Market review
Equity markets struggled in an environment of slowing growth and accelerating inflation. Both developed and emerging markets ended the quarter somewhat lower in US dollar terms, losing 1.4% and 0.8% respectively after an aggressive sell-off in June. Europe underperformed the US, while Asian developed markets posted better returns on the back of gains in Australia and Japan. The MSCI Emerging Markets Index was led weaker by Asia, with China posting a large negative return over the quarter. Both Latin America and EMEA (Eastern Europe, the Middle East and Africa) ended the quarter in positive territory, up 11% and 6.3% respectively (in US dollar terms).

Record high oil prices, up 35% over the quarter, set the tone for commodities. The oil cartel, OPEC, continues to ascribe accelerating oil prices to speculative activity and geopolitical risk and has refused appeals by developed market finance ministers to increase production. Steel, copper and precious metals saw price gains over the period, while recent price settlements by producers of iron ore with Chinese steel mills have averaged 85%.

Locally, there was further evidence of decelerating domestic activity as rising inflation and debt servicing costs constrained consumer demand over the quarter. This was evident in the negative growth in vehicle sales volumes and real retail spend. However, mining activity and agricultural output saw some improvement after a dismal first quarter. The outlook for domestic growth remains uninspiring as business confidence is at a four-and-a-half-year low. Forward looking indicators of the manufacturing sector point to a substantial decline in output over the next few quarters. A drop in income due to inflation, pressure on jobs as the economy slows and a decline in wealth as a result of falling house prices are likely to pose further headwinds to economic activity.

Against a backdrop of accelerating inflation, the South African Reserve Bank (SARB) hiked interest rates by a cumulative 100 basis points in April and June. Prior to the June meeting markets were positioned for a 1% rise after the SARB governor cautioned that tough measures may be needed to bring inflation back into the target band. However, rates were increased by only 50 basis points. The Bank cited evidence of a substantial slowdown in growth as the reason for the lower-than-expected hike in rates. Accelerating global oil and food prices as well as a weaker rand continue to underpin the negative domestic inflation outlook. The National Energy Regulator's recommendation of a 27% hike in the electricity tariff for 2008 and similar increases in 2009 and 2010, will further add to domestic inflationary pressures.

The bond market experienced substantial weakening across all maturities as the yield curve saw an upward shift in excess of 150 basis points over the second quarter. The All Bond Index lost 4.9% over this period, while cash (as measured by the STeFI) returned 2.7%. The listed property sector took its cue from rising interest rates and higher bond yields, selling off aggressively to shed 19.6% in the second quarter.

The All Share Index closed 3.4% up over the quarter losing some of its earlier gains as inflation fears gripped global markets. Substantial dispersion in performance across the sectors was evident as resources gained 13.4% over the quarter, while the Financial and Industrial Index lost 6.4%. General mining led resources higher, closing up 18.1% over the three months to the end of June. Banks and general retailers shed close to 15% over the quarter, while the defensive food retail and telecommunications sectors ended up 3.2% and 3.4%, respectively. The telecommunications sector was buoyed by corporate activity as MTN sought a potential merger with an Indian telecoms company.

Fund performance
The Investec Opportunity Fund earned a return of -1.3% over the second quarter and for the year to the end of June, the fund gained 6.9%. The fund enjoyed top quartile performance over the 12 months, five and seven years to the end of June (annualised returns).

Cash is King! Or is it? Only select resource stocks have beaten cash in the first half of the year. The same picture emerges when one analyses the past 12 months. Forty percent (55% if including international assets) of your portfolio has been in these two groupings and we are happy to report that we have earned good returns from Impala Platinum (up 30%), Sasol (up 36%), Assore (up 82%), NewGold (up 26%) and Illovo Sugar (up 20%). (The price increases are for the six months to the end of June). We continue to hold these shares as inflation hedges.

Richemont, Remgro, SABMiller and MTN have only held their capital value so far this year, which is a disappointing result given worse share price performance than the underlying profit growth. These rand hedge counters have outperformed industrials in general and should deliver a high return, given their expected profit growth. Our holdings in banks and in Steinhoff have been disappointing, with losses of value a feature over the quarter. Ironically, the largest future returns are potentially here, and we expect these to emerge as soon as we can see the peak in interest rates, inflation and the oil price. We have taken into consideration the tough conditions for credit quality, funding margins and asset growth and we still foresee rising profits for our bank holdings. However, rising government bond yields pose a significant risk to the outlook for these shares. Bond yields are one of the key factors in evaluating the future profitability of banks.

Portfolio activity
Our single biggest purchase in the first six months of 2008 was adding a reasonable holding in Richemont to the portfolio at the height of the market turmoil in January. The luxury business valuation was the lowest we have seen since 1998, when Asia suffered a massive economic crisis. Given the relative under-representation of Richemont in the US, and exposure to growth markets in Asia, we do not expect similar profit conditions. The business has no financial leverage, and is conservatively managed.

We sold out of Telkom in June. The share has been a reasonable performer, and we note the corporate action potential. However, we are concerned about future valuations, given current credit market conditions which make funding expensive. We believe the share is trading at the upper end of the value range and we see better value elsewhere.

Market outlook and portfolio positioning
By fully understanding the risks, we are able to position a portfolio to significantly cushion against downside risks. The peak in inflation is drawing closer. However, we suspect that inflation could exceed 12.5%, before retreating.

Cash will deliver 12% -13% over the next twelve months and is therefore a worthy asset for inclusion in the portfolio. However, we are increasingly starting to find real assets which can outperform that hurdle meaningfully. We believe our equities are priced to deliver 14% -15% over the next three to five years, with more upside, if interest rates are lower.

Listed property and bonds have lost money this year and we are still reluctant to invest in these assets as they offer no diversification benefit to the portfolio. Their risk-adjusted return forecasts are still low, even from these more reasonable entry levels.

Market review
Equity markets ended the first quarter sharply lower, driven by fears of a US recession, general risk aversion and a massive downward revision to earnings. The MSCI World Index declined by 8.9% over the quarter, outperforming the MSCI Emerging Markets Index, which closed down 10.9% (in US dollar terms). Global bonds saw strong absolute returns over the quarter, closing 9.7% higher over this period (in US dollar terms). The market ignored inflationary pressures and reacted instead to aggressive policy intervention, decelerating growth and a general risk aversion.

The shakeout in global markets saw investors flee the SA equity and bond market, resulting in a sharply weaker domestic currency. Over the quarter the rand underperformed emerging market peers, losing 15.9% against the US dollar and a much larger 22.4% against the euro. Facing the headwind of global market volatility and an uncertain growth path, the local economy further had to contend with severe power outages resulting in substantial costs to the local economy. Slowing domestic demand coupled with acute supply side constraints saw downward revisions of economic activity.

Bond yields succumbed to continued upward pressure on rising inflation, heightened risk aversion, a sharply depreciating domestic currency and potential further upside risk to monetary policy. The South African Reserve Bank faces rising global food and fuel prices, upward pressure on local electricity prices, as well as a depreciating rand. However, the outlook for domestic demand has deteriorated and monetary tightening in this cycle has not yet fully impacted domestic growth. This poses a dilemma for the inflation-targeting central bank. The All Bond Index lost 1.9% over the quarter with the short-dated bonds anchored by uncertainty about the next policy move, while the longer end sold off on the elevated inflation outlook. Cash (as measured by the STeFI Index) returned a steady 2.6% over the quarter.

Listed property remains under pressure from rising bond yields, rand weakness and some uncertainty with regard to income distributions as the economic outlook deteriorates. The sector lost 10.9% over the quarter, broadly in line with other interest rate sensitive sectors.

The FTSE/JSE All Share Index retraced the losses sustained towards the end of 2007, closing the first quarter up 2.9%. Resources were the clear winners, returning 17.6% as commodity prices reached new highs and earnings were aggressively revised upward. The domestically focused FTSE/JSE Financial and Industrial Index lost 8.5% over the quarter, depressed by tougher trading conditions and poor sentiment towards rate sensitive sectors. Banks, tainted by global credit market woes and local policy uncertainty, closed the quarter down 10.7%, while general retailers lost 14.3%. The construction and telecommunications sectors were less affected by the slowing domestic consumer environment, losing 7.6% and 4% respectively.

Fund performance
The Investec Opportunity Fund earned a return of 3.2% over the first quarter and for the year to end of March the fund gained 11.8%. The fund enjoyed top quartile performance over the quarter, one year, five years and seven years to the end of March (annualised returns).

October 2007 marked something of a turning point in the local financial markets. Since the turning point only offshore assets and inflation-linked bonds have delivered real returns to local investors. We have been concerned about inflation in the near term and raised this issue several times in our commentaries last year. However, we did not consider it prudent to attempt to buy large holdings of illiquid local inflation-linked securities on pitifully low real yields. Others that have followed this approach have been rewarded. We remain sceptical that exit opportunities exist.

The portfolio has appropriate exposure to offshore securities, which have benefited the performance. The full weighting to foreign assets has added considerable value. Equities have surpassed equity benchmarks and the fixed-income component, designed to offer solid returns in all market conditions, has also contributed to performance. The portfolio has not had material exposure to listed property and bonds. Both asset classes have lost money over the three and six months to the end of March.

In the wake of severe power outages impacting the mining sector, it was surprising that the performance of these shares has been spectacular. We have not owned the large diversified mining shares as we believe that the prices continue to discount high commodity prices, supported by production volume growth. However, the exposure to Sasol, Impala Platinum and Assore benefited the portfolio tremendously. A pure value orientation to local stock selection would have lost money in the past six months, which we simply could not afford. The value holdings like the banks still represent great long-term performance potential.

Portfolio activity
Strong resource share performance overshadowed poor financial and industrial share performance. We used market weakness to establish a position in Richemont, which represents our single big purchase during the quarter. This purchase increased the overall equity weighting in the portfolio at the same time.

The business has an unleveraged balance sheet, will restructure to unlock value in the tobacco interests, has sufficient earnings growth in the near term and is rated like a consumer stock with falling profits. Declining global interest rates will go some way to providing the seeds for the next recovery and we believe the market will realise all of this when final results are released in May.

We have not made any other major changes to the portfolio.

Market outlook and portfolio positioning
We never try to forecast short-term movements of any variables, including the direction of the stock market, as these forecasts typically prove fruitless. The overall equity exposure of the portfolio was trimmed by 5%, given the strong market bounce we experienced from late January. This call is about reducing exposure to shares that led the rebound, and we sold futures to the value of 5% of the portfolio. Commodity prices are behaving like there is no down cycle in global economic activity, yet financial shares are reacting as if the world's credit markets are shutting down permanently. Both views cannot be correct. We tend to think that the answer lies somewhere in the middle.

The further attraction of the short position is that we convert equity returns to cash returns on this part of the portfolio, thereby locking in more exposure to high, short-term interest rates. Based on the current positioning and the likely direction of interest rates over the next two to three years, we can still build a portfolio that will generate meaningful real returns over the medium term.

Market review
Against a backdrop of substantial volatility and heightened uncertainty, global equity markets fared poorly over the final quarter of 2007. All major indices closed down sharply led by the US S&P 500 Index (-3.3% in US dollars) and the Japanese Topix Index (-5.9% in US dollars). MSCI Europe outperformed other developed markets, declining by 0.4% in US dollars. The Global MSCI composite lost 2.3% over the fourth quarter (in US dollars). Emerging markets held up admirably on the back of domestic currency strength and somewhat different local growth dynamics. The MSCI Emerging Markets Index gained 3.7% over the quarter (in US dollars). Bond markets had to contend with the dichotomy of accelerating inflation and clear signs of economic deterioration. The Global Bond composite returned 3.9% in US dollars over the fourth quarter.

On the local front, the bond market focused on inflation data and the near term direction of interest rates. With inflation accelerating and the outlook for food and energy prices deteriorating, the bond market had priced in a fourth interest rate hike in 2007. The South African Reserve Bank's monetary policy committee statement leaned towards a peak in the interest rate cycle and the yield curve shifted down, retracing some of the earlier losses. The All Bond Index returned 0.9% over the quarter and 4.2% for the year. Cash (as measured by the STeFI) returned 9.3% for the year and 2.5% over the fourth quarter.

Domestic equities came under pressure during the fourth quarter, with the All Share Index closing down 3%, but achieving respectable returns of 19.2% for the year as a whole. The losses were concentrated towards the end of the period, as both resources and financials became victims of the uncertain global growth outlook and continued negative sentiment associated with the global banking sector. Gold miners ended the year as the market's worst performer, losing 14.1% over the quarter and 20.6% over the year. The construction sector continued its strong run, to end the year 77.3% higher as the best performing sector.

Fund performance
When we looked at asset prices at the beginning of 2007, we came to the conclusion that a well-structured portfolio that did not take excessive risks could deliver 12% - 14% total return for the year. The Investec Opportunity Fund returned 2.8% over the quarter and for the year to December the fund gained 14.5%. We are therefore not surprised by the overall fund returns that have been delivered, which match these expectations. However, we were surprised by the extent to which some sectors like construction outperformed, and other sectors like retail collapsed. Also, resource shares, particularly the big miners, fared better due to stronger bulk commodity prices than anyone would have expected.

Equities in general had a good year, although the performance of the market was remarkably narrow with the top five stocks by market value (BHP Billiton, Anglo American, MTN, Sasol and Impala) delivering some 90% of the market's return of 19.2%. We largely avoided the furniture, apparel and clothing retailers this year, in a move that added value to the fund.

The best share in your fund this year, from a performance perspective, was Associated Ore. This share was the best investable resource share for 2007 in terms of performance. The company mainly mines manganese and iron ore, and the expansion at its Khumani iron ore mine was well-timed and so far meticulously executed. On our numbers the valuation is attractive and the volume growth for 2008/09 will lead to handsome earnings growth. One of the big criticisms we have had of most mining companies like BHP Billiton and Anglo American has been their inability to deliver volume growth in their operations as the world seeks to feed commodities to the Chinese dragon.

The latest bid by Billiton for Rio Tinto solves a volume problem, but is potentially of limited long-term value, if commodity prices do not hold at the current elevated levels.

In contrast, your fund's resource exposure has been concentrated around reasonable valuation and volume growth; with companies delivering exemplary cost control. Impala Platinum has also fitted this category well with the business delivering best in class cost management and 5% PGM (platinum group metals) volume growth. Sasol continues to provide a strong hedge against future inflation risks from oil, reasonable organic growth prospects and an undemanding valuation.

Portfolio activity
Holders of retail stocks appear to be losing their appetite for these shares. We are starting to again look at counters like Foschini, JD Group, and in fact any business with a credit book. In particular, we are getting excited about brokers giving up on these shares and the market factoring in a very poor macro environment. We have started to nibble on JD Group shares. These shares have fallen some 32% this year. We are in no rush to populate the portfolio with this exposure just yet.

The fund has no material exposure to the retail sector. However, given that the purchase of Ellerines by Abil has improved the profitability and competitive positioning of this company in the sector, we continue to retain exposure. The share still offers a unique combination of strong growth and a substantial dividend yield.

Market outlook and portfolio positioning
The year ended with the South African economy running above potential in many areas. Evidence of this is the current account deficit ( 8% of GDP), CPIX ending close to 8%, four interest rate hikes and severe pressure on productive assets like infrastructure providers including roads and electricity generation.

We continue to be concerned about the rising monetary policy cycle trend. Apart from making cash an attractive asset class, interest rate hikes reduce the scope for earnings growth and the ability of many domestic shares to attain a higher rating.

We have been beating the drum on predictable earnings streams from quality businesses with good track records. This theme remains intact as we go into the New Year. We still think patience and a high cash weighting will reward investors. Our view is that cash should not currently be viewed as a residual holding, but as an integral component of performance delivery.

Local bonds continue to price in a substantial decline in both short-term interest rates and inflation into 2008. We remain sceptical on both fronts, as the decline in inflation will have to be due to a lower rand oil price, lower food prices and/or modest wage demands. Our view is that if oil prices fall, this will be due to weakening global growth negatively affecting all commodity prices. This implies that the rand is likely to weaken providing a renewed source of other inflation. Also, with full capacity utilisation, upward inflationary pressures will remain for some time to come.

We are enthused by the performance of the global equity holdings. In dollar terms, the fund is ahead of the MSCI World Index, and more importantly is displaying the necessary minimal downside deviation. We do note that the measurement period is only nine months. Given high and rising inflation and lower realised returns from real assets, we expect a difficult 2008. Nonetheless, we do not anticipate negative real returns.