The Daily Reckoning UK

When Will The Footsie Finally Fall?

David Stevenson

by

Posted 18th May 2017

Brexit was never going to be the disaster that the Remainers promised it would be. In fact, in several areas it’s already been good news.

The FTSE 100, for example, is up by about 25% since the referendum.

But after such big move, investors are now asking: can the rally keep on going?

Before trying to answer that question, I’d like to note that this isn’t written with the benefit of hindsight. It’s almost 11 months (hard to believe, I know) since our nation’s historic decision to divorce from the EU. Yet just after the vote, I wrote in Strategic Intelligence: “Don’t panic…the Armageddon scenarios are way too pessimistic”.

That applied both to our economy and also to our stock market. Since then the former has been (more than) fine while the latter has positively flourished.

Sure, as you’d expect, something had to give. And there has been a significant adjustment factor. Sterling is now some 10% lower across the board than it was pre-referendum. But that degree of devaluation has started to boost our global trade. Meanwhile it has made UK assets cheaper to acquire for external investors.

Add in the ‘Trump trade’ effect from across the pond and the net effect is a FTSE 100 that’s up by around a quarter since the aftermath of the June-2016 Brexit poll. At just below 7,500, the index is again in all-time high territory.

I often preface my comments about global equities with references to the US. That’s because the S&P 500 index sets the tone for stock markets worldwide. To repeat the old adage: when America sneezes, the rest of the world catches a cold.

In this article, though, I’m staying at home. I’m ignoring Mr Trump’s antics and over-extended US stock valuations. Today’s focus is on the FTSE 100 itself.

In truth, I didn’t expect British shares to be so strong right now. And I’m confident in claiming that hardly anyone else did either. And as often happens after such a strong rally, plenty of pundits are now forecasting further gains ahead. Talk of the abolition of the investment cycle – that’s markets both rising and falling – abounds.

But how realistic is this?

Several factors suggest that the FTSE 100 could soon be riding for a fall.

For one thing, the pound is now going up. Or at least it has stopped falling. In fact at about $1.30/£1, it’s hovering around its highest point since the end of September last year. And against the yen it isn’t far below its best level since the Brexit vote. Granted, the £/€ rate is showing less of a rebound in the pound, but this reflects euro strength rather than sterling weakness.

Put another way, the stock market’s initial post-referendum gains were helped by currency weakness. This makes British goods cheaper for overseas buyers while increasing the sterling value of our international sales and profits. But for the moment, this beneficial effect on earnings has come to an end.

Another consequence of sterling’s post-poll plunge has been an inflation pick-up as import costs have climbed. With UK wage growth still sluggish, disposable incomes are being squeezed. This has impacted real (i.e. inflation-adjusted) household spending growth and in turn, national output (i.e. GDP) and company profits. Not a good backdrop for UK-domestic shares that depend on the consumer.

OK, some activity indicators such as the composite PMI – the Purchasing Managers’ Index, a widely-monitored barometer – suggest that Britain’s economic growth rate may quicken again in the second quarter.

“But it’s not clear that this justifies further significant gains in the stock market”, says Jonathan Loynes at Capital Economics. “The relationship between the FTSE and the PMI already looks stretched.”

Of course, the pound could dip again. But this would have another adverse effect on inflation. Which has already just hit its highest level, at 2.7% annualised, since September 2013. In the good old days that would have been the catalyst for an increase in Bank of England policy rates.

Nowadays, anyone who suggests that UK interest rates will rise is immediately labelled insane. Current consensus thinking is that borrowing costs will stay at their present ultra-low levels for ever. But don’t bet too heavily on this. One day, rates will rise again. What’s more, a further surge in the cost of living could force the Bank to lift rates earlier than markets are now expecting.

That might not be viewed at all positively by the FTSE 100.

Further, the latter is selling on its highest valuation for many years. And let’s not forget that the index has more than doubled from its March-2009 lows. Markets standing at all-time highs are always vulnerable to external shocks.

Yet even if I’m wrong and a FTSE 100 fall isn’t looming, there’s another important question for investors to address.

How much upside do they see at current levels?

That boils down to individual stocks. If there are shares in your portfolio about which you’re very confident, staying on board could well be justified. But if you’re holding onto shares simply for the sake of ‘being in the market’, or if you’re tempted to pile into the FTSE 100 now because of all those bullish commentators, remember this comment from Bill Blain of Mint Partners.

“Should you buy into the story at this stage in the game?” he asks. “The rule remains – don’t join the last 5% of a rally just so you can catch the first 25% of the subsequent crash!”

In my book, that’s very good – and timely – advice.

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