labour within the LSM groups, as well as an infrastructure cycle that is gaining traction, but in the long run earnings drive share prices and as long as one focuses on business fundamentals and does not overpay for abnormal short term growth, you will generate very competitive returns in the long run. We believe that there are only a handful of companies of which the ratings currently reflect normalised earnings growth, which makes us cautious on the outlook in the short term and explains the fund's underweight position in equities. Based on our optimistic long-term outlook for equities though, we would be looking for an opportunity to take the equity position back to the benchmark weighting of 20%, but given the low risk mandate of the fund we will tread carefully.

Cash remains competitively priced and we continue to put more cash into 12m paper. As we approach the end of the rate cycle it makes more sense to fix cash at higher rates for as long as possible. Any indication from the Reserve Bank that the rate cycle might be over, will result in a flattening or even an inversion of the money market yield curve.

Starting off a monthly commentary with how well the equity market has performed has become monotonous, but it remains a reality. Equities were once again the star performer during March with a total return of 6.4% followed by listed property, with a total return of 3.2%. Bonds realized a negative return of 0.4% over the month, with old faithful, cash, returning 0.8%.

It is interesting to see how changing themes can swing market returns from month to month. Towards the end of February investors became skeptical about the outlook for Chinese equities, based on their extreme valuations, and the sell-off in China caused a ripple effect throughout equity markets worldwide. The rally in commodity prices and strong earnings reports stabilized the late-February sell-off and equities have since become the favourite asset class again, though volatility has increased at the same time. The fund remains significantly underweight the asset class based on the low risk profile of the fund and the limited value we can find as a function of our equity valuation criteria.

We maintain our view that bonds are overvalued despite the shortage of new issues in the market. The outlook for interest rates has deteriorated because of the upside pressures on domestic inflation. Inflation, according to the South African Reserve Bank, is expected to remain around 5.9% between the 2nd quarter of 2007 and the 2nd quarter of 2008. The margin of error for inflation to breach the upper inflation band is therefore limited, which should result in interest rates staying elevated for longer, at best. US Bonds have lost some ground during the month on the back of increased inflation fears by the FED.

With increasing food inflation globally and a weakening dollar this I is likely to remain the scenario in the near future and should cap I the performance from local bonds as well. We have trimmed back lour property exposure due to the strong performance we have, seen from the sector recently. The sector is performing more in line with riskier asset classes and, although the outlook for property - like equities - looks promising in the long-term, we feel it prudent to cut back our exposure right now.

We remain heavily overweight cash in the portfolio, based on the I expected returns from the asset class during the next 12 months. ; The nominal return from cash over the next 12 months is; estimated around 9.2%, which should yield a real return of close: to 4%, at zero risk. Bearing in mind that one of the main, objectives of the fund is to avoid any capital losses over a rolling, 12 month period, this return from cash is something not to sneer: at.

December's performance on the financial markets was, as is traditional, very buoyant. Thin volumes and continued interest from offshore investors resulted in record levels on the All Share Index, which gained 4.5% during the month. Bonds also gained 1.5% during the month, primarily as a result of the continued currency appreciation that we experienced towards year end. The additional interest rate hike in October saw cash returns creep up to 0.74% for December.

The fund has remained underweight equities since inception in April 2006 and has generated a very acceptable performance despite the low equity weighting. Commodity counters are struggling to maintain their relative outperformance against the rest of the market and can be blamed on frail commodity prices and a strong and very resilient currency. The exposure we have retained to commodity shares is mainly focused on asset quality and volume growth. A normalization of commodity prices is long overdue and as prices revert back to normal levels, companies with low quality assets that generate low returns should be avoided. On that basis we prefer exposure to quality diversified producers like BHP Billiton as well as counters that are exposed to high volume growth in the next few years like Exxaro, Kumba and Metorex.

In the short term we will not be rushing into equities, but the prospects over the next two to three years still look rosy. The investment cycle in South Africa remains very strong and the multiplier effect from that should be supportive of 4% to 5% economic growth in the next few years. It is therefore difficult to see the profit cycle evaporating in the face of strong economic growth. The only caveat is further aggressive monetary tightening by the Reserve Bank that could seriously dent investor confidence.

Our view on bonds remains unchanged and we are confident that it will be one of the worst performers of 2007. The South African consumer's resilience to rising interest rates will result in interest rates staying higher for longer. While this is the case the downside risk in bonds justify only limited exposure to the asset class, especially compared to the current yield on cash. The current yield curve inversion should correct during the next twelve months, but more likely through a rise in the long end than a decline in the short end, which normally coincides with a decline in interest rates.