UK equities investors should keep one eye on bond price movements in the near-term as an indicator of re-rating, according to Invesco Perpetual’s Mark Barnett. 
The FE Alpha Manager says UK equities have been dictated by bond prices over the past year, which have risen steadily alongside stocks.
“The strong performance of the bond market — which, unusually, has been accompanied by a rising equity market — and the perceived benefit from the drop in sterling have been the driving forces behind the ongoing re-rating of UK equities,” he said.
“Approaching year end, this valuation looks full, particularly relative to the disappointing overall level of underlying profit growth recorded this year – excluding the impact of sterling and the commodity bounce back.”
“With bonds and equities rallying and central banks stepping up their activity, there is a nervousness in the market.”
Barnett says UK equities have also benefitted from sterling weakness since the UK referendum result-inspired drop in the currency since the Summer.
Since the EU referendum in June sterling has fallen 16.34 per cent against the US dollar and Barnett says this will continue to impact UK equities as we head into 2017.
Performance of sterling vs US dollar since the EU referendum
Source: FE Analytics
However, Barnett cautions that the re-rating of UK equities is unlikely to continue unchecked against a backdrop of higher valuations and ongoing pressure on corporate profitability.
Below, the manager outlines four key areas that should shape the UK equity market next year and which also pose the biggest challenge to equity valuations.
Profits
Barnett notes that there has been a noticeable pick-up in the rate of profit warnings across the market over the last year.
Indeed this growing number of profit warnings and a generally downbeat view of earnings expectations have capped market expectations for 2017.
While overseas earners have felt a tailwind due to the fall in the pound, Barnett says, stripping out this one-off event overall profit growth would have been flat in 2016, adding that underlying earnings outlooks are likely to remain muted.
The manager of the Invesco Perpetual UK Strategic Income fund says “a more difficult near-term UK economic picture is likely to emerge” next year.
“Alongside the Bank of England’s (BoE) fiscal package, the UK Treasury is considering all options to avoid recession in the UK; additional measures around corporation tax, national insurance contributions and long-term infrastructure projects are all on the table,” he said.
Inflation
Another key theme for UK equities investors heading into 2017 is the reappearance of inflation which some suggest could reach as high as four per cent by the second quarter of next year.
Though this is largely as a result of the movement in sterling, Barnett says, it will pressurise consumer budgets and hinder overall levels of economic growth.
“This factor, coupled with the ongoing uncertainty over the political path to Brexit, may put a brake on UK employment levels and investment intentions, further moderating activity in the domestic economy,” the fund manager said.
“To some extent, this has been priced into equities, as the performance disparity between globally and domestically exposed companies since the EU referendum has been significant.”
“Nevertheless, the backdrop to corporate profitability is unlikely to ease over the coming year as pricing power remains elusive.”
Politics
One of the biggest and well-known challenges facing the UK in 2017 will be the activation of Article 50 as the British government seeks to leave the EU and begin exit negotiations at the end of March.
“The political environment has the potential to deliver more surprises over the coming year, a third factor likely to continue to exert major influence on both corporate behaviour and stock market performance,” Barnett said.
“The domestic political scene is currently overshadowed by the new government’s evolving political agenda, while internationally, there are a series of important elections that need to be addressed; the potential for a sudden policy shift or unexpected election result is significant.”
Indeed, both French presidential and German general elections are scheduled for next year, with any surprise results likely to change the tone and success of any UK negotiations with the EU.
Bonds
As previously mentioned, bonds will impact equities in 2017, following a year where both asset classes have risen in tandem – contrary to historical trends.
Performance of indices in 2016
Source: FE Analytics
As the above graph shows, global bonds, which have traditionally been held as a hedge to equities, have gained 20.42 per cent this year while the FTSE All Share has risen 14.7 per cent.
“The final challenge is the pace and extent of a shift in the value of global bonds, which also has the potential to pressurise the outlook for positive returns from UK equities,” he said.
“Such a shift could result from a change in the fed funds rate or simply from a realisation that the extreme low yields reached over the summer months across the world no longer represent a realistic view of the medium-term outlook for inflation and interest rates.”
Overall, investors should remain vigilant when looking at valuations, with bottom-up opportunities for the long-term investor starting to emerge as a result of the substantial sector rotations that have occurred since the June EU membership referendum.
“Navigating any one of these obstacles, either individually or in combination, will continue to be challenging,” Barnett said.
“Where new bottom-up opportunities arise, our emphasis will continue to be on companies that can demonstrate a sustainable top-line growth and translate that into profit, free cash flow and dividends, without excessive financial leverage.”
Barnett has run the Invesco Perpetual UK Strategic Income fund since launch in 2006, and took over the Income and High Income funds from fellow FE Alpha Manager Neil Woodford in 2014.
The funds have a strong long-term track record under Barnett and previous manager Neil Woodford but 2016 has been the first year since 2012 where the funds have failed to beat the IA UK All Companies sector average due to the outperformance of cyclical stocks, which it is underweight.