The themes which have dominated equity markets over the year to date show little signs of change. Interest rates, US-China trade wars, Brexit and disruption in Hong Kong have all dominated the financial newsflow and look set to do so again as we move into Q4. Major equity indices largely moved higher during the third quarter, but there was volatility and it was all too easy to be caught out by bursts of activity, particularly in currency markets which so often defy rational thinking.

The ongoing nature of these themes has extended the gap between market winners and losers and most especially between ‘growth’ and ‘value’ stocks. In Q3, US value stocks underperformed growth stocks by nearly 30%. Year to date, this underperformance widened to 53%, catching out many time-served market professionals. The principal reason for this phenomenon (if it can be called that) is the relentless decline in short term interest rates and the subsequent impact on bond yields. With the cost of borrowing at historic lows (at least for quality names), companies with good dividend yields and progressive dividend policies have been rewarded by strong inflows as investors look for alternatives to cash deposits and bonds. The divergence in performance has been exacerbated by fund flows into index-trackers and exchange traded funds. These are, by definition, indifferent to valuation or company analysis and simply drive earnings multiples (and share prices) to even greater extremes.

Thankfully, not all good stock performance can be attributed to such momentum investing. Second quarter results from the US as a whole and from many of our other international holdings were generally good, in no small part thanks to robust GDP growth in North America where we remain overweight. This is at odds with much of the rest of the developed world. Germany, for example, for so many years the powerhouse of Europe, is struggling to avoid recession. The UK is hamstrung by Brexit, a weak government and bitter Parliamentary infighting whilst the rest of Europe is perilously overborrowed and still trying to gain traction 10 years after the end of the global banking crisis. As a consequence, the Dollar has remained strong throughout the year in part thanks to good relative short-term interest rates (much to President Trump’s irritation), but also because the Dollar remains the currency of choice in uncertain times. Measured by the Dollar Index, the US$ is now approaching a 20 year high relative to the rest of the world.

At some point, the interest rate cycle will turn, but nobody knows when, not even the Federal Reserve Bank whose ‘dot plots’ of predicted interest rate movements have been unusually erratic. In the meantime, we have been fine-tuning the fund portfolio, taking partial profits where valuations appear excessive, adding to holdings which seem to offer better value and building new positions in investments which we think will thrive regardless of the short-term direction of the economy. In a world of haves and have-nots, this active approach helps us to avoid areas which have little scope for profitable growth whilst emphasising those areas where we expect performance to be above average over the next few years. It helps that the sectors which we favour have good earnings visibility, strong balance sheets and a progressive dividend policy. All of this reduces the likelihood of an unexpected profits warning. What we can’t forecast, though, is the increasingly erratic behaviour of politicians who dominate media headlines and influence another unpredictable force: sentiment.