As we approach the end of the summer and the start of a new school year, I thought it might be useful to update you on our recent performance and market views.

Polygon’s performance continued to be strong, in both absolute and relative terms, in the first half of the year, with returns for our primary strategy, Global Growth, averaging 6.9% (net of fees). As of 8/22, Global Growth was up 7.6%. For comparative purposes, year to date, the Dow is up 2.6% while the MSCI World Equity Index gained 5%. So despite our lower risk, diversified approach, which had an average equity weighting of approximately 70% (the remaining 30% was in fixed income and alternatives), we were able to exceed almost all equity indices over this period, not to mention bonds. This kind of risk-adjusted out performance is consistent with our long-term average annual returns of 12% since Polygon started at the end of 2002.

Looking at the source of this out performance, we benefited from a combination of good asset allocation as well as positive contributions from sector weighting. Globally, exposure to emerging markets was helpful (unlike last year), and in the US we were overweight in pharmaceuticals, energy and IT, which have been the three top performing sectors year to date.

As we enter the August doldrums, in the US all eyes have been focused on the annual Jackson meeting of the Federal Reserve. I have been privileged to have spent time in the last week with both Esther George and Dennis Lockhart, Presidents of the Kansas City and the Atlanta FEDs, respectively. Though they have very different perspectives, clearly hawkish sentiments are increasingly prevalent on the Board. While Janet Yellen’s more dovish views are likely to prevail for the time being, it is a question of when, and not if, rates will go up. We expect rates will start increasing in the first half of next year, somewhat earlier than the consensus forecast of 2H 2015.

Although US markets may have already discounted a rise in short-term rates, with equity markets fully valued, any increase in rates is likely to have a negative effect on stocks. In addition, though US corporates are sitting on record amounts of cash ($1.6 trillion), equivalent to more than double 2007’s level, corporate profits are at a record high of 9.4% of GDP (vs a long-term average of 6%). Given where we are in the economic cycle, cyclicality and mean reversion suggest both these numbers are likely to decline, which argues for the conservative, defensive orientation that we are currently maintaining in our portfolios.

Internationally, Europe continues to struggle with stagnant economic conditions and political issues revolving around both the EU and the current situation in the Ukraine. While the market has thus far shrugged off geo-political concerns, they may well provide a catalyst for a sell-off in the months to come. Nonetheless, valuations do not look as stretched as the US and this, combined with the continuous drumbeat of positive noises from the European Central Bank, provides rationale to maintain our current exposure to Europe.

On the emerging markets side, Asia looks more interesting. Even though China has struggled—laboring with concerns over credit exposure and with political risk simmering—valuations are attractive and economic growth remains robust at around 7%, although admittedly below the previous 9-10% level. In Japan, P/E ratios are substantially below historical averages, suggesting that bargains may be available. The government’s new growth strategy, and in particular the anticipated reduction in corporate tax rates, is an additional positive—though increased consumption taxes remain a concern. Across both these markets, price-to-earnings ratios remain depressed, while dividend yields are strong, particularly in Asia ex-Japan.

On the fixed income side, we continue to avoid long term bonds, given the potentially damaging consequences of rising rates. We have focused on investing in a diversified blend of fixed income instruments, including high-yield, floating-rate notes, and preferred stocks. Given the cautionary mood noted above, we have recently increased our cash position towards the 10% level.

In light of the uninspired outlook for both equities and bonds, alternatives look relatively interesting. We see pockets of opportunity in commodities, real estate and ‘toll-takers’, like MLPs, and certain types of utilities. Though not without risk, particularly in a rising interest rate environment, these types of securities generally provide high current income, combined with relatively low correlations with equities. We continue to grapple with the idea of investing in precious metals, which also hold the promise of inflation protection and low correlations with stocks, but lack a compelling growth story. Combining fixed income and alternative elements, while lowering the risk of the portfolio, may reduce expected returns. However, with global equity markets looking fully valued, this is a trade off we are content to live with for the time being..

In short, across our portfolios we continue to focus on maintaining a steady course, with an increasingly difficult search for value, while simultaneously seeking to retain a defensive equity posture leavened with a healthy dose of uncorrelated exposure.