Investors might look back on the first half of 2019 with a mixture of satisfaction and confusion – satisfaction because portfolios have made strong progress; confusion because safe haven and risk assets have prospered in tandem.
 

This continues to be perhaps the most mistrusted equity bull market in history, with traders constantly fearing that a trap door will open beneath them.

A recent survey of fund managers by Bank of America Merrill Lynch (BAML) revealed the highest holdings of cash since the financial crisis. Data from fund analysts EPFR show record flows of investment into bond and money market funds, while equity funds suffered net outflows second only to the first half of 2016.

With the world’s largest stock market in the US on the cusp of a new all-time high, a sentiment indicator from BAML is close to giving a rare “buy” signal based on investor pessimism and positioning. And there is no end of commentators predicting geopolitical conflict, ranging from trade wars to conflagration in the Middle East. 

We will attempt to square this circle in the Key Influences section of this review, but first a look back at the main developments. Many of the recent headlines have been generated by the President of the United States, Donald Trump. It is his pursuit of a trade war with China that has been the key factor in applying the brakes to the global economy, especially international trade.

While we continue to believe that there is some merit in his contention that China has benefitted from an unfairly tilted playing field, it is difficult to support the manner in which he has set about achieving a levelling of the terrain. His pursuit of the “Art of the Deal” leads to capricious decision-making and unexpected pronouncements, such as on May 5th when he declared that talks between the US and China had collapsed and that he was going to raise the tariff rate on $200 billion worth of imports from China from 10% to 25%, as well as threatening to impose 25% tariffs on the outstanding balance of imports worth $325 billion if no subsequent agreement could be reached.
 

The last act of the half was a meeting between Presidents Trump and Xi that brought the promise of further negotiations, providing relief to investors. 

This triggered the only real “risk off” period that markets have experienced this year, as investors saw increased risk of escalation leading to weaker economic growth and lower corporate earnings. The last act of the half was a meeting between Presidents Trump and Xi that brought the promise of further negotiations, providing relief to investors. However, we are of the opinion that the tensions between the two countries run deep and encompass far more than trade alone, and so future disagreements seem inevitable. 

Not for the first time in recent years it was the central bank cavalry, headed by Jerome Powell of the US Federal Reserve, which rode to the rescue with the promise of easier monetary policy. The market’s expectation for the path of US interest rates was revised sharply lower, with futures now discounting as much as a full percentage point of cumulative reductions from the current range of 2.25-2.5%, with the first cut expected in July.

Outgoing European Central Bank President Mario Draghi surprisingly joined the party by suggesting that the ECB could also lower its deposit rate deeper into negative territory and even restart its Asset Purchase Programme.

Brexit continues to dominate the domestic headlines, and we currently await the result of the final round of the Conservative Party leadership contest between Boris Johnson and Jeremy Hunt. Such is the nature of the voting party membership that both contenders are required to lean towards a “No Deal” Brexit option in the event that the EU fails to offer any concessions in renewed negotiations.

It remains to be seen if acquiring the keys to Number 10 will elicit a change of tack, but for now the outcome remains as uncertain as ever. This has been reflected in renewed weakness of the pound, and also in the lacklustre performance of the UK economy, notably with respect to investment.  
 

Trump walked away from Barack Obama’s nuclear treaty with Iran and imposed heavy sanctions that have crippled Iran’s economy.

Another notable development has been the escalation of tension in the Middle East. Trump walked away from Barack Obama’s nuclear treaty with Iran and imposed heavy sanctions that have crippled Iran’s economy. Iran, in turn, has allegedly attacked oil tankers in the strategically important shipping channel the Strait of Hormuz, as well as sponsoring incursions into other Gulf states.

There is a real risk that the Strait could be closed, cutting off the flow of as much as a third of global oil supplies. This, along with production discipline, has been reflected in a 28% rise for the oil price this year, but a much sharper spike in the event of more serious supply disruption would have a far greater dampening effect on global growth. While we believe that escalation suits neither side economically (much as in the case of the US/China trade dispute), brinkmanship and miscalculations could yet exacerbate the situation.

We have commented before that judging the balance between growth and monetary conditions is a key plank of successful investment. This played out again in May and June. Growth forecasts came under pressure from threatened trade war escalation, but the promise of renewed central bank largesse triggered a recovery in sentiment. And yet, as alluded to earlier, shares and bonds seem to be following different narratives. How do plummeting bond yields align with soaring share prices? 
 

The answer can be seen to some degree in the relative performance of Value and Growth styles. Value investors continue to have a hard time, whereas Growth managers continue to prosper. Companies in the Value category tend to be more influenced by the economic cycle, whereas Growth companies are deemed to be able to generate decent returns even during periods of slower growth.

The valuation of Growth shares is heavily influenced by the discount rate or bond yield, and so a falling bond yield leads to a higher present valuation for the cash flow they will generate in the future. It is consequently no great surprise that Technology has been the best performing sector in the US. Around a quarter of the US equity market capitalisation is attributed to Technology, against just 6% in Europe and a mere 1% in the UK. Almost inevitably, then, the US stock market has been the best performer amongst major developed markets. Japan, packed full of banks and industrial stocks, has been the notable laggard. 

It would not be unreasonable to expect a period of outperformance by Value managers if trade war and Iran tensions were to reduce, which would leave the world on a better growth footing and reduce the need for much looser monetary policy, thus pushing up bond yields.

However, past rotations into Value have not persisted, and as long as we remain in a relatively low growth world compared with the period before the financial crisis, combined with still high levels of debt, we would be willing to endure a short term period of underperformance by not chasing a Value rally. Our core equity holdings remain built around companies with high returns on capital, strong franchises and sustainable balance sheets.

Liquidity within investment funds has been a big story in recent weeks, first with the suspension of redemptions from the Woodford Income Fund, and then with mass redemptions from bond funds run by H2O. We have written in the past that there is a risk of a mismatch between the daily liquidity that is offered by certain funds (whether they be Exchange Traded Products or governed by UCITS regulations) and the ability of the fund manager to raise the cash. This is not an issue most of the time, but a period of underperformance leading to redemptions, as experienced by Mr Woodford, can create difficulties.

There were no such performance problems at H2O, but a Financial Times investigation into some of their funds’ holdings touched a nerve when investors were vulnerable. As long as markets and the economy remain in reasonable health, none of this should be a problem, with investors potentially being compensated for the lack of liquidity with higher returns. However, a period of increased volatility could well uncover further problems. Our fund analysts remain highly vigilant in monitoring such factors, and we cut our cloth accordingly. 

UK equities continue to look superficially cheap, especially on a yield basis, but dividend cuts from the likes of Vodafone, with other big payments also under threat, highlight the risks of being stuck in a value trap. The biggest contributors to the rise in the index this year have been Resource companies, such as Royal Dutch Shell and BP (thanks to the oil price), and Rio Tinto and BHP Group (courtesy of supply disruptions driving the iron ore price sharply higher). While we commend all of these companies for displaying much greater capital discipline than in the past, it is clear that that their fate often lies outside their own hands, which tends to limit our enthusiasm. 

The US has shown most other equity markets a clean pair of heels this year, mainly thanks to its high proportion of Technology companies. This is despite disappointing public market debuts for ride-sharing companies Uber and Lyft. More successful was the flotation of Beyond Meat, the producer of plant-based (although apparently extremely palatable) meat, which has risen six-fold. There is a virtuous circle of capital, intellectual property and a vast consumer market available in the US which continues to make it well placed to take advantage of technological advances. For now, it also looks as though the Fed has put a safety net beneath investors. We continue to believe that President Trump will do everything in his power to keep the economic plates spinning at least until next year’s election.

Europe sidestepped a potential landmine in the form of EU Parliamentary elections in May, with extreme, anti-establishment parties failing to make the sort of inroads that were feared. However, pressure remains on the bloc to breathe some life into a still sluggish economy. One country that is trying to do that via fiscal loosening is Italy, but its plans are consistently blocked by Brussels owing to its already high debt levels. This conflict continues to influence the value of Italy’s government bonds, many of which are owned by Italian banks, creating fears for the country’s financial health. Although we enter the second half in a better mood, Italian politics are set to continue to be a destabilising factor. Europe as a whole would benefit from a trade agreement between the US and China, owing to the region’s greater-than-average exposure to global trade. 

Despite having been attracted by apparent good value and improving corporate governance, we have to admit that investment in Japan has been frustrating. Happily our preferred managers of Japanese equities continue to extract better returns than those available from the broad market. It is easy to forget that Japan is still the world’s third largest economy in dollar Gross Domestic Product terms, despite a shrinking population which presents it with a long-term growth challenge. But, necessity being the mother of invention, it is home to some of the world’s most innovative companies. It also benefits from having a government and central bank that are fully aligned in their policies. 

Emerging Markets (EM) are massively dominated by China, for which this year has been a very mixed bag thanks to trade war threats and a domestic economy that continues to decelerate, even if its growth rate is the envy of the developed world. The unwritten contract between the Chinese government and its people, offering increased prosperity in return for uncontested rule, suggests to us that more stimulus will be applied should the economy weaken further. Elsewhere, Prime Minister Modi’s surprisingly easy win in the Indian election delivered a mandate for more growth-friendly reforms, which the market duly priced in. Ultimately, though, the best thing for EM would be a weaker dollar, which would loosen financial conditions for indebted companies.

Central bank policy shifts referred to earlier in this review were reflected in bond markets, with the US 10-year Treasury yield once again dipping below 2% and the UK 10-year Gilt below 1%, while the German 10-year Bund yield fell to an all-time low of minus 0.35%. Indeed, such is the demand for safe assets that some $12.7 trillion worth of global sovereign bonds are trading with a redemption yield of less than zero, thus, in all probability, guaranteeing a loss of real value for the purchaser if held to maturity. This underlines the fact that investors have little option but to take on more portfolio risk in order to generate positive real returns. 

At least the hurdle for real returns is not as high as it might be, with inflation remaining remarkably subdued, especially in the face of near-record low unemployment rates in many developed countries, including the UK. The debate about the sustainability of low inflation rages on. The argument in favour centres around technology benefits and an ageing demographic, while the inflation hawks cite the historic impact of low unemployment on rising wages and ultimately price inflation. The evidence is insufficiently conclusive for us to take a strong view either way, but we do observe that investors in aggregate are not well positioned for a burst of higher inflation should it occur. 

UK Gilts have delivered a total return of 1.31% over the last three months and 4.9% over the last year. Index-Linked Gilts returned 1.74% and 7.96% over the same respective periods. Emerging Market sovereign bonds produced a total return of 7.18% in sterling over the three months to end May (16.19% over 12m). Global High Yield bonds delivered 5.57% (11.66% over 12m).

When we raised our risk tolerance in portfolios at the end of 2018, it was in response to the fact that we thought equity and credit markets had sold off too much in response to fears of slower growth and too tight monetary policy. Subsequently the lower growth outlook has been recognised in company earnings forecasts for 2019, which at a global level have fallen from around 10% last October to 2-3% today. But at least it’s still growth. At the same time central banks, led by the US and Europe, have executed a policy U-turn, thus providing liquidity support to financial markets. Geopolitical risk hangs over the market almost constantly, but a game theory approach suggests that in almost all cases, be it US vs China, US vs Iran, US vs North Korea, or (to provide some light relief) Brussels vs Rome, the result of escalation would be so damaging to both sides that neither will ultimately dare to push the other over the brink. However, the risk of a miscalculation or mistake is not negligible, which helps to explain, for example, the strong performance of gold so far this year. 

Investors, both private and professional, have to recognise that we live in times we have never experienced before, especially with reference to the amount of debt that has been created in the world and the extraordinarily low - even negative - yields on cash and government bonds. Add to that the profound influence of new technologies, ageing populations and the widespread challenge to the liberal order that has dominated the West since World War II, and the challenges of investing can appear almost overwhelming. However, a clearly thought-out investment process and robust financial planning are indispensable weapons in this fight, and we continue to believe that our capabilities in both areas are up to the task. Even as the current US economic cycle becomes the longest in modern history (dating back to 1854), it will inevitably slip up at some point, and we remain as attuned to the task of protecting capital in a downturn as to maximising returns during the growth phase.