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- Crisis, what crisis? Equity markets have ignored a myriad of negative surprises and shocks to post positive returns for the first half of the year.
- The main reason for this is that the global economy remains solid even after April’s tariff disruptions. A delayed reaction to the tariff hit remains the major risk we see on the horizon. We are keeping our fixed income overweight on (which will benefit from lower interest rates) as a partial protection against this risk.
- Diversification in equity markets paid off this year with last year’s relative losers (including Europe, the UK and China) turning into this year’s winners. We continue to believe this diversified approach is the right one for the second half of the year.
- For our Sterling and Euro clients, the main drag on returns this year has come from a weaker US dollar. In part this has reversed some of the exceptional dollar strength we have seen over the last decade. We think there is probably more to come but we expect the dollar will maintain its safe-haven status if a real crisis hits. This is one reason dollar assets still have a place in our portfolios.
- Another reason is that US equities still give the best exposure to the ongoing software and AI revolution. We are balancing this (more expensive) technology exposure with some of the much cheaper opportunities we currently see in the UK, Europe and Asia.
- The other secular risk looks to be today’s high and rising government debt levels. We remain vigilant on this but so far government debt markets have remained relatively orderly and our fixed income returns for the year are in line with our longer-term targets.
- Our alternatives book (including gold and investment trusts) was our best performer for the quarter. While this pace will be hard to maintain, the tailwinds that drove Q2 performance remain in place. Gold continues to benefit from central bank buying and the continued strong cashflow generation of our investment trust book means it remains attractive.
Review of the first half of 2025
The first sentence in my January overview was: A strong global economy was the foundation for positive equity returns in 2024 and – absent the usual surprises and shocks – there is no reason to think this will not continue into 2025.
If you read that and thought, great, let’s switch off the news and go on holiday for 6 months, then congratulations, from an investment perspective at least, you probably did the right thing. If instead you stayed here and followed the news closely you would have worried about (amongst plenty of other things):
1. Donald Trump announcing tariffs that took the US effective tariff rate from 2.5% to over 20%, the highest since the Great Recession, which caused the US S&P 500 market to fall over 12% in 5 days.
2. War in the Middle East, including both Israel and the US bombing Iran, which led to a (short-lived) 30% spike in oil prices.
3. Trump’s US tax bill being announced which, if enacted, means no fall in the US deficit and US debt to GDP being projected to keep rising indefinitely.
4. The delayed impact of the tariffs combined with a weakening employment picture meaning there are plenty of people worrying about economic growth in the second half of the year.
And yet, in spite of all this, Table 1 shows that equity markets (in local currency terms at least) are up for the year. And even bond markets, where concerns about government deficits matter the most, have been generating steady bond-like returns for the past 12 months. How best to explain this disconnect between some of the negative surprises I’ve listed above and the returns for the year so far?
The first point I would make is that, to return to my starting sentence in January, the global economy remains relatively solid. And solid economies are normally friendly for equity markets. In April there was a general view that companies were delaying investment and hiring decisions until there was a clearer picture on where tariffs would end up. And for the big two, China and Europe, I still don’t think we have that clarity yet. There was also a view that it would be around now (so three months on) that the increase in tariffs (which are, after all, a tax rise) would start to hit the consumer. Yet, try as I might, I have yet to see the impact of either of these show up in the US economy. The US has proved remarkably resilient over the last three or so years. Equity investors are of the view this will continue to be the case.
The second more big-picture point is that the world does not have to be perfect for investors to make money. Chart 1 shows returns for US equities since 1871. The real return over this period (so the extra earned over inflation) was a respectable 6.9% per annum. And remember this was a period that had bank runs and financial panics in 1873, 1893 and 1907 as well as World Wars I and II (including nuclear bombs being dropped on civilians), the Great Depression, the Vietnam War, the collapse of the USSR, the 2008 crisis and most recently CoVid. We of course face plenty of challenges today, but it is not obvious to me they are worse than the ones we have overcome in the past. And sometimes just things not getting worse is enough of a catalyst for market recovery.
Looking forward, the main risk to us still remains that tariffs and higher interest rates will ultimately trigger some sort of slowdown. As I mentioned above, it has in fact paid to believe this will not happen over the last three years and the fact we have kept our overall risk levels more or less steady during this volatile period has helped performance. We have, however, consistently had an overweight to bonds (which should benefit if and when a slowdown does arrive) during this period. We have not really needed this insurance yet but our bond investments continue to generate respectable returns and we are keeping this overweight on for the third quarter at least.
As for our portfolio performance, we were helped in the second quarter by a number of our active managers beating our internal targets. We were also rewarded by keeping our faith in the UK Investment Trust market. We have written here several times about the value available in that market. Sadly, a lot of that value was created by a 24-month bear market where it seemed prices would fall every day, whatever the performance of the underlying assets. In January, however, that bear market finally ended, helped in part by bids from bottom-fishing private equity and trade buyers. This helped our Trust book (for our sterling based clients at least) be our highest performing sector in the second quarter. Outlook for H2 2025
Equities
Our equity strategy is built on a platform of diversification. And we have felt the value of this over the last 18 months. In 2024, US equity markets comfortably outperformed every other region (with plenty of investors talking about US exceptionalism). 2025 then began with a complete volte-face. Our best performing equity investments in the first quarter were in China and Europe (ironically the regions likely to be hardest hit by higher tariffs). And in Q2 2025 our standout performers were a UK equity fund and an active global manager focused on the US. It is hard to predict surprises.
Our best protection is therefore to maintain meaningful allocations to the US, Europe and Asia and hope for some manager outperformance on top. This approach has, broadly, worked for the last 18 months and I see no reason to change it today.
But even if we are diversified, we still want to focus on a few core themes. Today we would highlight two. First, I have lived through three technological revolutions (home PCs, the internet and mobile phones). AI is the fourth and may be the most important of the lot. The most important new company is OpenAI, but there are plenty of AI focused companies in the US and China. Nvidia, up over 12x since 2022, being the poster child. US technology giants continue to dominate the US stock indices. Although US equities are lagging this year (triggered in part by a weaker US dollar) a core allocation to the US (and hence exposure to US technology) remains a central pillar of our approach.
Secondly, to balance this mainly tracker based US allocation, we also have investments in value-focused managers in Europe and the UK. Current equity valuations remain expensive relative to history (see Chart 2) but our European value manager has a book valued at around 9 times earnings. For our UK manager that multiple is 10.6 times. This effectively gives a barbell of expensive (but faster growing) US equities balanced by the much better value available over here. And both can work at the same time: Chart 3 shows that (cheap) European Banks have outperformed the high-flying US Magnificent 7 technology companies since 2022.
Fixed Income and Alternatives
If Chart 2 shows that equities remain expensive relative to history, one source of comfort is that fixed income valuations still look attractive. For those that worry about inflation, plenty of US and UK inflation protected bonds will currently pay you whatever inflation turns out to be plus a healthy cushion of over 2% per annum.
The risk you are taking here is, of course, that government deficits remain large and debt to GDP ratios keep getting worse not better (see Chart 4). This might push real yields (or your 2% cushion) even higher. We remain attentive on this but my main observation is that government bond markets have, so far, remained pretty orderly and well behaved (in spite of all that Trump and our Labour government are throwing at them). The UK 10 year government bond has remained in a range of between 4.4% and 4.9% so far this year and total returns from most fixed income has been accordingly steady and ahead of inflation. If a recession does come, then central banks have plenty of room to cut rates and that should prove to be good news for our fixed income portfolios. In spite of the deficit risks, we are keeping our overweight on for now.
Finally, our alternatives book (which includes the investment trusts I wrote about above) proved to be our strongest returner in Q2. While this pace will be hard to maintain there are still some attractive tailwinds for the sector. Gold continues to benefit from strong central bank buying as many countries continue to reduce their reliance on the US dollar. The Investment Trust market continues to see new buyers arrive (attracted by recent returns) just as the supply of assets shrinks (driven by both wind-ups and takeovers). Ultimately, though, it is the performance of the underlying assets that matters most. Cashflow generation for the assets in our portfolio remains strong and this is the foundation on which our recent returns have been built. There will of course be plenty of surprises waiting for us in the second half of 2025, but I would expect our investment trust assets to keep returning cash to us come what may.
Chris Brown
Chief Investment Officer
