Investors cannot afford to get carried away with the strength of the UK’s equity market or economy, according to FE Alpha Manager Mark Martin, who warns that current valuations in risk assets and the highly interest rate sensitive nature of the UK economy are major headwinds. 
Equity investors have enjoyed a good 2015 so far as markets have continued to climb the so-called ‘wall of worry’, meaning the bull-run in risk assets is now very firmly into its sixth year.
According to FE Analytics, the FTSE All Share is up a hefty 160 per cent since it bottomed after the global financial crisis in March 2009 and has had a maximum drawdown, which measures the most an investor would have lost if they had bought and sold at the worst possible times, of just 15 per cent over that period.
Performance of indices since March 2009
Source: FE Analytics
Those gains mean the FTSE 100 has breached its record high and even explored the 7,000 territory at points this year, shaking off concerns about weaker than expected economic growth, a general election, worries about interest rate rises and the Greek debt negotiations along the way.
In fact, the likes of Old Mutual’s Richard Buxton say investors should use any signs of volatility to up their exposure to the UK as the FTSE is entering a structural bull-run which is likely to last for the next decade.
However Martin, head of UK equities at Neptune and manager of the group’s UK Opportunities and UK Mid Cap funds, says investors cannot afford to get carried away within their portfolios.
“With markets at all-time highs, there is obviously a lot of optimism around and lots of positive stories to tell. Maybe it’s partly because of DNA, but when markets at all-time highs I feel that it is my responsibility to point out some of the more bearish issues that the UK faces,” Martin (pictured) said.
The first issue facing the UK, according to the star manager, surrounds the nature of the UK mortgage market.
“Very simply, in the UK we have very few fixed-rate mortgages – particularly compared to the US – and what few fixed-rate mortgages we have are very short in duration,” he said.
“What that means is that we are highly interest rate sensitive as a nation, particularly in our housing market, but also economically as we have a big current account deficit and it is bigger than it has ever been.”
He says this is a particularly big issue now as a result of the changing dynamics in global fixed income markets.
“That has always been the case, but the reason I am mentioning it now is because the UK has benefitted over the last 35 years because bond yields have been falling pretty much in a straight line – so interest rate sensitivity has been a great thing.”
“If you believe, as we do at Neptune, that bond yields are starting to trough out and maybe even move up, what has been a real bull point for 35 years could become a headwind.”
According to FE Analytics, thanks to the credit boom of the 1980s, very accommodative monetary policy in the period up to the financial crisis and ultra-low interest rates and quantitative easing from the Bank of England since the crash, the average fund in the IA UK Gilts sector has returned 313.65 per cent since our data began in December 1989.
Performance of sector since Dec 1989
Source: FE Analytics
As the graph above shows, those returns haven’t been volatile by any stretch of the imagination.
However, global fixed income markets have had a tough time of it this year as improved economic data, a kick-back against negative rates in the eurozone and a lack of underlying liquidity caused yields on gilts, US treasuries and German bunds to spike in tandem.
With the possibility of an interest rate in the US at some stage this year increasing and inflation set to trend upwards, the consensual view is that the already expensive bond market is heading towards a pro-longed bear market of rising yields.
Martin says this could well be very painful for the UK economy, especially because of our mortgage market.
“If you look at mortgage repayments, as a percentage of disposable income in the UK, 26 per cent of the average UK consumer’s disposable income is spent on mortgages which when interest rates are at all-time lows – that’s a pretty high number,” he said.
“It is certainly a lot higher than 12 per cent in the US.”
“For us, this is a reason to be more cautious on certain areas of the market that have performed the strongest such as UK housebuilders and some of the other domestic cyclicals where valuations are sky high.”
Of course, there have been many instances in the past where a country’s equity market has performed well despite the fact that its underlying economy is weak.
However, Martin is also concerned about overall market valuations in the UK and particularly in the US, which FTSE has historically been highly correlated to.
“I think is it also worth pointing out that CAPE [cyclically-adjusted price to earnings] ratio in the US is at a very high level and actually [as of last week] the only two times in history when it has been higher than this were in 1929 and 2000 – so valuations aren’t low and it is something to be aware of.”
Price performance of S&P 500 since Jan 1980
Source: FE Analytics
However, Martin says investors shouldn’t feel too down about the state of the financial landscape. He is, for instance, bullish on small-caps as valuations are still well within their 12 year range – unlike in large-cap land.
Martin also thinks M&A will be a driver of returns of the coming years, as companies are awash with cash after a painful period of deleveraging and are now willing to spend due to the need to generate future growth.
The likes of Ladbrokes, Thornton’s Chocolate, Anite and BG have all been approached at significant premiums recently and Martin says this trend is only likely to continue.
Martin has managed his five crown-rated Neptune UK Mid Cap fund since its launch in December 2008, over which time it has been a top decile performer in the IA UK All Companies sector and, more importantly, has comfortably beaten its FTSE 250 ex IT benchmark with returns of 339.24 per cent.
Performance of fund versus sector and index since launch
Source: FE Analytics
Martin has shown a real knack of protecting his investors as while his £577m has tended to slightly lag the index in rising markets, it has historically made money when its benchmark has fallen thanks to his more cautious approach.
Martin was also handed the responsibility of the group’s all-cap £60m UK Opportunities fund in February this year following the departure Scott MacLennan and since then it is outperforming both the sector and the FTSE All Share.