Manager's View

Why is the FTSE 100 near all-time highs - and can it go higher?

18/10/2016

David Brett

David Brett

Investment Writer

Sterling has hit a 31-year low and the prospect of a “hard” Brexit has reduced expectations for growth in the British economy in the near-term, so why is the stockmarket approaching all-time highs?

As the chart below illustrates, the Brexit vote on June 23 hit all UK-focused markets hard. The FTSE 100, FTSE 250 and FTSE All-share all fell in tandem with sterling.

However, while sterling has continued to struggle the UK stockmarket has bounced back.

The black line (UKX) in the chart represents the FTSE 100 which been rising since Brexit, while the grey line represents the value of the pound, against a basket of currencies, which has been falling. The ASX (FTSE All Share) and the MCX (FTSE 250) have also sharply outperformed.

Why has the UK stockmarket performed well?

The reasons, as is so common in financial markets, are heavily interlinked.

  1. Action from the Bank of England and other central banks

    Stocks benefit when interest rates are low and central banks deploy other measures to support the financial system and encourage spending.

    Following Britain’s decision to leave the EU, the Bank of England has cut interest rates to a record low of 0.25% and restarted its quantitative easing programme.

    The Bank has made it clear that it is ready to do more, signalling a further cut in the bank rate to 0.1% is possible.

    A lower bank rate means lower savings rates. It also has the effect of driving down the income available on other assets, such as bonds. This tempts income-hungry investors to buy stocks, pushing up prices.

    This accounted for much of the initial rally. More recently it has been more about the weakening UK currency…

  2. Sterling at 31-year lows

    Concerns have grown that the UK may face a “hard Brexit”, particularly after a speech by Prime Minister Theresa May on Sunday. The pound has fallen sharply in the last few days.

    But falls in the pound have provided a boost to the profits of many companies listed on the London Stock Exchange.

    Large FTSE 100 companies with international operations have been the most notable beneficiaries. This is because the dollars and euros earned abroad are now worth more in sterling terms.

    Around 75% of the revenues for companies listed on the FTSE 100 are generated in overseas markets.

    This is how, perversely, a worsening outlook for the UK economy, leads to a rising stockmarket.

    It should be noted that stocks outside the FTSE 100, which tend to be more domestically focused, have felt far less benefit from the swing in currencies.

    There are other more tangible benefits from a falling pound. The pain felt by British holidaymakers when spending abroad works in reverse, with foreign tourists more likely to come to the UK and take advantage of cheaper prices in restaurants and shops.

    In a similar vein, British exporters benefit too as the value of their goods will be more attractive to overseas buyers.

Are UK stocks still good value?

There are many ways to value stocks, but perhaps the simplest method is the price-to-earnings ratio (P/E).

The P/E ratio illustrates the relationship between a stock price and its company’s earnings. A high P/E ratio might suggest an expensive stock; a low P/E suggests it could be undervalued.

As for the market as a whole, it looks overvalued on a P/E ratio of 22 against a long-term average of 15.

But another measure of stockmarket value – the cyclically-adjusted price to earnings ratio or “CAPE” – tells a different story.

This averages the earnings over 10 years to give a reading less distorted by the ups and downs of cycles in the economy. It puts the UK market on ratio of 15.6 versus a long-term average of 20.4.

Investors can also look at valuations for sectors within the stockmarket. The chart below compares today’s CAPE valuations for each sector (the blue squares) compared with their long-term averages (the yellow dot). The thin line range represents the full range of CAPE scores over the years.

This analysis highlights the cheap sectors as being raw materials, oil and gas and financials. At the other end of the spectrum, consumer staples (companies that make everyday goods) and technology stocks have high valuations.

As you can see most sectors are valued either well below or inline with their long-run averages. Only consumer staples and the technology appear to be overvalued.

PE ratios and CAPEs are not the only ways to measure the value of stockmarkets and sectors and many other factors can affect their future paths.

Matt Hudson, Fund Manager and Head of Business Cycle for UK and European Equities, said: “If you look back on a historic basis, the UK market is trading on quite a high PE multiple. Share prices have risen in anticipation of a recovery in earnings which has yet to occur, and that has pushed up PE multiples.”

Investors, he said, have also been herded into a few high-income defensive sectors, such as tobacco and healthcare. This has led to a wide gap between cheap and expensive sectors within the market.

“The valuation dispersion in the UK market is still quite high, reflected especially in high valuations for defensive shares,” Hudson said.

“However, if you believe that other sectors of the UK market, whether it is financial, or basic materials, or oil, can start to grow again, then this valuation point looks very attractive. Furthermore, if you think sustained rises in inflation are coming, commodities and financial stocks should also benefit in that environment.

“This is all before you begin to look at the market on a more cyclically-adjusted basis (CAPE) or when you look at equities against other asset classes such as bonds. On the latter measure, shares certainly look cheap.”

A little FTSE 100 history

While the FTSE 100 steers a course towards a fresh all-time high it is worth noting that in the last 20 years the index, without dividends reinvested, has actually moved sideways.

Had you invested in the FTSE 100 at the technology boom peak of 6930 on 30 December 1999 you would have made little through capital gains: that 1999 high wasn't exceeded again until April 2016.

But dividend payments would have provided substantial returns. As the chart below illustrates, the FTSE 100 total return has been 81.2% between its 1999 high and 05 October 2016. Such performance would theoretically turn a £1,000 investment into £1812, before charges and other costs.

 

Important Information
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document.
The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments.
Derivatives carry a high degree of risk and should only be considered by sophisticated investors.
The fund is authorized by the SFC but such authorization does not imply official approval or recommendation.
Schroder does not provide any securities or investment products for offer, solicitation or trading within The People’s Republic of China (PRC). Should illegitimacy arise thereof, contents of this document shall not be construed as an offer or solicitation or trading for such securities or products. All items mentioned herein are sold through financial products issued by commercial bankers in the PRC under regulations by the China Banking Regulatory Commission (CBRC). Investors should read the relevant documents clearly before invest in the mentioned funds. Please consult the relevant commercial bankers in the PRC and/or professional consultants if necessary.
This material including the website has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.