Bearish views on the current market have been widespread over recent months as more and more industry experts have voiced concerns about the immediate outlook for risk assets. 
It is understandable why so many have become more cautious, given that economic growth and inflation are still very low despite huge amounts of firepower in the form of quantitative easing and ultra-low interest rates from the world’s central banks.
On top of that, the largest fall in the FTSE All Share since the period after the financial crisis has been just 16 per cent while the index has delivered a total gain of 160 per cent over that time. Also, like in the US and other markets, UK equities have also hit record highs this year.
Performance of indices since March 2009
Source: FE Analytics
Justin Oliver, deputy chief investment officer at Canaccord Genuity Wealth Management, is one expert who has his concerns about the immediate outlook for UK equities.
While he doesn’t foresee a catastrophic collapse in the market or anything particularly long-lasting, he is of the view that investors should expect a period of “period of heightened stress” in the not-too-distant future.
“For many months we have been arguing that an increase in volatility is all but inevitable and yet, if one uses the VIX index as a guide, equity markets are seemingly becalmed,” Oliver (pictured) said.
“However, it is fair to say that stocks have been a notable outlier within the investment landscape, with most of the action, so far, having been centred in bond and currency markets. Our view remains that equities will eventually succumb to a period of heightened stress, with there being at least three potential catalysts on the horizon.”
He added: “All have been well flagged, but all await some form of resolution.”
In this article, Oliver tells FE Trustnet what he thinks are the major risks facing the UK equity market at the moment and what he thinks investors should do to prepare themselves for the potential volatility.
Greece
The first potential catalyst, according to Oliver, is the ongoing Greek debt negotiations which are likely to come to a head over the coming weeks.
It has been a source of concern for some time now, but Oliver says that just because the talks and huge levels of repayments involved haven’t caused a sell-off it doesn’t mean that it could cause a correction in the future.
“Back in March we wrote that the day of reckoning for Greece was drawing ever closer and that it was inconceivable that the situation would rumble on much longer. Three months later and this still holds true, although it seems that we can now be more specific in terms of timing – June must surely be the month when Greece’s destiny is clarified,” Oliver said.
He notes that over the course of this month Greece must repay €1.6bn to the IMF.
While the IMF has confirmed that Athens would be permitted to delay all of its payments until the end of the month and therefore pushing back a possible default date, Oliver says there is no way these debts be paid without rescue aid which in turn “will only be forthcoming if there is an agreement on economic reform proposals”.
“These negotiations with the IMF, European Central Bank and European Commission remain deadlocked on issues such as pension overhauls, fiscal restructuring and labour market liberalisation and a cold, hard analysis of the situation raises severe doubts that a deal is possible.”
He added: “Whether the Greek assertion that an agreement is imminent proves fanciful or not, a resolution one way or another must surely be only a month away.”
Interest rates
When the US Federal Reserve first slashed rates to 0.25 per cent it was seen as a short-lasting emergency measure and yet, six years later, investors have become incredibly used to such loose monetary conditions.
While it is still highly debated, the consensual view is that interest rates in the US will, albeit slowly, rise over the coming six to 12 months – which is expected to cause bond prices to fall and equity markets to gyrate.
Many have warned that a 1994-style sell-off in bonds and equities is on the cards, a correction which was caused by a surprise interest rate rise by the Fed. Some think it could be a lot worse though, given that bond yields are far lower than they were 20-odd years ago.
Performance of indices in 1994
Source: FE Analytics
“What will likely take longer to resolve is the obsession with when we can finally expect the first rise in US interest rates,” Oliver said.
“The release of the US Federal Reserve minutes confirmed as much, commenting that many policymakers ‘thought it unlikely that the data available in June would provide sufficient confirmation that the conditions for raising the target range for the federal funds rate had been satisfied, although they generally did not rule out this possibility.’”
“That currently leaves September as the most likely lift-off date, given Janet Yellen’s acknowledgement that rates were likely to rise this year, although admitting this is by no means a certainty.”
The major argument against a potential tightening of monetary policy is the fact that inflation shows no sign of rising and economic growth in the US has been far more lacklustre than first expected. Nevertheless, Oliver says investors should be aware of the possible dangers.
“While any moves will be data dependent, and the economy’s first quarter contraction adds greater uncertainty to the picture, any move in September should not come as a surprise to anyone, although an uptick in volatility as this time draws nearer seems inevitable.”
China
Concerns about the state of the Chinese economy, such as over-investment, an overheated real estate market and the rise of the country’s unregulated shadow banking sector, have been ongoing for a number of years now.
Nevertheless, China has been the best performing equity market this year thanks to stimulus from the Chinese central bank and the implementation of the Hong-Kong Shanghai Stock Connect.
Performance of indices in 2015
Source: FE Analytics
“The other potential catalyst must be China, although when and how this plays out is far from clear,” Oliver said.
“What is apparent is that there has been a frenzied rally in both the Shanghai and Shenzen markets this year, heavily fuelled by margin lending whereby loans to invest in the market are secured against the stocks purchased.”
“All of this has come at a time when China is experiencing its worst economic slowdown in nearly three decades with fixed asset investment, a key driver of the economy, expanding by 12 per cent in the first four months of the year, the slowest pace since 2000 and driven by sharply reduced investment in the real estate sector.”
“China seems certain to grow at its slowest pace in 25 years during 2015 and the target of ‘around 7 per cent growth’ seems optimistic.”
Oliver says there are reasons why the rally could continue such as the more central bank intervention and MSCI’s decision whether to include China’s domestic shares in its global indices. However, he remains cautious.
“One cannot but feel that a correction in the region’s stock markets – albeit potentially short-lived – is all but inevitable and it is entirely possible that this introduces greater volatility into global stock markets as a whole,” he added.
So what should investors do?
As pointed out at the start of the article, Oliver isn’t of the view that a financial crisis is on the cards and that although unpleasant, any sell-off is unlikely to lead to a longer term bear market in equities.
He points out that UK equity investors with a long-term horizon may be able to sit through the upcoming volatility but he say that portfolio diversification – and an increased level of cash – are key in the current environment.
“Pulling everything together, we are not yet at the stage where changes to portfolios are believed to be a necessity, although it feels that the time for action is close,” he said.
“With the anxiety surrounding Greece, Fed tightening, stretched equity valuations and a deteriorating economic growth impulse, it is likely that any move will be toward reducing risk, although outside of elevated cash levels, it is also difficult to pinpoint which assets one might want to target in order to achieve this aim.”
He added: “Ultimately, an aggressive position in any asset class may not be appropriate at this juncture.”
