Developments in the UK’s plan to quit the EU, the health of the banking sector and the risk/reward balance being seen in the bond market are themes that investors need to pay attention to in 2017, according to experts at AJ Bell. 
2016 has proved to be a challenging year with several political and macroeconomic events surprising investors and leading to many active managers being positioned on the wrong side of the year’s successful trades.
AJ Bell investment director Russ Mould and head of fund selection Ryan Hughes (pictured) argue that 2017 will present several more flashpoints that investors have to take into account when constructing their portfolios, which could have the potential to make 2017 just as testing as this year.
In the following article, Mould and Hughes highlight five themes they think will be instrumental in 2017 and suggest the funds that are worth considering in light of them.
Article 50 and Brexit - Jupiter UK Special Situations & Henderson UK Absolute Return
Mould says whether the UK looks like it is heading towards a ‘soft’ or ‘hard’ Brexit is one factor that investors cannot ignore in 2017.
A hard Brexit, he notes, could end any improvement in sterling, which would boost the foreign earnings of several large-caps. However, he says that the real value could be seen in “downtrodden domestic names” where a hard Brexit is already priced in.
“This may offer further scope to funds known for their value-hunting expertise, especially as Brexit does not turn out to be as bad as feared,” he added.
Hughes says that Jupiter UK Special Situations could be a good option to play this theme.
Performance of fund vs sector and index under Whitmore
Source: FE Analytics
“With value strategies having been out of favour for so long, we’ve started to see the early signs of a switch in investor focus away from defensive companies towards highly unloved, lowly valued companies,” he said.
“This plays nicely into the hands of Ben Whitmore, manager of the Jupiter UK Special Situations fund who has forged a fantastic long-term reputation of finding well run and financially sound businesses that other investors have shunned. With a patient approach and a comfort in investing away from the crowd, this strategy could do very well in 2017 as investors look away from the ‘expensive defensives’.”
But given the potential for increased market volatility after the UK government triggers Article 50 and starts the process for leaving the EU, Hughes suggests that investors should consider more defensive strategies.
“One way to play this may be through long / short UK equity funds which can profit from winners and losers in this environment and one of the very best is the Henderson UK Absolute Return fund,” he said.
“Managers Ben Wallace and Luke Newman have proved they are highly capable of navigating volatile markets and often come into their own when markets become disrupted. 2017 could well prove to be that environment again.”
Banks – db x-trackers Stoxx Europe 600 Banks UCITS ETF 1C
Banking stocks have been poor performers since 2010, as the sector has had to cope with tighter regulation, growing levels of competition from challengers and subdued lending demand from consumers.
“Contrarians may see this is a positive sign, especially as all of the ‘Big Five’ bar HSBC trade at below one times book value. Sceptics will point to negative earnings momentum, ongoing misconduct fines, the UK’s modest economic momentum and hefty debts as good reason to stay away,” Mould said.
“With the banks representing 14 per cent of the FTSE 100’s market cap and 15 per cent of both profits and dividend payments last year this is one sector that fund managers have to get right in 2017 if they are to outperform as the rally in late 2016 has caught many off guard.
“If that momentum continues in 2017 it will be a huge pain trade that could force many into clambering aboard, giving the FTSE indices a lift. However, if the UK economy fails to deliver and bond yields go lower again, banks could once again find themselves out in the cold.”
Performance of EFT since launch
Source: FE Analytics
Hughes suggests the db x-trackers Stoxx Europe 600 Banks Ucits ETF 1C as a potential candidate for exposure to this theme, arguing that an ETF is the best way to take exposure to a specific sector.
“With valuations on European banks (including the UK) still at low level, the db x-trackers Stoxx Europe 600 Banks Ucits ETF 1C could be a good play to play this theme,” he said.
“With an ongoing charges figure of just 0.30 per cent, this ETF gives diversified exposure to banks across Europe with 30 per cent in the UK and the balance well spread across the continent.”
The dollar, the Fed and Trump – Polar Capital Global Insurance
Investors are paying a lot of attention to the reflationary potential of the fiscal-spending, tax-cutting and regulation-slashing programme that seems to be on the cards for a Trump administration, Mould notes. This has already been reflected in rising US share prices and a stronger dollar.
“Any acceleration in US GDP growth and inflation, or further Fed rate hikes in 2017, could further boost the greenback and the value of US assets held by UK investors,” he said.
Polar Capital Global Insurance is one fund that Hughes expects to be a beneficiary of this theme, given that it has more than 45 per cent of its portfolio in US businesses.
Performance of fund vs index since launch
Source: FE Analytics
“The global insurance sector is one that can benefit from rising bond yields and with the industry predominantly based in the US, a strong dollar helped by rising rates could help this fund have another strong year,” he said.
“The industry is cash generative, giving a nice stable outlook, while consolidation could well prove to be a friendly boost. The team at Polar are hugely experienced and this approach offers a great way to diversify from traditional US equity exposure.”
Bonds – Royal London Short Duration Credit
Mould points out that as equity markets are welcoming the reflationary environment promised by Trump and the surging oil price, the bond market is “recoiling from it” as rising inflation is adverse for the asset class.
“The question facing income-starved investors now is whether bonds offer a suitable risk-reward balance – inflation is still low, the world is more indebted than it was in 2007 and long-term demographic trends in the West look deflationary as the population is ageing and shrinking,” he said.
“Moreover, low interest rates are keeping a lid on corporate default rates and credit spreads (the premium yield offered by corporate bonds relative to government ones) are tightening, not widening so there may be some value to be had here.”
The investment director points out that there is no guarantee Trump’s plan will work, which would disappoint equity markets but bring to an end any sell-off in bonds. Fixed income volatility could rise as investors attempt to weigh up if any inflation is temporary or not.
In addition, there is no guarantee the Trump plan actually works – Japan has seen multiple stock rallies and bond sell-offs fizzle out since 1989 while US and UK government bonds have seen around 10 hefty reversals since 1986, only for yields to make new subsequent lows.
Hughes believes that bond yields could continue to rise over 2017, which creates “a bit of a conundrum” for investors. Given this, he recommends a cautious approach and says Royal London Short Duration Credit could well be appropriate.
Performance of fund vs sector since launch
Source: FE Analytics
“The team, led by Paola Binns are highly experienced and by focusing on bonds with less than five years to maturity have lower turnover than many,” he said. “For those that want fixed interest as part of a strategic asset allocation, looking to short duration could prove to be the best way to mitigate the problems caused by rising rates.”
Emerging markets – Hermes Global Emerging Markets
Emerging markets enjoyed a strong start to 2016 thanks to a weakening in the dollar, rising commodity prices and attractive valuations, but have started to suffer more recently after Trump’s election win.
Mould said: “The good news is that commodity prices are still holding firm (at least in the case of oil and the industrial metals), something which Bank of America Merrill Lynch research says has only happened 30 per cent of the time during periods of dollar strength and during that 30 per cent emerging market assets have generally done well. The dollar and commodities look set to once more dictate how emerging markets do in 2017.”
Performance of fund vs sector and index since launch
Source: FE Analytics
Hughes points to Hermes Global Emerging Markets as a potential option for investors, as the environment from here looks like it will be best played through a stock-picking approach.
He added: “As differentiation increases across emerging markets, a shift towards alpha rather than beta has become the key focus and the stock picking approach from Gary Greenberg, manager of the Hermes Global Emerging Markets fund is well suited to capitalise on this.”
“As a bottom-up stock picker who is entirely comfortable investing away from the index, Gary’s focus towards quality companies could prove to be highly appropriate for 2017.”