Global equities
10 Jul 2017

Consistent returns in a changing world

A powerful cocktail of economic headwinds, disparities in income between rich and poor, polarisation in beliefs and sporadic ‘lone wolf’ terrorist attacks has conspired to destabilise the political landscape across much of the developed world.

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A powerful cocktail of economic headwinds, disparities in income between rich and poor, polarisation in beliefs and sporadic ‘lone wolf’ terrorist attacks has conspired to destabilise the political landscape across much of the developed world. Recent elections and referenda have had unforeseen results. Anti-establishment sentiment has flourished. Over recent years political risk has become accentuated, and has arguably not been so acute for a generation. Traditionally, political risk has traditionally been embedded in the risk premia of emerging market equities. Recently, the political dynamic across equities currently appears to be experiencing something of a ‘volte face’: markets that in the past were associated with populist regimes, such as Peru, Argentina and Brazil, have, for now at least, embraced market orientated reforms; while political risk in developed markets has increased.

Many of today’s active equity managers investing in developed markets have not faced the challenge of managing such specific political risks before in their investment careers. Given that recent elections in Austria, the Netherlands, and France failed to crystallize any political shocks, some have concluded that the wheels have fallen from the populist band wagon and that political risk is abating. Markets’ continued upward performance trajectory lends credence to their hypothesis. 

Their optimism may be premature.For some time now markets have relied on the central bank put, that is, the belief that central banks would always be able to step in to avert a crisis. Belief in central banks’ omnipotence has propped up markets during times of elevated risk. It may be that investors have become desensitised to risk, numbed by years of accommodative policy by central banks. Certainly, conventional metrics of market volatility are at record lows.

Different stories told by US bonds and equities 

Yields have fallen again while the S&P 500 price earnings ratio forges ahead.

Source: Bloomberg as at 28 June 2017.

A warning note is sounded by the bond market. While the price earnings ratio of US equities has continued upwards, bond yields have fallen this year (see graph), as investors have become sceptical about the potential for fiscal stimulus and higher rates in the US. 

Given the speed with which the market environment can change, it makes sense to be alive to the argument that the forces behind the resurgence of political risk have been playing out for some time and, far from being transitory, may not quickly abate. The case may be made that the initial upsurge in populist support has now given way to a second, more fractious, phase in which deadlock and polarisation threaten to strangle the political process.

These developments pose fresh challenges for active equity managers. When political aftershocks proliferate and instability abounds, skilled and experienced fund managers will embrace the challenges, and even find opportunities, but not all investment processes will withstand the trial. Our investment process aims not only navigate these challenges, but to be sufficiently robust to avail itself of mispricing opportunities generated along the way.


The economic headwinds feeding the resurgence of political risk originated in the 2008 Great Financial Crisis and the subsequent 2011 European debt crisis. Their collective impact was to blight many developed market economies and cause a sustained period of income stagnation. Real per capita GDP growth in the eurozone averaged -0.4% year on year between 2008 and 2015, against 1.8% from 1996 to 2007 and 2.1% from 1985 to 1995.

The pound in your pocket:  UK wages’ real decline 

Average weekly earnings regular pay, real and nominal, seasonally adjusted.

Source: ONS, as at 14 June 2017. 2015 = 100.

In consequence of these economic challenges, wealth dispersion has increased, especially in the US. There has been a growing perception of social exclusion amongst certain demographic segments. Although youth unemployment has fallen across Europe as a whole since 2013, it remains at crisis levels in several countries, including Spain (39.3% as at April 2017), Greece (46.6% as at March 2017) and Italy (34% as at April 2017), reinforcing a gulf between the generations, and encouraging young people to take up anti-establishment, anti-globalisation causes. From the European periphery to the rust belt of the US, divisions in society have deepened, with feelings of social exclusion across swathes of the voting population. The increase in asset prices following years of quantitative easing has done nothing to reverse the perceived generational gap between the haves and the have nots.

Silicon Valley v rust belt: income inequality in the US 

Source: ONS, as at 14 June 2017. 2015 = 100.

Tragically, a surge in ‘lone wolf’ terrorist activity across various developed market economies has increased fear and a sense of instability. The most recent terrorist attacks in Manchester and London are only the latest in a string of atrocities. The suicide attacks at the Brussels airport in 2016 killed 32, and in 2015 Islamic State-linked extremists attacked a concert hall and other sites across Paris, killing 130. Trucks were used to plough through crowds in Stockholm, Berlin and Nice, killing many.  In 2016 Europe suffered the second largest increase in terrorism in the world compared with 2015; the worst increase was in the Middle East and North Africa region. Fatalities from terrorism in Europe have more than doubled in Europe over the past five years. One consequence has been to spur nationalist and anti-immigration sentiment, and a growing distrust of incumbent governments and status quo. A significant number of people believe traditional government is impotent to defend against terrorism. 

In consequence, a succession of alternative political parties have arisen in Europe, including UKIP in the UK, Alternative fur Deutschland in Germany, the Front National in France, and Movimento 5 Stelle (Five Star Movement) in Italy.  While none have succeeded, to date, in achieving mainstream political power, their populist policies continue to inform political debate. In an effort to mirror shifts in sentiment among the electorate, some mainstream parties have co-opted elements of the populist agenda, bringing them into the mainstream.

While most of the new alternative parties are right-wing, the left wing has responded with its own radical agenda, as pursued by Podemos in Spain, Syriza in Greece, and the UK’s Labour Party under Jeremy Corbyn. 

Brave new world: support for authoritarian populism 

Mean support for left-wing and right-wing authoritarian and totalitarian parties, 1980-2016. 

Source: Timbro, as at 12 June 2016.

While some believe the alternative parties have peaked, it may be argued that, on the contrary, the drivers of political risk could continue for some time, continuing to test risk management as well as offer investment opportunities for active investors capable of meeting those challenges. 


The resurgence in developed market political risk is, for many, best exemplified by the outcome of the UK’s Brexit referendum on 23 June 2016, and the US presidential election on 8 November 2016. In each case, the political event has been followed by an aftershock. 

Brexit: twelve months on

Almost 12 months after the UK’s decision to leave the European Union (EU), the nature of Brexit remains unclear. Less than a year after voting for Brexit, the UK electorate withdrew support for the political party (the Conservatives) promising to deliver the country’s exit from the EU. This illustrates the potential for ongoing aftershocks to destabilise the investment universe. Following Prime Minister Theresa May’s decision to call a snap election, a disastrous election campaign ended with the Conservative party losing its parliamentary majority undermining the government’s credibility in negotiations with the remaining 27 European Union member states.  Questions abound over whether the UK may soften its Brexit goals, and reverse its policy to leave the EU’s single market for goods and services and the EU’s customs union. The final outcome will depend on complex technical and political negotiations involving commercial, business and strategic considerations and will have potentially profound ramifications for the structure of the EU economic framework and prosperity of its citizens.

US election: Trump disappoints

A hard fought political campaign exposed deep divisions between US citizens in terms of class, race and region. There were also allegations of Russian interference in the electoral process, claims which if substantiated have the potential to undermine confidence in the democratic process in the US. To date, the market has been disappointed by the Trump administration’s failure to capitalise on the Republican control of both houses. Policy optimism after the election has degenerated into policy depression. The market has had to adjust sharply its expectations around a pro-growth, fiscal expansionary agenda underpinned by tax reform and a massive program of infrastructure investment.

The outlook for ‘Pax Americana’ remains equally unclear. This preeminent doctrine of US foreign policy over decades has been usurped by an alternative global order. Despite the Trump’s administration’s unexpected airstrike in Syria in April, the ability and willingness of the US ability to resolve crises, foster compromise, discipline rogue states, and defuse regional and local conflict appears generally diminished. 

Global growth of nationalism

Arguably political risk has already led to a shift towards gradually looser fiscal policy.  There has been a trend away from globalisation, leading to disruption in levels of trade, foreign direct investment, capital flows, and immigration. The swing towards more nationalist policies has significantly increased the risk of more belligerent interstate relations, and the preponderance towards regionalism. These forces potentially lay the ground for more state intervention in the economy and rising economic nationalism. Greater political interference clearly threatens monetary policy independence, and potentially signifies a break with the existing relationship between central banks and markets.  


The binary nature of the outcomes associated with political instability has the potential to wrong foot many active equity managers, and undermine the consistency of the return structure. We remain resolute in our belief that forecasting future binary events leads to inconsistent returns.  What is not so often commented on is the fact that it is even harder to predict the reaction of the stock market to those binary events. One would have to get two things correct: first the macroeconomic event itself, and second, how the market will react to it. This double task increases the complexity, the risk and reduces the likelihood of predictive success.

If we apply this principle to the two most significant binary events in the market last year, we know that many observers failed to forecast that the UK would vote for Brexit in the referendum on 23 June 2016. Similarly, many failed to forecast that Donald Trump would win the US presidential election on 8 November 2016. Both outcomes were difficult to predict.  However, forecasting the reaction of the market was even harder. Many believed that a vote for Brexit, which was expected to damage the UK economy and to throw Europe into turmoil, would lead to a stock market fall. In fact, during the two months after 23 June 2016, the FTSE 100 rose by 8%. So even if one had forecast the result of the vote correctly, one could easily have incorrectly predicted the market reaction. Similarly, many believed before the US election on 8 November 2016 that a Trump victory would be bad for the stock market, because he was an unknown quality, and political risk would rise. In fact, during the two months after the Trump victory, the S&P 500 rose by 6%.  Political outcomes just became a whole lot harder to call; and irrational and unanticipated outcomes are becoming the new norm.

Rather than trying to predict political outcomes, our approach is to focus on market state, here and now.  We do not allocate our risk budget to anticipating binary outcomes, which may or may not play out..  Instead our approach is reactive. We observe the effect the big issues are having on the state of the market itself.  Our approach to the current elevated policy uncertainty is to react to how it is impacting the market, and not to try to predict the direction of travel.  More precisely, we try to understand which stock selection techniques will be most effective in the current market environment.  In seeking to determine the current market environment we are not forecasting macro. Instead we are trying to understand the type of stocks which will outperform in the environment here and now. With that in mind, our conviction is less on an individual stock level, and more around what investment style is suited to the current market environment in which we find ourselves.

Our stock selection process utilises a variety of independent, but complementary techniques.  Each of these additional techniques is a means of identifying mispriced opportunities in certain market states.  They are embedded within our five separate, independent stock selection criteria: Dynamic Valuation, Sustainable Growth, Analyst Sentiment, Company Management and Market Dynamics. 

Our investment process dynamically weights each of the five stock selection criteria according to how profitable it is expected to be in the current market environment. In essence, we give greater weight to those which have done well in past similar market states, specifically those closest to the market environment in which we currently find ourselves.Their effectiveness in different market environments is due, in part, to the independence that we have enforced in the construction of each of these five criteria. It has been further enhanced by the highly versatile, dynamic overlay that we use. This allows us to rotate the weighting scheme of the five criteria. We change the amount of importance given to each of them as conditions demand. Our dynamic weighting scheme has proven highly responsive to changes in the regime or state of the underlying market. The ability to rotate our stock selection criteria represents an integral part of our investment process, and has the aim of achieving positive returns across different types of environment. This aspect of our investment process, we believe, significantly differentiates our fund from peers.


We have seen, over time, how all five of the stock selection criteria have made a strong positive contribution. The fact that all five criteria made good contributions to outperformance is important, as we are aiming at providing diversified sources of alpha. For example, our Analyst Sentiment criterion captures behavioural aspects of the market reaction to analyst forecasts; this is quite different from our Company Management criterion, which seeks companies whose managements use their capital effectively; and both are different from our Market Dynamics criterion for example, which looks for market trends and seeks to avoid bubbles.

Active funds were in the spotlight last year after many failed to beat the index following a series of political surprises and the resurgence of the value style investing, which had lagged growth for a number of years. However, our flexible, unconstrained and opportunistic approach meant that we were able to navigate these various conditions.

In 2016, our strategies were able to flex their style exposures, in order to benefit from the strong rally in the value style (that is, a market preference for relatively cheaper stocks) in the latter months of the year. By contrast, at the beginning of 2016 we were quite defensively positioned, which proved the correct posture. As we moved through the year we built up our exposure to value, and this helped our performance for the calendar year as a whole.

Should the impact of political instability continue to impact the investment universe, in the ways described above, we have conviction that our approach to portfolio construction, together with the diverse techniques which we deploy in our stock selection, will continue to allow us to aim for consistent returns in an ever changing world.


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