What are the challenges and opportunities for UK funds in 2017?

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Fund managers list inflationary pressures, politics and a lack of profit growth among the challenges facing UK markets in 2017, while the FTSE large caps look set to continue to shine post Brexit.

Higher oil, cheap domestic plays, particularly banks, and a weaker pound all provide a foundation for further gains in the FTSE 100 index, according to AJ Bell investment director Russ Mould.

Financials, oil and gas, and mining stocks represent 44 per cent of the FTSE 100’s market cap.

While this mix has seen the UK market lag its international counterparts for the last five years on a total returns, sterling-denominated basis, next year it could be more helpful, Mould says.

Invesco Perpetual head of equities Mark Barnett says inflation is set to put pressure on consumer budgets and hinder overall levels of economic growth therefore hitting more domestic economic growth.

“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.”

Alongside inflation, Barnett argues politics, global bond values and an overall lack of profit growth will challenge UK equity market valuations.

“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.”

Underlying earnings outlook for next year looks similarly muted, minus a significant further sterling devaluation.

“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,” Barnett says, suggesting the US Federal Reserve or simply a market realisation that the outlook for inflation and interest rates is no longer a realistic view could be trigger.

But not everyone is so pessimistic about the year ahead.

Jon Cunliffe, chief investment officer at Charles Stanley, argues concerns about inflation and the labour market have been overdone.

While Cunliffe says it is difficult to refute the impact of sterling weakness on higher inflation, he points out the retail sales deflator is currently running at -1.3 per cent on an annual basis.

The depreciation of sterling when the currency left the Exchange Rate Mechanism in 1992 provides a parallel for current weakness, Cunliffe argues.

“Most commentators at the time were negative on the UK outlook, with the risk of stagflation the predominant concern.

“In the event, inflation did not really rise and the economy benefitted from the ease in financial conditions represented by weaker Sterling and lower interest rates.”

Cunliffe adds that in the labour market 16-year highs and labour income growth has been reasonable.

“A case can be made for these relatively-tight labour market conditions feeding through to further gains in labour incomes, offsetting much of what we think will be a less headline-grabbing rise in high street prices than many commentators are expecting.”

But AJ Bell’s Mould adds that there are threats from further afield too. “Rising US interest rates, rising Government bond yields, a rising dollar and a rising oil price must also be seen as potential threats, at least if they go a lot farther than expected.

“All could hit global growth and short-circuit the “reflation” trade which has become popular post the UK’s Brexit vote and the election of President Trump.”

Fund picks

Artemis Income

In the UK Equity Income sector, Ryan Hughes, head of fund selection at AJ Bell, points out Adrian Frost’s fund has navigated its way through all manner of market conditions since he took control in 2002. Hughes says the positioning points towards a successful 2017. “With around 30 per cent in financials and top 10 positions for BP, Royal Dutch Shell and Lloyds and almost 75 per cent in large cap companies, this fund could benefit if the FTSE 100 moves higher next year.”

Jupiter UK Special Situations

“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,” Hughes says. Ben Whitmore’s fund has established a long-term reputation of finding well run and financially sound businesses that other investors have shunned, Hughes says. “This strategy could do very well in 2017 as investors look away from the ‘expensive defensives’.”

UK All Cap – Old Mutual UK Alpha

In the UK All Cap sector, Hughes says Richard Buxton’s three largest positions – Royal Dutch Shell, BP and HSBC – set him up well for should the FTSE 100 enjoy a strong year. “[Buxton] has been a strong advocate of the valuation opportunities in large cap UK equities for some time but it is only recently when this area of the market is once again being rewarded.”