Why three trends will shape sentiment toward the FTSE 100 for this year and beyond

At the time of writing the FTSE 100 sits just above the 7,300 mark, a fraction below the new record-highs north of 7,400 reached earlier in the month.

One reason for the fresh gains may be positive momentum in corporate earnings and dividend forecasts.

Ultimately it is profits and cash flows that dictate long-term returns from securities, either via capital gains or dividends, so this is an encouraging trend.

It does at least suggest there is some substance to the fresh gains in the UK stock market as relying on politicians, economists or central bankers leaves advisers and clients trying to predict the thoroughly unpredictable.

These – no doubt well-meaning – individuals do not have a crystal ball so they have no more idea of what is going to happen than you or this column.

As such, advisers and clients would do well to remember legendary US investor Warren Buffett’s maxim that: “If you mix your politics with your investment decisions, you’re making a big mistake.” The minor market stumble caused by the failure of President Trump to ‘repeal and replace’ Obamacare is a timely reminder of the value of this aphorism.

Equally, advisers and clients still need to stress-test the quality as well as the quantity of the earnings and dividend upgrades we have seen for the FTSE 100, to make sure the forecasts prove sufficiently reliable to keep supporting further advances in the index.

In sum, Mining, Banks and Oil remain the key sectors when it comes to earnings and dividends.

So metals prices, interest rate expectations and oil price are likely to be the key tone-setters over the rest of the year and beyond and an adviser or client will need to take a view on all of these when assessing the UK market, whether they are looking to take exposure through a passive tracker or exchange-traded fund (ETF) or an actively-managed collective.

As such, a 5% pull-back in copper, a seven-week low in iron ore and a slide back toward $50 a barrel in oil need to be watched carefully, while the UK yield curve (as defined by the gap between two- and ten-year Gilt yields) has flattened a little too, a trend that is unhelpful for banks and suggests that market faith in the ‘reflation’ trade is ebbing a little.

Fresh weakness in copper and iron ore is a concern given the importance of miners to FTSE 100 earnings and dividend forecasts for 2017

Source: Thomson Reuters Datastream

A drop in crude needs to be watched as oil producers are expected to generate a big chunk of FTSE 100 earnings and dividend forecasts for 2017

Source: Thomson Reuters Datastream

A steeper yield curve would be helpful for banks, the third key contributor to FTSE 100 earnings and dividend forecasts

Source: Thomson Reuters Datastream

None of these three signals on their own mean the bull run is coming to an end by any means but all three merit close attention, given their influence on shaping FTSE 100 aggregate profit and dividends going forward.

Numbers game

AJ Bell has carried out its quarterly test of the consensus forecasts for all of the members of the FTSE 100 and then aggregated those figures to provide a total for the index overall.

  • The bad news is that profits and dividends for 2016 came in lower than anticipated, as banks (owing to more extraordinary charges for conduct, litigation and payment protection insurance), media and retailers generally disappointed, relative to expectations. This continued a run of downgrades that stretches back to 2014.
  • The good news is that profit and dividend forecasts for 2017 moved higher for the third quarter in a row. Analysts now expect total pre-tax profits from the FTSE 100 of £197 billion for 2017 and dividends (excluding special dividends) of £80.4 billion, compared to £171 billion and £75.4 billion respectively nine months ago.

Forecasts for FTSE 100 aggregate earnings in 2017 continue to rise

Source: Digital Look, consensus analysts’ estimates

  • In addition, initial forecasts for 2018 call for another increase in profits to £215 billion and in dividends to £87 billion.

Forecasts for FTSE 100 aggregate dividends in 2017 continue to rise

Source: Digital Look, consensus analysts’ estimates

Admittedly these forecasts are not guaranteed to be correct but at least the trend is currently the friend of advisers and clients, especially the dividend figures, which imply a 2017 dividend yield from the whole index of 4.1% and a 2018 one of 4.4%.

Quality test

With the UK 10-year Gilt offering a yield of 1.1% at the time of writing, the FTSE 100 is offering a premium yield of 300 basis points (or 3.0%) for 2017, based on the forecasts above.

Adviser and clients will be only too well aware that stocks bring greater capital risks than bonds, at least in theory, so there is always a chance that a share price fall, or tumble in the broader index, wipes out the yield premium if a client then finds themselves obliged to sell at an inconvenient moment.

It is also worth considering the source of the dividends. Banks, life insurers and oils are forecast to provide 46% of the £80.4 billion aggregate payment from the FTSE 100 in 2017.

Financials and oils are expected to be the dominant dividend payers in 2017

Source: Digital Look, consensus analysts’ estimates

Dividend payments are expected to rise by £9.5 billion in total in 2017. A third of that growth is due to come from miners (notably Glencore, BHP Billiton, Anglo American and Rio Tinto), while banks and insurers are forecast to provide 26% of the increase (notably Lloyds) with another 15% coming from the oils (although that is a function of dollar gains against the pound rather than actual payment increases from BP or Shell).

These are the key sectors to watch when it comes to dividends in the year ahead (excluding special dividends):

Miners, financials and oils are the key to dividend growth estimates for 2017

Source: Digital Look, consensus analysts’ estimates

On the face of it, dividend cover at the miners is good at 2.5 times, but that cover will shrink if metal prices roll over. Banks and insurers look sound enough at 1.9 times and 2.0 times – although the banks need to avoid another rash of fines and conduct charges – while the oils at 1.0 times earnings cover could do with an improvement in the oil price to provide long-term comfort.

Profit pointers

The same sectors dominate when it comes to earnings forecasts. Banks, insurers, mining and oils are expected to generate 51% of aggregate FTSE 100 pre-tax income in 2017:

Miners, financials and oils are FTSE 100’s leading profit generators, according to analysts’ forecasts

Source: Digital Look, consensus analysts’ estimates

This quartet’s importance is made all the clearer by their forecast 77% contribution to profit growth estimates for 2017.

Miners, financials and oils are FTSE 100’s leading earnings growth drivers, according to analysts’ forecasts

Source: Digital Look, consensus analysts’ estimates

It is fair say this column views such a mix as decent in quantity but low in quality, and all four sectors remain treacherously difficult to predict. A slowdown in the UK economy and housing market would quickly trip up banks, disappointment from President Trump or China could derail the recovery in metals prices and oil is already looking soggy, owing to rampant US production.

Equally, the banks could continue to benefit from a gradual rise in interest rates in the US, China is unlikely to disappoint in a year when the nineteenth Communist Party Congress is due to take place and OPEC is currently sticking to production cuts.

These sectors can cut both ways.

The UK’s reliance on oil, miners and banks hurt its performance in 2014 and 2015 and helped it in 2016. They, along with the pound, are likely to set the tone for some time to come.

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.