A better year ahead for the FTSE 100?

It seems the UK is back in fashion, at least in terms of equities. JPMorgan Chase & Co is just one of several investment houses to have recently upgraded their recommendations on UK equities, citing discounted valuations based on both price/earnings (PE) and price/book value (P/BV) multiples. Those discounts are particularly pronounced among FTSE 100 constituents, where valuations have not kept pace with the recovery in corporate earnings.

It’s certainly borne out in the average ratings. According to FactSet data, the respective forward multiples for the index are 11.8 and 1.7, against 20.8 and 4.29 for the S&P 500, while the average dividend yields come in at 4.1 per cent and 1.4 per cent.

Flattering to deceive?

On the face of it, these basic comparisons point to a compelling argument in favour of UK blue-chips, but in isolation measures like these are indicative at best. After all, you could always take the contra view that US valuations are simply overcooked, a reflection of excess liquidity in the economy. We might get a better steer on this when US interest rates start to bubble-up, but it’s worth noting that the 20-year forward PE and P/BV averages for the S&P are 15.8 and 2.69.

Even if JPMorgan Chase is on the money, it’s worth questioning how such a glaring disparity has opened up between two mature indices, particularly if we suspect it has as much to do with externalities as it does with fundamental analysis.

Brexit casting a long shadow

We can certainly say that politics has played its part. Since the UK voted to leave the European Union (EU) in June 2016, the FTSE 100 index has performed woefully against its US and European counterparts. The UK benchmark has risen by 15 per cent in the intervening period, an anaemic return set against the Euronext 100, up 58.4 per cent since the referendum, while the Dow Jones Industrial index has all but doubled over the same period. 

At the end of 2018, Schroders published the results of a survey of 400 financial advisers which indicated that over a third of their clients had either pulled assets out of the UK or were considering doing so. At that point, Whitehall and the EU were still haggling over the shape of a post-Brexit settlement (as they still are), while the prospect of a command economy under Jeremy Corbyn seemed a more realistic scenario than we might have dared to imagine.

In the event, voters in the traditional Labour heartlands turned on Corbyn, partly due to his seeming ambivalence to the outcome of the Brexit vote, but also because he simply alienated too many of the party faithful. Whatever the reasons, by the end of 2019 the Tories had won a handsome majority in the House of Commons, enabling Boris Johnson to pursue a bolder approach to negotiations with the EU.

That was the theory at any rate. The feeling in certain quarters now, at least judging by recent statements from the UK’s chief negotiator, Lord Frost, is that Brussels is quite prepared to drag out talks on the trade issues not covered under the EU–UK Trade and Cooperation Agreement indefinitely. Unfortunately for the UK, that includes financial services.

It is conceivable, therefore, that the UK could trigger Article 16 – a safeguarding mechanism under the Northern Ireland Protocol – to break the deadlock. Such a move would almost certainly destabilise trade relations between the UK and EU member states, increasing the possibility that the former might simply choose to ‘go it alone’.

Stasis an unpalatable option for Corporate UK

The point is that the same uncertainties that have undermined UK indices over the past five years or so are still in evidence. But you could even make the argument that any market turmoil that followed a decision to invoke Article 16 would be preferable to a seemingly permanent impasse. Resolution in one form or another would provide greater clarity for investors, even if it entailed increased volatility in the short term.

But it’s not all about Brexit, far from it. The initial reaction to the referendum vote was suitably erratic, with a steep dip in the FTSE 100 swiftly followed by a commensurate retracement. At that point, some may have found succour in Benjamin Graham’s adage that “in the short run, the market is a voting machine but in the long run it is a weighing machine”.

Profit shortfalls ahead of the virus

The trouble is that the benchmark’s subsequent performance has as much to do with return analysis as it does with trade uncertainties. In the year that the European Union (Withdrawal) Act 2018 was introduced to parliament, the constituents of the FTSE 100 delivered aggregate pre-tax profits of around £170bn, a 29 per cent shortfall on consensus estimates.

A year later, Covid-19 hit the headlines. And it would be fair, if not slightly crass, to say that the UK has not had a good pandemic. Profit forecasts duly headed south and balance sheets were swollen through a relaxation in debt covenants and a record surge in new stock issuance. Add in a tsunami of monetary and fiscal stimulus, and you start to get an idea why it has become more precarious to make a definitive call on index valuations.

That may sound like a cop-out, which, of course, it is. But, by now, many of the historical assumptions relating to the performance of capital markets under certain circumstances, including the relationship between equities and bonds, have been brought into question.

The evolution of a globalised index

Even if we take the view that market assumptions have become distorted due to unprecedented intervention on the part of central banks, the evolution of the FTSE 100 could also help to explain its relative underperformance.

Since its inception in 1984, the FTSE benchmark has moved away from a largely UK-centric affair to one dominated by global multinationals. Roughly a quarter of its current constituents were there at the beginning, but the inevitable tide of M&A, new listings, demotions and corporate failures have taken their toll. Add in the accelerated trend towards globalisation and we are left with an index comprised of UK-domiciled corporations that derive less than a third of their sales domestically.

Essentially, the index largely reflects aggregate demand in the global economy. If you’re looking for a more meaningful barometer of UK plc, you would be better off with the FTSE 250.

Questions over growth and value

But it isn’t really the globalised nature of the index that has seen it lag many of its overseas counterparts. It is more to do with the fact that its weightings largely fall in favour of mature, lower-growth stocks, hence attempts by UK listing regulators to ease the way for the tech-driven unicorns of this world.

Although the UK benchmark has missed out on much of the growth generated from the new economy, matters may be set to work in its favour if, as some market-watchers suggest, September’s tech sell-off was a staging post on the gradual rotation out of growth into value stocks. Many institutional portfolios are still overweight in the former, essentially businesses with higher-than-average earnings growth rates. But it’s generally held that growth stocks tend to suffer disproportionally when liquidity is withdrawn from the market. So, all eyes on the US Federal Reserve.

Solid long-term returns and low volatility

Some younger investors may view the composition of the FTSE 100 as almost anachronistic in the modern age, a melange of miners, finance companies and Big Oil. But it would be churlish to downplay its inherent strengths.

For a start, in the year prior to the outbreak of the pandemic, it boasted four of the world’s 10-largest dividend-payers. And it’s those distributions that make all the difference. From the end of 1985, the FTSE 100 increased by 404 per cent by index value and 1,877 per cent on a total return basis. This equates to an annual price return of 4.6 per cent and an annual total return of 8.65 per cent.

Threats to distributable reserves

That’s a decent rate of return for a low-volatility index, although the reinvestment of dividends is clearly a major component. Many of the constituents find support in the market through progressive dividend policies, but investors need to be mindful of issues that could potentially constrain distributable reserves.

We have already seen that to an extent with the increased capital requirements placed on the banking sector in the wake of the global financial crisis of 2007-08. Now, you’re left wondering what impact a regulatory-led renewables transition will have on pay rates for the three constituents of the energy sector that account for 9.83 per cent of the index weighting. Indeed, the banking and energy sectors accounted for 24 per cent and 17 per cent, respectively, of dividends paid in the fourth quarter of 2019, a record year for distributions. And that’s to say nothing of the buyback programmes in place prior to the Covid-19 outbreak.

Eyes on the MPC and fund managers' cash positions

It’s something of a fool’s errand to try to predict future index values, but the latest fund manager survey from Schroders shows that 81 per cent of respondents are expecting higher UK growth, perhaps unsurprising given where we were last year. But even if improved expectations on the economy do not lend support to the benchmark, we can say that the FTSE 100 could conceivably outperform other global indices based on mean regression alone. 

Unfortunately, the timing of said regression is far from certain. And even if the relative performance of the FTSE 100 improves markedly, there is no guarantee that the index value will improve in absolute terms. There is every chance that both central banks in the UK and US could gradually pull back the stimulus they’ve provided during the pandemic, a precursor to increasing base rates.

Across the Atlantic, central bank officials have already indicated that they’re ready to begin “tapering”. Admittedly, the Federal Reserve hasn’t always followed through on its forewarnings, but its hand will eventually be forced due to the unprecedented level of support for financial markets and the economy.

The Bank of England, or at least members of its monetary policy committee, have recently struck a more cautious tone on interest rates, a reflection of concerns over the impact of the Omicron variant.

If you take the long view, then an improved showing compared with foreign indices may represent a viable entry point if you are looking at increasing your exposure through a tracker fund. Just keep in mind, however, that some fund managers have started building their cash positions in anticipation of a rockier road ahead for the global economy. The latest Global Fund Manager Survey from the Bank of America shows that although the overall cash position fell 30 basis points from the October record of 4.7 per cent, it remains lofty from an historical perspective. Uncertainties are also manifest in the CBOE Volatility Index (VIX), which is also well in advance of its long-term average.