It has been some time since the negative performance of the currency has shot to the top of the business headlines. In this vein the rapid loss of value in the rand has been troublesome to some. The two important economic reasons for this deterioration have been sheer overvaluation in term of purchasing power parity following three years of gains and the associated resultant negative competitiveness in SA's terms of trade. Whilst foreigners were happy to finance the commodity and consumer booms over the past four years through continuous inflows, the cracks have been plastered over. Sadly, this could not last forever.
Before we get caught up in a negative maelstrom of newsflow, let us consider the following: The good news is that the currency following the 35% loss of value is finally on the cheaper side of fair value as measured in international terms and the pro-growth policies of the SARB have meant that interest rates have been slow in their rise. In fact a 1% increase has thus far had virtually no impact on consumer behaviour. The SARB is clearly waiting for convincing evidence of higher inflation before acting further. Our expectations are still for 2% further increase in interest rates, in order slow the demand side of the economy down to a rate that allows the supply side to catch up, thereby prolonging the expansion of the economy.

On the foreign front, there are signs that the 11th of May marked the peak in the commodity cycle, particularly as witnessed by the CRB Index. This pullback and evidence that the global economy is slowing, led by the US, could be enough evidence to see the end of the US rate hike cycle. However, the period post the peak usually is a difficult period for equity markets, as the market digests renewed optimism around interest rates measured by downward pressure on corporate profits. This could see a more difficult period for financial markets in general, and would argue for caution on overall fund positioning. Although we have seen material weakness in the share prices of many consumer discretionary shares, we still believe it too early to add weightings to this area, and hence the overall equity weighting remains around the 56% level.

We are encouraged that in most cases, the performance of the shares we own have lagged the increase in their intrinsic value, and this notwithstanding solid levels of absolute returns. In our view the average Resource share has through outperformance started to discount a far weaker rand than is likely to materialise (around R11/$). In many cases the shares are therefore ahead of their cyclically adjusted fair values. We continue to have limited exposure on this front. The only other rational explanation would an anticipation of higher commodity prices.

The unrecognised area of value lies in the manufacturing export oriented businesses, the import replacement businesses and the businesses domestically that have an element of pricing power. We prefer to also concentrate the consumer exposure into non-discretionary spending items like healthcare, food and fuel, where the prospects are fairly robust. Share like Nampak, Afrox, Mediclinic, Pick 'n Pay, SAB, Tiger Brands, Bidvest and MTN fit this bill.
We have not reduced the exposure to banks, noting however the vulnerability to a negative interest rate environment. The flexibility of the business models should continue to provide a robust profit underpin.

The valuation of the equity market is consistent with a low 3% real return from here. Although bond yields have increased, their forward yields are vulnerable to unexpected higher inflation the market's current 6% view. This could occur, given the precedent that the rand weakness episode of 2001 set in the domestic markets. Cash still looks more attractive at lower risk. Offshore assets look less attractive now that the rand has weakened, but global equities could surprise on the upside. We continue to retain cash for better prices and opportunities where the forward risk return trade-offs are more favourable.

The past three months has seen financial markets experiencing a more malignant expression of the scenario that we have been anticipating a quarter or more ago. Following a period of incredible prosperity not witnessed in some 20 years, led by a remarkable commodity and domestic consumer boom. After four years of relative strength in the exchange value of the rand, we have seen a marked sell-off in the past quarter, the worst quarter for the currency in over five years.

The bad scenario that the markets have been starting to discount is an interest rate driven global growth slowdown with knock on effects for risky assets including emerging markets and commodity prices. The strong negative performance of the rand has been due the perception that both these shoes fit very squarely on SA's foot. The continuing unsustainable credit growth in SA, tied with low real interest rates has delivered an unsustainable current account deficit to the tune of 6.4% of GDP in the first quarter of 2006.

Foreigners have realised that their growth driven investment strategy in SA has been somewhat self-fulfilling after pouring a record $42bn in equity flows in the first five months of 2006. Capital inflows led to exchange rate strength and lower interest rates in turn leading to higher asset prices. This virtuous cycle is showing signs of reversing. Following the sharp decline in the rand and the marked lower level of overall equity market valuation, we re-asses the long run expected returns for SA assets. Early in May this year, the equity market was priced to give us no more than 3% in real terms over a minimum five year time horizon.

The equity market level now is consistent with forward looking returns of slightly more than 5% real, showing a noticeable improvement. The irony is that even though many of the high quality shares in your fund are more defensive, they have struggled to hold up in the face of the universal sell-off in all equities. The market has now re-established a decent margin of safety in general valuations of assets.

Unfortunately, enough damage has been done to raise the long run inflation expectations in the market to around 6%, with potential for inflation to rise above 7%, leading commensurately to rational expectations in the short term another 2% rise in short term interest rates. Under this scenario, the ratings multiple of share prices to underlying earnings will head lower in the months ahead as share prices under perform profits growth, but we think that good quality business will still produce the dividend flows to provide for a solid return on capital. It is important to recognise that during such leaner times, the intrinsic value of good business will rise with time. Any divergence between share prices and intrinsic value in the favour of intrinsic value will further encouraging the long term investor. We are careful and do not want to own businesses whose fair value ebbs with a change in the big picture environment.

The overall fund contains some 56% invested in equities, with a large cash weighting, and where allowed, we have taken the foreign weightings to close to the 15% mark, where clients have given us full discretion. Having exposure to non-rand sources is an integral part of the solution to generating long run forward looking real returns. We continue to like the long term prospects for Standard Bank with its quality banking franchise, Sasol with its unique oil from coal technology, Remgro with a 50/50 domestic offshore portfolio, and Afrox, with a sound annuity business and broad pricing scope.

The commodity bull market appears to be accelerating. The bulls argue that the strong gold and base metal price movements in 2005 came despite a strong dollar, which in turn was supported by higher US interest rates. They argue that as soon as the rate cycle peaks in the US, the bear cycle in the dollar will resume. This will support commodity prices. The bears will argue that the Federal Reserve is targeting commodity prices and will only be finished raising interest rates when commodity push inflation is controlled, with the result that the commodity cycle will stall because the demand is curtailed. The bear market outlook has profound negative implications for the continuation of the bull market in SA, the rand and interest rates. Who is right? At this stage we do not know, but the best thing we can do is allow for some upside if the bulls are right, and protect your money if things don't work out and the bears view prevails.

Valuation levels of the overall equity market are consistent with low (3- 4%) real long term returns going forward, but still slightly ahead of cash and both conventional and inflation linked bonds. Property unit trusts have delivered simply stellar returns over the past 1 - 7 years, and are now also approaching peak levels. We still have some exposure, but will continue to sell into strength. We know that in the longer term, more modest returns will prevail. In the short term, the lack of pressure on interest rates in SA and the overall earnings momentum is supporting all share prices. We continue to hold the shares in businesses that offer flexibility around the macro-economic environment and good earnings and dividend visibility. In this regard, the portfolio is little changed from the previous two or three quarters. We continue to steer clear of shares like Sappi and Didata where the price discounts a lot of the next 2-3 years possible earnings potential already.

The only certain way to protect capital is cash, but such comfort exists in the short term only and before inflation is taken into account. We continue to like offshore cash as a strong portfolio hedge in a rising global interest rate environment, but coupled with holding shares in good businesses that are not expensively priced. As such we still have more than half the funds in select SA equities. We have added some offshore equity exposure to the portfolio, but have chosen very defensive high quality branded consumer companies, rather than geared exposure to China, which most of Asia offers.