While global risks such as those posed by monetary tightening and Brexit remain elevated, the UK market continues to offer a range of stockpicking opportunities, according to Invesco Perpetual’s Mark Barnett.
FE Alpha Manager Barnett said interest rates, economic trends and politics continue to interweave and interact to influence markets.
But Barnett, who is Invesco Perpetual’s head of UK equities, said he ultimately interested in the financial performance of the companies he owns and how that will lead to sustainable dividend growth.
The fund manager said while the economic cycle can affect the performance of portfolio companies it does not have to be a defining factor in the long term, particularly for medium-sized companies and niche players who can grow organically by winning market share.
Yet, Barnett said a number of inflection points have been reached across “a number of global macro and political fronts”, with high valuations, shifting monetary policy and geopolitical volatility having the potential recalibrate across several sectors.
Barnett said: “While stock markets have enjoyed a pretty smooth ride since the 2012 eurozone crisis, the macro risk now seems to me to be very much to the downside, with the exception of the perceived Brexit risk to the UK economy.”
Below, the manager assesses the risks posed by some of the macroeconomic headwinds facing the UK economy and market.
Brexit
Of the range of challenges affecting the UK market, Brexit may have not be the biggest challenge for investors, said Barnett.
The Invesco Perpetual manager said he is not convinced that Brexit negotiations will result in stalemate between the two sides.
Domestic stocks have underperformed exporters dramatically
He said: “The significant underperformance of sterling-based investments and the sharp decline in the currency supports a view that Brexit is an accident waiting to happen for the UK economy.
“This bearish view is not my central scenario. Brexit brings with it all the uncertainties that politics can throw up, but I believe it is highly unlikely that the negotiating process will end in stalemate.
“Even now, at the height of the uncertainty, the UK economy is performing robustly.”
Barnett (pictured) said he believes that the short-term price for Brexit has “almost been paid in full” in the spike in inflation following the referendum vote, which has already begun to reverse. 
He said: “A key risk now to investors in the UK stock market is a material recovery in sterling and a violent rotation away from the international earnings that dominate the FTSE 100 index, into domestic-facing companies currently trading on recession-type valuations.
“Sterling assets are now undervalued on a risk-adjusted basis and I have increased investments in domestic companies in my portfolios.”
Monetary tightening
A more significant challenge for the UK market, according to Barnett, is the normalisation of monetary policy with the return of positive real interest rates.
The tide of changing sentiment among central banks in the developed world is likely to have implications for valuations in many parts of the market, which Barnett said have been inflated “by the consequences of super low interest rates”.
Barnett said bond markets could begin to sell off, notwithstanding low price and wage inflation.
“I do not find it bullish that the US Federal Reserve is openly declaring itself perplexed over the relationship between unemployment, wages and prices,” he explained.
“The Bank of England is being similarly coy about committing itself to further rate rises whilst Brexit uncertainty persists.
“What we can say is that 10-year bond yields at or below the rate of inflation worldwide in these economies are probably unsustainable unless we are heading for an economic downturn.”
Politics
Another destabilising factor affecting the UK market, said Barnett, is the political environment, which has become increasingly challenging since the onset of the global financial crisis.
“Politics in most key democracies cannot survive another recession without a total re-think of fiscal policy and how to protect the interests and income of the labour market,” he said.
“A re-run of the post 2008 quantitative easing policies would not be welcomed by those voters who associate it with growing wealth inequalities.”
Barnett said that the rising prominence of inter-generational issues, such as elevated house prices and the rise in social security and pension liability, and surge in support for populist politics has brought western governments to an inflection point. 
He explained: “These issues are set to influence policy makers and will be critical to the Conservative government over the course of this parliament.”
Equity valuations
Finally, high equity valuations also pose a headwind for markets. Indeed, investors have become increasingly concerned by valuations in recent months as the bull run for equity markets has shown few signs of ending.
Barnett said against a strong economic growth backdrop, monetary tightening in the US may not be an issue if earnings continue to rise.
However, he warned that too many segments of the market have been boosted by the long-term growth agenda and share buybacks. Barnett said the US market feels vulnerable to a de-rating.
“Another key driver of equity markets has been the recovery in commodity prices,” the manager said. “This has been coupled with renewed confidence that the Chinese drive for more balanced growth can be achieved.
“The drive by the Xi [Jinping] presidency to cut back on inefficient metals production for environmental reasons raises the question of whether steel production in 2017 will continue to push higher.
“Housing and infrastructure are giving way to services, technology and electrification as the drivers of economic growth, an overall headwind for metals prices.”
Barnett manages the £10.5bn Invesco Perpetual High Income and £5.2bn Invesco Perpetual Income funds.
The manager said he has become more cautious on so-called ‘bond proxies’, selling out of consumer names such as Reckitt Benckiser and Smith & Nephew and reducing his position in the tobacco sector.
He added that performance in the pharmaceutical sector has been a source of major disappointment since 2015, although he has found attractive risk/reward opportunities in new and developing therapeutic areas.
Furthermore, he noted that sterling and UK-focused sectors and stocks are central to the future performance of his portfolios, where investments are diversified across life insurance, retail, travel, support services and specialist financial businesses.
“Specialist real estate companies feature prominently in my portfolios: quality real estate portfolios are selling at historic discounts in REIT share prices which strikes me as an attractive entry point for the sector,” he added.
He added: “At the individual stock level, it happens that a collection of previously well-regarded companies currently held in my portfolios have seen very weak share price performance in the last two years.
“Provident Financial, Capita, Babcock, Next, easyJet are the most recognisable names. As a result, there is a recovery element in these holdings over and above the normal market rotation potential.”
Invesco Perpetual High Income and Invesco Perpetual Income have underperformed the average IA UK All Companies fund in 2017, as the manager has experienced a number of stock-specific issues. (It should be noted, however, that while the funds are benchmarked and located against the sector, unlike many of their peers they are income-focused strategies).
The High Income fund has risen by just 3.45 per cent, while the Income fund has fared a bit better rising by 3.65 per cent. In comparison, the average IA UK All Companies fund has risen by 10.91 per cent.
Performance of funds vs sector YTD
Source: FE Analytics
The Income fund has an ongoing charges figure (OCF) of 0.91 per cent and a yield of 3.37 per cent. The High Income fund, meanwhile, has an OCF of 0.92 per cent and a yield of 3.27 per cent.