We maintain a small overweight to cash on a tactical basis, given concerns with some assets that are traditionally defensive.

There have been three factors driving perception of risk in equity markets recently:

1. The US Federal Reserve’s neutral policy stance with regard to interest rates
2. Poor global economic data especially from Europe and China
3. A possible escalation in the US/China trade war

Judging by the performance of equity and bond markets over the last few months, we think they each reflect different opinions about the state of these factors. It is possible for such differences to persist for some time, but eventually they should coalesce.

We think both markets have probably gone a little too far. The bond market’s expectation of interest rate cuts by the end of 2019 seems ambitious given the poor economic data has improved somewhat. Current expectations would also be reflective of the belief trade negotiations will fail.

Equities on the other hand seem jubilant, reflecting the modest turn in economic data, expecting trade risks to disappear or possibly that bond markets are pricing in rate cuts.

The Fed’s mandate is to maximise employment, stabilise prices and moderate long-term interest rates. It is the first two of these which have a more immediate impact on the policy rate. Unemployment in the US is close to 50 year lows but inflationary pressures have yet to build significantly.

We think the bond market’s expectation of rate cuts is too high. As a consequence, we think market risk perception is susceptible to change again in the near future and some defensive assets such as absolute return strategies may struggle.

Industrial activity in March bounced in Britain, because it was supposed to be disrupted in April.
But, Brexit got bumped from March to October.
We remain neutral on and balanced within UK equities, ready for any Brexit outcome.

Britain is frustrated and remains divided. This is true across the electorate and Westminster. The boards of UK companies are probably divided too, but on one point there is widespread agreement. The longer it takes to find a way forward (either leave or remain), the worse the economic damage will be in the interim – irrespective of any damage that might come after departing.

Valuations in the UK look very attractive versus other developed markets and corporate profits are reasonably strong in some key industrial sectors such as consumer staples, financial services, and especially so in energy and materials (after a significant slowdown since 2013). There is weakness, however, in UK industrials as the economy stutters.

There has been a recent bounce in economic data – but the devil is in the detail. The boost came from building inventory stocks ahead of the 29 March Brexit deadline. With that deadline now pushed out to October, we could see economic weakness over the summer as we work through the inventory bulge. We do not believe confidence will lift to deliver a sustained rise in economic activity until Brexit is resolved, one way or the other.

Until then and in the absence of compelling alternative regional ideas, we remain neutral on UK equities. We have balanced our portfolios across industrial sectors and company sizes. Our aim is to remain as diversified as possible, prepared for any Brexit outcome, and focused on incoming data to guide us further.

European business activity has slowed down alarmingly, but there are signs of change.
European exports to China are a significant contributor to business activity. If the recent uptick in Chinese PMI data is sustained, we could see a recovery in European exports too.

Europe has been a cause for concern since early in 2018 with a slowdown in industrial production. Several reasons have been cited, such as new auto emissions regulations, slowing exports to China, protests in France and low water levels in the river Rhine hindering transport of products.

Of all these reasons, we find the slowdown in exports to China as being the most significant and given new economic stimulus efforts by the Politburo in China, it is possible the headwinds to European industrial activity could abate.

Looking elsewhere across the European economy, we find continued strength on the consumer front with continued gains in employment and wage increases. Drilling down into the cause of recent weakness in consumer sentiment surveys, we find most of the weakness is linked to consumers’ economic outlook. We believe this is naturally linked to the industrial slowdown and consequently should also abate as Chinese industrial activity also stabilises.

Having been reducing our exposure to Europe through most of the last 12 months, we have now returned to neutral and are monitoring incoming data closely.

The US economy is still growing but weakening from the supercharged growth of 2017 and early 2018. As with other regions, the weakness is found mainly in the industrial sector but consumer facing sectors are starting to show some weakness also.

Generally, small businesses are cautiously optimistic but still worried about the business outlook, driven in part by disappointment in earnings growth. Given the medium term trend, this disappointment in year-on-year comparisons may be a ‘hangover’ from the 2017 tax cuts. Nonetheless, part of the weakness surely relates to the industrial slowdown and we cannot overlook the impact of trade wars that are starting to take their toll – notably on the semiconductor sector.

We think the pause in interest rate hikes by the Federal Reserve gives the market some breathing room, but the recent rise in trade rhetoric means the market’s focus may be diverted from corporate fundamentals. The high degree of bipartisan support for continued action against China and deteriorating relations during the negotiation process has prevented us from taking on more US exposure.

Japanese consumers weaken and industrial production dives. We have slightly reduced our exposure again, waiting for more positive signs of growth.

Much like the industrial slowdown in Europe, we believe Japanese industrial activity will take its cues from two drivers. The first is when Chinese economic growth stabilises (i.e. the growth rate stops falling) which will likely come when their recently enacted economic stimulus feeds through into activity levels. But unlike Europe’s broad industrial base, Japanese industry is heavily reliant on the electronics and automobile industries, whose supply chains are entangled in the US-China trade war. Therefore the second cue is seeing a receding risk of further escalation in the US-China trade war.

The other key difference with Europe is that the Japanese consumer is weak. Retail sales and broader household spending growth is anaemic and despite labour shortages, real wage growth is far from impressive. In fact, the most recent data indicate a fall in contractual earnings though we note with a high degree of caution that data sampling problems have led to a string of revisions to economic data releases, notably by the Labour Ministry.

We have slightly reduced our exposure to Japan until we can get more comfortable with either the state of the Japanese consumer or some resolution to the trade war.

Chinese economic stimulus has boosted manufacturing, but the stimulus was much smaller and more targeted than that delivered in 2015.
We turn slightly positive on the region, held back from further optimism given ongoing trade related tensions with the US.

The economic stimulus injected by China is boosting sentiment in the region. However, unlike the stimulus of 2015, the current programme is far smaller and much more focused on internal demand stimulation. There has also been a recent boost to activity given the Lunar New Year holidays. Consequently we view the scale of the bounce with some speculation, having more confidence in longer-term trends.

The trade dispute with the US is far from over. We expect some form of resolution in the coming months, since it would help to arrest the economic slowdown in the US. Longer term, we anticipate flare-ups between the two superpowers, as each continues to push for technological supremacy.

The economic fundamentals tie much of Latin America to the price of industrial metals.
We maintain a neutral stance given weak industrial activity.

Mexico’s economy relies on internal consumption as well as exports. The drop in exports and industrial production over 2018, together with a 2019 pickup is similar to that experienced in other regions. In Brazil on the other hand, there has been a material headwind caused by the failure of a Vale dam in January.

The Latin American equity market remains highly correlated to industrial metals which are in turn highly dependent on moves in the US dollar and the capital expenditure cycle in China. There are reasons to think we may see a period of dollar weakness as the US Federal Reserve pauses monetary tightening. However, the economic stimulus in China is smaller than in 2015 and includes more consumer driven tax cuts. If more stimulus is deemed necessary, it may provide the opportunity for a short term pick up.

We have trimmed our exposure to corporate credit, while slightly increasing our exposure to US government bonds to take advantage of their defensive characteristics.

Government bonds

As we approach the end of the business cycle, the US monetary policy stance has started to make US government bonds more interesting again. The Federal Reserve has stopped raising interest rates, and economic data from multiple regions has weakened. This explains the tightening in government bond yields since Q4 2018. That said, there are some signs of improvement in activity and the market may still be overestimating the chance of interest rate cuts. US yields may rise again.

In the UK, there are material risks to the outlook for gilts in the face of Brexit and possible interest rate moves by the Bank of England.

For defensive exposures in portfolios, in case we do see economic deterioration, we are adding some exposure to US government bonds. Given the chance that US yields could rise again, we are holding off making a more aggressive move for now.

Corporate bonds

The yields available on investment grade bonds are more attractive now than they have been over the last couple of years. However, the composition of risk within the corporate bond market – especially in the US – looks very different compared to a decade ago, with a higher proportion of riskier borrowers.

European high yield is a bit on the expensive side, but offers a viable alternative to owning European equities in the short term.

As we approach the end of the cycle, we are less worried about the risk of company defaults, but more that corporate credit forms an additional source of correlated risk in portfolios. Our preference, therefore, is to reduce our exposure to credit in favour of government bonds that we expect to provide better protection.

Our view on other asset classes is more constructive than property and so we have slightly reduced exposure.

Valuations of UK properties in the industrials sector are getting expensive. There is a risk of price falls if consumption activity drops materially in a hard Brexit scenario.

We maintain our preference for prime assets in the South East, long leases and the industrial and alternative sectors given our perception of greater risks in the standard retail and office segments of the market.

We have limited exposure to physical commodities and commodity equities.

Commodities usually perform well in the later stages of the business cycle as increases in demand bump up against supply constraints.

However, there is a generalised cooling of fixed asset investment in China with a greater focus being paid to fostering domestic consumption. That said, there is a short term boost to infrastructure spending to stabilise the growth slowdown.

We believe bonds will be more defensive in portfolios than alternatives and so slightly reduce our allocation here.

We no longer hold a significantly negative view on bonds, so our counterbalancing allocation to alternatives remains neutral.

Higher uncertainty stemming from the impacts of trade wars, its impact on economic growth and consequently an uncertain Fed policy path are perturbing otherwise stable market relationships. This means some funds that manage risk solely by portfolio diversification, may be less reliable than historically.

The most important decision we make as Portfolio Managers is the distribution between each of the main types of investment such as:

• Equities (shares in companies based anywhere in the world)
• Bonds (short, medium and long term debt)
• Commercial Property (offices, shops, warehouses etc.)
• Commodities (metals, oil and gas, agricultural products)
• Alternatives (such as hedge funds)

The amount we invest in each will vary depending on the level of risk you are happy to take and on our opinion of the relative attraction of each asset. Typically we will reduce the amount invested in Equities for lower risk profiles.

We periodically adjust the amount allocated to each asset depending on our views on the various markets. Periods when the trend in stockmarkets is upwards are called Bull markets and the opposite Bear markets. It would be very helpful if we could predict accurately when Bull phases are coming to an end but markets don’t work like that. They constantly reflect the views of all those participating, so attempts to predict the timing of changes in direction are futile. In fact they can seriously damage your wealth: the Dalbar Quantitative Analysis of Investor Behaviour measures the impact on US investors and the conclusions are stark.

Although we are sceptical of the potential to time accurately when markets will change direction we do take a view on their relative attractions. We focus on the Cyclically Adjusted Price/Earnings Ratio (‘CAPE’) developed by Nobel Laureate Robert Shiller. Shiller has shown that if you buy assets when they are cheap and wait long enough you will earn excellent returns. We supplement this by also looking at other measures, such as Momentum. Once markets start to move in one direction they usually carry on for a while.

Our aim is try identify the very best fund managers in each specialist sector, whether that be Japanese Smaller Companies, or US High Yield Bonds or Property. Fewer than 1 in 10 active managers beat their benchmarks in the long term, so it is essential to be highly selective.

Identifying the best managers is more complex than most people realise. Numerous academic works have shown that simply looking at past performance is next to useless in terms of predicting the future, mainly because more than 90% of stock market price movements are believed to be random noise. Therefore, we have developed a bespoke screening system to make sense of the performance numbers and to act as an initial screen to weed out those who show no evidence of skill.

Fewer than 1 in 10 active managers beat their benchmarks in the long term

Then we meet the fund manager and quiz them on their techniques, trying to establish if their process is sound and repeatable. Over time we can build up a clear picture of their thought processes. This leads to the production of a detailed report which is then reviewed by our Fund Selection Committee.

Every fund manager will have periods of poor performance from time to time when their style is out of favour. Our job in those periods is to try and make sure that nothing fundamental has changed. Perhaps the manager is spending too much time on marketing, or the fund might have become too large to manage in the same style? In the investment world circumstances change continually and it’s our job to keep reassessing.

The final part of our investment process is to build a portfolio in line with the asset allocation guidelines that have been set from the small universe of funds that meet our quality standards. Typically we will hold at least 20 different funds in each portfolio to give us the optimal balance of quality and diversification.

Selecting the right combination of funds requires a knowledge of their ‘style’ characteristics. If we build a portfolio that is biased sharply towards a particular style then this will affect the performance when that style is in, or out, of favour. Building a portfolio a bit like designing a gourmet recipe: it’s not just the quality of the ingredients, its the way in which they work together.

Building a portfolio a bit like designing a gourmet recipe: it’s not just the quality of the ingredients, its the way in which they work together

The most important style factors are:

• Value vs. Growth – value stocks (those that trade on a low rating) outperform in the long run but can encounter long periods when they lag
• Capitalisation – smaller companies generate larger returns in the long term but are more risky
• Momentum – stockmarket trends usually persist (but when they do reverse it can be savage!)
• Yield – high yield stocks seem to perform better

In order to do this analysis our team make full use of a number of industry leading analytical tools, including Bloomberg, Morningstar and Style Research. We also need to check that the risk profile of the portfolio is compatible with the parameters.

Over time the allocation of assets within a portfolio will change as various markets move in different directions.
As part of our review process we will regularly rebalance portfolios. This is a very important process that helps to improve the risk/reward profile of the portfolios.

In effect it involves selling assets that have become expensive and reinvesting in those that are cheap.

We will also be alert to any changes in circumstances, both in the big picture and at the fund level. If a fund manager moves, or we sense that a fund has become too large to be managed efficiently then we will make changes.