Three reasons why the FTSE 100 can make a fresh high before year-end (and three why it may not)
Before concerns about Turkey and emerging market contagion burst onto the scene last week the FTSE 100’s summer surge had taken the index back toward its May closing all-time high of 7,877. This seemed to be a classic case of share prices ‘climbing the wall of worry,’ as it cast aside fears over Brexit, a wobbly Government, modest economic growth and higher interest rates to press higher.
However, the latest failed attempt at a new peak (and indeed the 8,000 mark) raised the issue of whether UK equities are instead poised to ‘slide down the slope of hope,’ if expectations for economic, profit and dividend growth are not met, for whatever (unexpected) reason.
Three factors look quite capable of providing support to the FTSE 100 or even taking it higher – a weak pound, its lofty dividend yield and positive earnings forecast momentum.
Equally, the index’s reliance upon a quartet of (highly unpredictable) industrial sectors for its profit growth, its skinnier-than-ideal dividend cover and rapid ascent from the March low could leave it looking a touch overextended, at least in the near term, given how a lowly reading from the FTSE VIX (or ‘fear’) index is still trading near historic lows, to perhaps warn of investor complacency.
The case for further gains
A. Dividend yield
According to consensus forecasts the FTSE 100 offers a 4% dividend yield for 2018, with total payments to shareholders expected to rise by 9% this year to a record £88.7 billion.
That 4% easily beats cash in the bank and inflation. It also beats the yield available on the 10-year Government bond, or Gilt, which is often used as a benchmark for the so-called ‘risk-free rate’ by which all investment returns can be judged.
The UK 10-year Gilt yield is currently around 1.35% so the FTSE 100 beats that by 265 basis points, or 2.65 percentage points. A yield premium of around 200 basis points, or two percentage points, has tended to provide support to the FTSE 100 index in the post-crisis era (even if we must all accept that the past offers no guarantee for the future).
Dividend yield could still support FTSE 100
Source: Thomson Reuters Datastream
The Bank of England may be raising interest rates but it is doing so only slowly – and much more slowly than the US Federal Reserve, for example. Throw in concerns over Brexit and some patchy economic data and the pound is on the back foot once more, especially against the dollar, and this is also providing support for UK-quoted stocks.
Around two-thirds of the FTSE 100 index’s earnings come from overseas, so the lower the pound goes, the more those foreign earnings are worth when they are translated into sterling.
This explains why the FTSE 100 did so well in 2016 and early 2017, as the pound fell in the aftermath of the EU referendum vote, stalled badly as the pound rallied in early 2018 (amid tougher talk on interest rates from the Bank of England) and has then rallied again as Governor Mark Carney and the Monetary Policy Committee failed to deliver on tighter monetary policy on 10 May and talked a dovish story when they did take headline borrowing costs to 0.75% in August.
Pound down, FTSE 100 up has been a strong trend since summer 2016
Source: Thomson Reuters Datastream
A weak pound also makes British assets cheaper for overseas buyers – it may be no coincidence that FTSE 100 members Sky, Smurfit Kappa and Shire have all received bids from overseas firms in 2018 and any further slide in sterling could – perhaps – tempt more predators to pounce.
C. Positive earnings momentum
Sterling’s latest slide, to around $1.2750, fits in here, too.
In a marked contrast to the past four years, earnings forecasts for the FTSE 100 are rising, not falling, helped by the weaker pound, a higher oil price and the absence of new major restructuring costs, legal bills and asset write-downs at the banks.
The lines below show how aggregate profit forecasts for the FTSE 100 have developed on a quarterly basis over time.
Earnings estimates have gone higher over the past 12 months
Source: Digital Look, company accounts, consensus analysts’ forecasts
History suggests that market tops occur when interest rates are rising, stocks are expensive and earnings estimates are falling. For the moment, at least, it seems that only the first of those pre-conditions is in place.
The case for caution
However, this is not to say that advisers and clients can be complacent when they next address their weighting towards UK equities as part of a wider asset allocation process.
Earnings forecast momentum has begun to ease and there are three reasons for approaching UK stocks with a degree of caution.
A. No fear
The time to buy securities is when no-one is interested, not when everyone is, so the fact that the FTSE 100 started this year out in the cold but is now seen as a hot property again should at least give advisers and clients pause for thought.
In addition, a low reading on the FTSE VIX index, which measures future volatility expectations, suggests complacency levels are relatively high. It may not take much to frighten everyone as a result and usher in a more difficult period and the chart makes the inverse relationship between the FTSE VIX and the FTSE 100 pretty clear. It could be argued that we are overdue a storm of some kind.
Low readings on the FTSE VIX index warn of high levels of complacency
Source: Thomson Reuters Datastream
B. The dominance of banks, oils and miners
The FTSE 100 is heavily skewed in terms of its market cap, income and dividends to just a dozen or so stocks and three or four sectors: financials (and banks in particular), oils and miners.
Any adviser or client with exposure to UK stocks, especially those who put their money to work via a passive tracker, must therefore be comfortable with these firms’ and sectors’ prospects.
For the moment, banks (as the economy chugs along and regulatory pressure and conduct fines start to fade away), miners (cost cuts and greater capital discipline, commodity prices) and oils (juicy dividends, cost cuts and greater capital rigour) all look set fair but they are all volatile, unpredictable industries and nothing can be taken for granted. In addition, oil prices have softened and so have copper and iron ore, for example.
Three sectors will largely determine the FTSE 100’s fortunes
Source: Digital Look, consensus’ analysts’ forecasts
C. Dividend cover
Although the FTSE 100’s dividend yield is attractive, it may not be entirely safe. Forecast earnings only cover forecast dividend payments by 1.7 times – although that is higher than of late it is still below the 2.0 times cover ratio that provides some comfort should anything suddenly go wrong.
The yield premium relative to bonds may look attractive but if dividends are cut (say in the event of a sudden economic downturn), or bond yields go up (because the Bank of England raises interest rates more quickly than expected) then that relationship could change.
The good news, for the moment at least, is that dividend cuts have become much rarer after a bad run of reductions in 2015-2016 but any unforeseen economic stumble could leave pay-out growth forecasts exposed – and profit and growth disappointment could then lead to a trip down the slope of hope.
FTSE 100 dividend cover is still less robust than ideal
Source: Company accounts, aggregate consensus analysts’ forecasts