Price performance of index since 30 December 1999
Source: FE Analytics
In truth, the FTSE 100 has been very close to breaching the psychological barrier a number of times over recent weeks, only to retreat on the back of poor mega-cap company results or macroeconomic fears.
Nevertheless a number of market experts, such as Fidelity’s Tom Stevenson, say the UK equity market can power through its record and, as it is fairly valued, now is a good time for investors to up their exposure to domestic funds.
However, there is little doubt that a number of risks are lurking around markets.
Therefore, before investors start getting carried away, we ask four industry experts about the major headwinds that are not only keeping them up at night, but also have the potential to cause the UK equity market to correct.
The general election
“The obvious one this year is political risk,” Rob Morgan, pensions and investment analyst at Charles Stanley Direct, said. “We have an election ahead and as a result a higher than normal degree of company and sector-specific risks in my view.”
A number of fund managers, such as Neptune’s Robin Geffen, have told FE Trustnet that they are completely avoiding the UK this year as there is massive uncertainty in the UK’s political landscape ahead of the May general election.
“I see ahead of us the most difficult general election in several generations, which has been further complicated by Alex Salmond’s determination to rip the heart out of Labour’s vote in Scotland. We have UKIP who will, despite what many pundits think, take seats across the board from all three major political parties and you get left with a serious political conundrum,” Geffen said.
Morgan (pictured) agrees and says that the uncertainty will not only weigh on equity market returns this year, but cause the sterling to loose strength which will have further consequences for investors.
“I would also extend this to currency markets as we might find that the pound is more volatile than normal and this would have an impact on the value of UK companies’ foreign earnings as well as the value of investors’ overseas funds – though for both these things a weak pound is a positive.”
An inflation or interest rate shock
The consensual view is that with disinflationary pressures – such as eurozone deflation and a lower oil price – and the upcoming election, the chances of a rise in UK interest rates over the short term are very unlikely.
However, now that inflation expectations are priced off a much lower base and as disinflationary forces seem short term in their nature, Morgan says a major risk is that investors are caught off guard by a shock inflation-induced rate hike.
“The other main risk is inflation and interest rates in my view. Presently I believe the UK equity market – along with most other world markets – has a degree of yield support,” Morgan said.
“That is to say a large scale sell-off would appear unlikely given the relatively high and stable yield on offer. However, that yield is only high in relation to interest rates and inflation close to zero. Should this side of the equation change and inflation and interest rates begin to rise more suddenly and to a greater extent than people currently expect, that yield support will diminish.”
“This is a key risk all investors should be keeping an eye on – despite all the current talk of disinflation.”
It might not just be UK monetary policy that hurts the UK equity market, however.
The likes of JPM’s Bill Eigen have warned that both bonds and equities will be hit this year when the US Federal Reserve inevitably does start to raise rates.
Performance of indices in 1994
Source: FE Analytics
Eigen says this would cause both asset classes to react like they did when the Fed pushed up rates unexpectedly in 1994. While the graph above shows this was a problem for investors in US assets, the FTSE 100 also lost more than 6 per cent that year as a result.
Richard Scott, manager of the PFS Hawksmoor Distribution and Vanbrugh funds, agrees that there are major risks surrounding distorting effects of ultra-low interest rates for such a long period of time.
“In my opinion the authorities need to normalise monetary and fiscal policy to give themselves the firepower to respond to the next downturn whenever that comes,” Scott said.
“I think there is quite a lot of complacency about low short-term interest rates as though they are normal, when in fact that judged by historical standards they are still at emergency levels six years after they were cut to 0.5 per cent.”
Greek debt negotiations
“I think the biggest risk in the short term is if the Greek position in the eurozone looks untenable,” Tony Cross (pictured), market analyst at Trustnet Direct, said. “The resulting shock would send equity markets across the globe sharply lower, at least in the short term.”
The ongoing Greek debt negotiations have been the major macroeconomic headwind which has kept a lid on the FTSE pushing forward over recent weeks, as the newly elected Syriza party attempts to change the terms of the previous bailout, which came with crippling austerity measures.
This has thrown up the possibility of a ‘Grexit’ from the eurozone and while Keith Ashworth-Lord –manager of the Premier ConBrio Sanford Deland UK Buffettology fund – says that would cause severe short-term volatility, it is better than the longer-term consequences.
“The Greek can has only been kicked down the road and the risk of an ultimate default is still all present,” Ashworth-Lord said.
“They need to go back to the drachma and have an orderly conventional devaluation. If they stay in the euro and suffer much more austerity, the whole place could blow up and the colonels put back in charge.”
“The failed euro project is causing such tensions in the Club Med countries that there is a risk of democracy being undermined and continental Europe flirting with extremism. That isn’t priced into the market.”
Russia and Ukraine
The Russian economy and markets have been in dire straits recently as not only did a 40 per cent fall in the oil price cause the Russian central bank to raise rates to 17 per cent, sanctions from the west over the ongoing crisis in Ukraine have weighed heavily.
Performance of indices since Jan 2014
Source: FE Analytics
Ashworth-Lord (pictured) says his largest concern is if Russia and Putin continue to be backed into a corner.
“My biggest concern is the sabre rattling with Russia over the Baltics. I have the ultimate faith in the EU and its leaders to make matters worse if they possibly can,” he said.
“It was the EU that provided the catalyst in the Ukraine by backing a motley crew of rebels to overthrow the pro-Russian government. Look where that has got us. Make no mistake, if tensions escalate over Estonia, Latvia and Lithuania, it will be Ukraine squared.”
He added: “We are talking about NATO members here. The stock market will not be immune.”
Ashworth-Lord’s concerns are echoed by Cross, who says that growing geo-political risk is a problem in general.
“We have the risk of another ‘shock’ with Russia - the rhetoric is ratcheting up so another incursion into a neighbouring state would look bad; whilst there’s a growing threat being played out by Islamic State and the accompanying risk of terrorism closer to home,” Cross said.
“There are certainly plenty of reasons to be bearish over the outlook for the FTSE 100.”
A black swan event
While the four risks mentioned so far are clear and present danger to markets – and though the header for this risk may seem very open-ended – crashes or corrections usually come about when the large majority of investors aren’t expecting them.
The likes of BP’s oil spill in 2010, the Japanese earthquake and tsunami and the 9/11 attacks have all come out of nowhere to force markets lower.
While investors cannot prep their portfolios for such an event – unless they are prepared to hold 100 per cent in cash – Rob Morgan says the reason why the FTSE could fall out of bed is because of such a “black swan” event.
“What derails markets often comes out of leftfield – natural disasters, Russia, terrorist attacks, take your pick. Most likely it will be something we have barely thought of,” Morgan said.