Markets are at risk from being knocked off course next year by diverging monetary policy, slowing global growth and steep equity market valuations, according to Kames Capital investment strategist Patrick Schotanus.
Last week’s decision by the Federal Reserve to raise interest rates for the first time in nine years put a tacit full stop on the post financial crisis era for some and underlined that there was enough resilience in the US recovery to handle higher interest rates.
Schotanus says markets are still adjusting to the move but that aside from this “major change in direction”, there are other challenges to remember.
“The risk of a Brexit (for example) and continued volatility across fixed income assets if rates – and inflation – rise faster than expected,” he explained.
In this article we take a closer look through the four main concerns that Schotanus flags up.
Sterling
Firstly, the strategist says the British currency could be hit by the debate surrounding the UK’s membership of the European Union amid a shift among the electorate towards an exit vote in the wake of the migrant crisis this year.
With prime minister David Cameron currently negotiating in Brussels, markets are yet to start pricing in the Brexit vote but issue is quickly gaining more attention with senior Tories such as former defence secretary Liam Fox saying he will vote for the country to leave the EU.
This, together with the UK’s current account and budget deficits, could sharply weaken sterling against other currencies.
“We think sterling will face a headwind in 2016 given we face an increasingly likely referendum on Brexit and with the UK’s double deficit also impacting sentiment,” Schotanus said.
“A rate hike is also unlikely until much later in the year, so sterling’s recent spell of weakness could well continue.”
Performance of sterling vs dollar and euro
Source: FE Analytics
Global airlines
Airline stocks such as British Airways owner IAG and budget carrier easyJet have found some favour with UK growth funds of late thanks to their rapid re-rating over the past 18 months as the oil price has fallen.
Performance of stocks vs index over 2yrs
Source: FE Analytics
The retreat in the oil price has provided a direct improvement to revenues over this period and boosted airlines’ profits but Schotanus says current valuations look stretched.
“Airlines globally have benefited from the collapse in energy prices, but that is done now and it is definitely an industry to be underweight or even short,” he said.
Funds such as Jupiter UK Growth Artemis Capital, Artemis Growth and Miton Undervalued Assets have IAG in their top 10 largest positions.
Gold
While historically the go-to asset for the very cautious investor, Schotanus says gold will do little to provide a safe haven next year despite its substantial fall in valuation across 2015.
Gold is down almost 20 per cent this year while funds specialising in gold mining equities have fallen even harder, as shown the graph below. At its 2015 peak gold reached $1,300 per troy ounce but is just $1,056 per troy ounce currently.
Performance of funds and index over 1yr
Source: FE Analytics
Schotanus says the strength of the US dollar had been one of the main causes of the precious metal’s decline and while it may stabilise in 2016, he warned it was unlikely to recover next year.
“It is quite possible we have seen the biggest part of the upward move for the US dollar, so that may help gold, but in reality the best we can hope for is that the price stabilises around the $1,000 mark,” he said.
“We would need an extreme event in order to provide a real boost to gold and given the current economic outlook globally is fairly benign, it is hard to make a case to invest at these levels when there is likely to be further pressure on the asset.”
US housing market
Lastly, Schotanus says recent weakness in the US housing market could destabilise housebuilders in the US due to rising interest rates with potential ramifications for further afield.
The US housing market, as well the housebuilders, have seen strong gains in recent years after one of the sharpest downturns on record due to their prominence in the unfolding of the 2007/8 financial crisis.
Schotanus says a more recent correction in housebuilding stocks could continue if a historical relationship with one of the core raw materials needed in house construction is anything to go by.
“If you do a ratio of housebuilders to lumber, the stocks have come back some way from the peak seen earlier in the year,” he said.
“Housebuilders got too expensive, and now as the Federal Reserve starts to hike rates, it will put renewed strains on the sector. Therefore, housebuilders should see share prices mean revert back to their historical trend versus lumber, and so going underweight (or indeed short) the sector looks attractive.”
