The concurrent rise in historically safe assets like bonds alongside traditionally higher risk assets, such as equities, continued unabated in 3Q. This suggests investors remain uncertain about the outcome of a series of geopolitical and macroeconomic issues including trade talks and the path of monetary easing. The broad regional stock market rally continued through 3Q, with the S&P 500 Index’s 19% YTD gain, after gaining 1.2% over the past three months. In so doing equities maintained their largest year-to-date gain in over two decades and served to extend the longest bull market in history. In the absence of irrational exuberance, investors were drawn to equities in their quest for income in an increasingly negative yield environment. Slowing global growth forced global central banks to keep monetary policy loose. Falling rates on ultra-safe strategies have fuelled interest in corners of the market investors may conventionally have considered too risky.

In 2019, year-to-date returns in most equity indices have been driven predominantly by defensive sectors, which have been treated as proxies for long duration bonds and favoured as being resilient against economic woes. This is a perception which has led to investor crowding and stretched valuations for stocks which are disproportionately impacted by moves in bond yields. However, the S&P 500 Index has only risen 2.2% over the past 12 months, following the seismic sell-off in 4Q18. Equity indices attained fresh historic highs in July. This was driven in part by expectations of the US Federal Reserve’s first interest rate cut in more than a decade. In August, the indices fell again as the trade frictions with China once again escalated and fears of a US recession increased.

In the final phases of 3Q19, major equity indices clawed back their earlier losses. Since mid-August 2019, beneath the seemingly calm veneer of broad equity markets there has been a meaningful rotation between winners and losers. This has been characterised by a sharp increase in cheap value stocks, with previously outperforming defensive and quality stocks retreating. The recent rally in sovereign bond yields, and growing expectations of a thaw in the US-Sino trade war, have provided catalysts for these significant rotations amongst equity market sectors. These rotations were driven by upside surprises in economic data and optimism over trade talks that drove short covering. By contrast, last year’s 4Q unwind was brought on by a growth scare: data deceleration, trade tensions, and central bank tightening. Volatility was not limited to equities at this time. Government bond yields in the US and Europe fell in August, while Brent crude oil recorded its largest percentage jump on record following an attack on Saudi Arabia’s oil infrastructure. Moving into 4Q19, the main drivers of returns in equity markets remain corporate earnings and global economic growth, both of which remain in the ‘cross hairs’ of the ongoing trade war.

The returns to value, quality, momentum and growth have been weak over not just 3Q18, but over the past 12 months. There has been inconsistency in many factor returns, and intermittent spikes in correlation between factors. Overcrowding in medium-term factors, particularly in North America, has contributed to this effect, which has been accentuated by capital outflows and liquidity being withdrawn from strategies using these factors. Many of the medium-term factors employed by the team have overlapped with some of these overcrowded areas. In turn, this has contributed to a period of extended softer performance.
The fund performance was weak across most stock selection criteria throughout the period. At a portfolio level, for example, it has proven challenging to blend value with a series of our other factor sets. The nature of the relationship between value and momentum, as well as between value and company management, has detracted from returns in our funds this year, as evidenced by the weaker contribution from the market dynamics and company management factor sets. The long track record of success validates the benefits of such an approach; however, there will be episodes when it struggles. We believe the proposed model enhancements will mitigate such effects going forward.

Market environment indicators have maintained some regional dispersion in volatility profiles with Japan and North America respectively exhibiting low and high volatility. All other regions remain unchanged, anchored in medium volatility states. In addition, all four regions have retraced from their previous pessimistic sentiment states. All regions are now firmly positioned in neutral sentiment states. Over the course of the month, all regions have experienced an uptick in risk tolerance. By month-end, all regions have posted risk appetite levels which are range bound between one-third, and fiftyfifty risk on. As such this represents an improvement in risk appetite relative to previous months, following the value rally during September, but across most regions, risk appetite still remains somewhere between risk-averse and risk-neutral.

The fund aims to offer superior returns over the medium to longer term by investing in shares from developed countries around the world.

Despite a number of underlying indices reaching near record highs during 2Q19, equity investors generally appear somewhat "conflicted". Accommodative nearterm monetary policy from central banks appears reliant upon trade conditions continuing to remain unresolved in the near-term. Such an outcome is clearly not supportive of an asset class where investors crave clarity or visibility. In turn, this lack of visibility appears to be perpetuating and sustaining certain dislocations in the broader market.

To put this in context, returns exceeding 5% for both the S&P 500 and long-dated US Treasury paper during the first half of the calendar year have occurred on 10 occasions in the past 39 years. Three of those occasions have occurred since 2014, coinciding with an extended period of policy-informed markets. Price drivers such as central bank policy continue to dominate the market’s return structure. Currently, stocks most positively correlated to rising bond yields have significantly re-rated versus cyclical and negatively correlated equities, which have seen valuations slump to near recessionary levels, suggesting investors may be overly reliant on near-term monetary easing. For hedging against an economic slowdown, investors appear willing to pay a high premium for companies posting reliable earnings growth and dividends. The median P/E for S&P 500 defensive sectors is 18.9x, which is 1.8 standard deviations above the long-term history, or a 17.6% premium to cyclicals.

A further dislocation in market structure appears to be the “value conundrum”, particularly as expensive growth stocks continue to sustain excessive growth rates for prolonged periods. The FAANGS in particular appear to have defied the historic growth slowdown associated with large companies. Meanwhile, the increasingly concentrated and competitive universe of growth stocks appears to have created a structural disadvantage for value. It has meant that few value stocks have been able to benefit from the rebalancing effect when investors sell their expensive stocks in favour of those boosting improved operations or with tailwinds from a changing economic cycle. Moreover, the availability of cheap capital has meant investors have bought more growth companies in M&A transactions, reducing the takeover premium bias previously enjoyed by value stocks.

Distortions and dislocations of this nature may ultimately feed near-term shifts in sector, industry or factor rotations, particularly should expectations around future central bank support prove unfounded, or should long duration assets sharply reprice as they did at the beginning of 4Q18.

The effects of ongoing oscillations and regime changes have continued to broadly coincide with the fund’s investment implementation period, characterised by meaningful industry and sector rotations throughout 2Q19. In response to the unabated nature of market oscillations, we chose to modestly increase the risk aversion parameter within the fund’s optimisation framework. The implementation of this nuanced refinement has coincided with some marginally less pronounced industry and sector positions at the portfolio level, although it should be stressed that this is often seen during periods when there is a more elevated level of change in the leadership between industries and sectors at the market level.

We reiterate our belief that the investment process is well placed to deal with the current levels of higher dispersion in the market, since it is more closely reflecting the level of uncertainty in the real economy. Furthermore, the near-term drivers of the higher dispersion appear entrenched in the current market regime, thereby affording the strategy valuable visibility in terms of market state going forward.

The market environment analysis of the regions across our investment universe moderated marginally in response to the latest directional changes in equity markets. Risk appetite, which in May had been positioned at the lower end of the historic range in most countries, rebounded to finish close to onethird risk on globally. North America saw the most pronounced rebound in risk appetite to finish the month in line with global risk levels, followed by Japan, which was equally split at 50-50 risk on-off. Asia ex Japan and Europe both registered more modest improvements from their risk levels in May. In the context of market sentiment, all regions except for Japan remained anchored in pessimistic states, although these positions moderated somewhat to leave each region clustered on the borderline with a neutral outlook. Japan is currently positioned on the neutral side of that border. All regions demonstrated a similarly elevated volatility state.