My three reasons to be less cheerful about UK markets

Now there’s a danger that the same thing will happen in reverse.

There are three main reasons why I’m nervous about the UK market: interest rates, politics and valuations.

My overarching view of interest rates is that they will stay lower for longer because that is what happens after a financial crisis. It’s why rates remained at 2pc from the Great Depression to the beginning of the 1950s. That’s the good news.

The bad news is that even a modest rise in rates could have a significant dampening effect on an economy still blighted by debt. Look at the yield curves and they are pointing to an interest rate hike in February next year. It’s not so long ago that we didn’t expect any move before summer 2016.

It’s been so long since rates last rose that markets will struggle to reconcile themselves to a change in direction.

Elsewhere in the world, we’ve seen recently how politics can have a galvanising effect on markets. In both India and Indonesia, for example, the prospect of a change of government has been seized on by investors as a sign of more business-friendly conditions ahead. That’s unlikely to be the case here over the next 12 months.

Currently, Labour is ahead in the polls – but only just. Normally, that would be a signal that with the economy improving the incumbent government would be a shoo-in for a second term. That’s because reality tends to bite when the vague idea of the other lot getting in becomes a possibility, then a probability.

The electoral status quo has changed in Britain, however. Next year, the likelihood of Labour winning the election by default as Ukip splits the naturally Conservative vote and the Lib Dems implode is very real. The prospect of more spending, higher taxes and an interest rate squeeze to compensate would be likely to unsettle markets.

The third concern is the most measurable. As investors have grown used to the idea of economic recovery in the UK, they have swung back from defensive blue-chips to cyclical mid and small-caps.

The FTSE 250 has risen by nearly a fifth in the past year, while the FTSE 100 is less than 3pc higher. That’s not surprising when you consider that half of sales in the mid-cap index are made in Britain, versus only 22pc of those for the largest companies. For small-caps, it’s as much as 60pc.

As a consequence, valuation multiples are significantly higher for smaller companies than larger ones. Ahead of a period of heightened uncertainty, with the good news already in the headlines and interest rates limbering up for their first move, the blue-chips feel like a safer place to be over the next year or so.

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