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Why the FTSE 100 is warming to an economic upturn

2 weeks ago

As the UK starts to emerge from its latest (and hopefully final) lockdown, the FTSE 100 already trades above the levels reached just before the pandemic first made its presence felt in China and Southern Europe in early 2020.

There can be no finer example of how financial markets are forward-looking, discounting mechanisms which seek to price in future events before they happen. Yet they are not right all the time. No-one, but no-one, owns a crystal ball (or at least one that works) and if markets really were that prescient, then there would never be major sell-offs or upward surges, as no-one would ever be surprised by anything.

What the advisers and clients must therefore do, in order, is assess the facts as they are known, determine the current consensus about what will happen and – by looking at valuation – decide whether the risks are to the upside or downside. Therefore, they must look at the broad range of possibilities concerning what may happen, what could be the biggest surprises and their potential impact so they can decide whether the potential upside rewards outweigh the downside risks over their preferred time horizon.

“In sum, the best fund managers are not necromancers or chancers trying to guess the future. They are experts at judging probabilities and act according to the cold maths of valuation, be that measured by earnings, cash flow or yield.”

In sum, the best fund managers are not necromancers or chancers trying to guess the future. They are experts at judging probabilities and act according to the cold maths of valuation, be that measured by earnings, cash flow or yield. It may not take much good news to boost a market that has fallen sharply to price in negative events (it may even just take the absence of fresh bad news), while it may not take much bad news to jolt a market if it has made big gains.

The FTSE 100 bottomed in late March 2020 at 4,994, long before the worst news about the pandemic and its toll on lives and the economy became known. After a near-40% gain in the UK’s headline index over the past year, advisers and clients must once more assess the balance of probabilities so they can decide whether the index has further to run or not and a good place to start is earnings forecasts.

New highs

At face value, it does seem odd that the FTSE 100 is trading above its pre-pandemic levels, even if the number of daily new COVID-19 cases is back to where it was last March and last September, and the vaccination programme continues apace. The economic outlook is still uncertain: the effects upon the behaviour of corporations and consumers alike are yet to reveal themselves and other parts of the globe are less advanced in their race to inoculate their populations.

“An aggregate of the estimates made for each member of the index suggests that the FTSE 100’s total pre-tax profit will be £178 billion in 2021 and £205 billion in 2022. If the 2022 figure is attained, that would represent a new all-time high for annual earnings.”

But it does make sense if you think that the consensus earnings forecasts for the FTSE 100 are going to be accurate. An aggregate of the estimates made for each member of the index suggests that the FTSE 100’s total pre-tax profit will be £178 billion in 2021 and £205 billion in 2022.

FTSE 100 is forecast to make record pre-tax profit in 2022

Source: Consensus analysts’ forecasts, Marketscreener

Those figures exceed the £166 billion made in 2019, before the pandemic hit home. Moreover, if the 2022 forecast is attained, then that would represent a new all-time high for annual earnings, surpassing the £199 billion made in 2011.

In this context, it is not too hard to see why the FTSE 100 is trading where it is, or even make a case for further gains, since the index trades below its May 2018 zenith of 7,779 even though record profits are expected for 2022.

Advisers and clients must therefore decide whether the forecasts are reliable, too optimistic or too pessimistic and what must happen for analysts to be off-beam (which they usually are, owing to the absence of that crystal ball).

Heavy metal

To do this, advisers and clients need to parse the FTSE 100’s earnings mix. Roughly 60% of forecast profits come from just three sectors: mining (now the single biggest earner), financials, and oil and gas.

Just three sectors are expected to generate around 60% of FTSE 100 earnings in 2021 and 2022

Source: Consensus analysts’ forecasts, Marketscreener

In some ways, this makes it easy for advisers and clients to judge the upside and downside potential: in crude terms, the stronger the economic recovery the better, so far as the FTSE 100 is concerned as the index’s key industries offer huge gearing into GDP growth. The opposite also applies. A weak recovery (or heaven forbid an unexpected double-dip) would be potentially a nasty surprise.

“Miners and oils are expected to generate two thirds of the FTSE 100’s forecast profit increase between them in 2021. Miners, oils and financials are forecast to provide four fifths of the expected profit uplift in 2022.”

A breakdown of forecast earnings growth makes this picture clearer still. Analysts think that the FTSE 100’s aggregate pre-tax profit will rise by £75.1 billion this year and by a further £27.1 billion in 2022. Miners and oils are expected to generate two thirds of that between them in 2021. Oils, consumer discretionary and financials are forecast to provide four fifths of the expected profit uplift in 2022.

Just three sectors are expected to generate more than 75% of forecast earnings growth in 2021 and 2022

Source: Consensus analysts’ forecasts, Marketscreener

Rising commodity prices and steepening yield curves would therefore be a good sign; falling and flattening ones would not. Those advisers and clients who buy into the narrative that inflation is coming, after being largely dormant for 40 years, will therefore feel right at home in the UK. Those who still fear debt-ridden deflation may be tempted to steer clear and seek their fortunes elsewhere.

Author
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Russ Mould
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Russ Mould

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AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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