Where the FTSE 100 will go next year

When we evaluated prospects for the UK market at the end of last year, we noted that the negative correlation between bonds and equities had become less evident and that we were faced by “a prolonged period of sluggish (or negative) growth”. Well, we were hardly in Mother Shipton (the soothsayer and prophetess) territory there, but we also speculated that the discount rate applied to future earnings was about to become more unpredictable in 2023. Again, that statement might best be filed under the general heading of “stating the obvious”, but after a decade of ultra-low interest rates, we could be forgiven for overlooking – or at least underestimating – the relationship between stock market valuations and metrics like these.

Sluggish corporate earnings growth also presents a problem for investors; normally, if it keeps pace with the level of rate rises, it can usually offset the discount effect, but that simply hasn’t played out. Yes, investment markets are not fixed, but it wouldn’t be unreasonable to suggest that the breakdown in the standard assumptions linked to capital markets are due to the distortive effects of a decade-long monetary policy experiment. We simply became addicted to cheap money – and now we’re going cold turkey.

The good news is that the UK is no longer being forced to pay an extravagant risk premium in debt markets, as was the case at the end of 2022, but outright interest rates remain elevated as central banks stay focused on core inflation rates ahead of any inflection point. That last point is germane where risk assets are concerned, and it will be interesting to see how the relationship between bond and equity prices plays out over the next 12 months.

What's in store for the FTSE 100

Given the outward-looking nature of its constituent base, it is worth noting that many leading indicators across the globe are faltering as we head into January. Tightening monetary conditions are hampering growth in the eurozone economies – particularly Germany – while the anticipated recovery in the mainland Chinese economy has faltered.

Expectations on rate cuts in developed economies continue to move around. Tighter-for-longer interest rate policies, if they do materialise, will constrain growth rates in many major economies, including the UK. It’s worth remembering that the impact of rising interest rates tends to be a lagged affair, so many of the negative impacts, including rising corporate insolvencies, may not become fully apparent until next year. Although it’s generally accepted that UK inflation is now on a downward path, the Bank of England (BoE) will not relent on the interest rate front until wage growth is constrained. A short-run recession might be the preferred outcome, unpalatable as it may seem. 

At the time of writing, it appears as though the FTSE 100 will finish this year roughly where it started. This would be an unfavourable outcome compared to the S&P 500 and the Euronext 100, although it had outperformed many of its rival indexes in the prior year – a partial consequence of elevated crude oil prices. The reality is that the FTSE 100 index has a significant weighting to defensive sectors, so it became a more attractive destination for capital when the world was convulsed by geopolitical shocks in 2022.

Nonetheless, the index continues to trade at a much lower average forward multiple than rival indexes across the Atlantic. Irrespective of the fact that the recovery in US index valuations has been driven by a concentrated number of tech stocks, the relative performance of the FTSE 100 has reignited the well-worn debate over the lower-growth nature of its 'mature' constituent base.

Yet for all its perceived structural inadequacies and near-term macro challenges, it doesn’t automatically follow that the UK benchmark index growth rate is headed into negative territory. If nothing else, the sagging index performance may already reflect a deteriorating consensus outlook on net profitability, as corporations are faced with increased refinancing costs and a higher tax burden. That suggests there will be, at some point, upside potential. But the index weighting given over to basic resources is also potentially problematic given China’s stuttering post-Covid economic recovery. The outlook on UK miners has darkened accordingly.

Any deterioration in the collective bottom line may have negative implications for dividend rates, although it’s worth noting that analysts at the Computershare Dividend Monitor predict that the underlying UK growth rate – excluding one-off special dividends and the effect of exchange rate movements – will reach a creditable 5.4 per cent this year. It means that 2023 promises to be the second-best year on record for shareholder cash returns.

The outlook for next year is clouded at best given the likely reduction in cover rates. This isn’t necessarily a precursor to falling payout rates, but, if nothing else, the UK benchmark has traditionally been a happy hunting ground for income seekers, a reputation that UK stock market officials would be keen to keep intact as it serves to prop up valuations. Lest we forget: a sizeable portion of the UK market can be found in dividend-paying sectors. UK blue chips have traditionally favoured capital returns for shareholders and generally have flexible distribution policies in place. 

The FTSE 100 is inexpensive

Even if UK payout rates are maintained and grow throughout next year, it is likely that US indices will continue to trade on a hefty premium to their UK counterparts, if for no other reason than the market draw of the so-called “Magnificent Seven”: Apple (US:APPL) Microsoft (US:MSFT), Amazon (US:AMZN), Alphabet (US:GOOGL), Meta (US:META), Nvidia (US:NVDA) and Tesla (US:TSLA). Indeed, the average price/earnings (PE) multiple on Nasdaq is nearly three times that of the FTSE 100. Yet at some point, this valuation gap, no doubt exacerbated by last year’s mini-Budget fiasco, will draw the attention of institutional investors.

The FTSE 100 is inexpensive, not only in absolute terms, but also from an historical perspective. Indeed, the discounts on offer relative to global markets have not been this pronounced since the global financial crisis. Shell (SHEL) now trades on a 28.7 per cent discount to ExxonMobil (US: XOM) based on forward consensus earnings, and opportunities abound for stockpickers, at least those with a degree of patience.

Consider that 37 constituents within the FTSE 100 are trading at less than 1.5 times book value – including the likes of Lloyds Banking (LLOY), Rolls-Royce (RR.) and Glencore (GLEN) no less. Admittedly, some of the companies within that cohort have been marked down simply because they’re hampered by underlying trading issues, but when you look at an accompanying price/earnings-growth (PEG) ratio of 0.4 for an industrial heavyweight like Rolls-Royce – its legacy challenges notwithstanding – it’s hard to think that there aren’t some mispriced assets at play, even among the FTSE top tier.

That last statement also applies further down the food chain. The FTSE 250 index has lost 2.6 per cent of its value this year as of the first week of December, but it had retraced by around 11 per cent since its low point at the end of October. It no longer trades at a premium to the main UK benchmark, significant given the solid rate of medium-term earnings growth from the index constituents.

Reservations over the state of the UK economy and fears of a prolonged recession have weighed on the more domestically focussed mid-cap index, particularly in view of the inflationary spiral and the consequent vulnerability of the service sector in the UK. Latest figures from the Office for National Statistics (ONS) indicate that, while the UK economy flatlined in the third quarter, it has dodged a recession this year.

Pessimism is not supported by the data

The UK economic performance, though hardly world-beating, does support the view that the level of pessimism has not been supported by the data. Domestic employment rates remain in relatively good shape and the upward pressure on consumer prices has moderated. Still, a higher proportion of mortgagees will revert to variable rates over the coming months, potentially depleting any excess savings and reducing aggregate demand. We’re clearly not out of the woods yet on the macro front.

Any slowdown in the UK economy certainly wouldn’t be favourable where the FTSE 250 index is concerned, but it’s worth noting that its constituents now derive a higher proportion of their sales, some 57 per cent, from foreign markets than was the case a decade ago. So, its fortunes aren’t quite as intertwined with domestic economic trends as was previously the case. The index's marked discount to global indices, most notably in the US, appears even more anomalous given the rise in overseas sales channels.

At any rate, the market is not the economy, and growth prospects for many constituents are predicated on structural trends, not least of which is the ongoing digital transformation. Mid-cap companies tend to be nimbler and more adaptable to change than many of their blue-chip counterparts, a significant advantage when the industries are evolving.

Recent evidence, including November fund flow data, suggest that investors may now be building exposure to risk assets after a lengthy fallow period. Could it be that the mere assumption that rates have peaked could have a galvanising effect on investor sentiment? Figures from Calastone show private investors put a collective £450mn into UK equities in November, the first inflow for half a year. If, indeed, we’re witnessing a nascent rotation out of mutual funds invested in high-quality, short-term debt, it shouldn’t be long before institutional investors will reassess the undervalued corners of the market.

Ultimately, market conditions may not be any more favourable than they were a year ago. The best hope for the UK market rests on the assumption that rates have peaked. Recent price activity reminds us that we should assume that investors will act long before the BoE makes substantive progress towards the 2 per cent consumer price index inflation target.

It’s conceivable, therefore, that the discount to US indices could narrow rapidly, even though investors – those returning to the risk asset fold – may well initially allocate capital on a momentum basis, further intensifying the US stock market’s narrow leadership. Some believe that US indices are now more vulnerable to cyclic corrections due to their top-heavy nature. That may or may not be the case, but a simple linear regression theory suggests that their current premium to UK counterparts may not endure through 2024.