Three reasons why the FTSE 100 could keep on running (and three why it might not)

Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

“The FTSE 100 continues to overcome investors’ concerns over the Brexit negotiations, a wobbly Government, indecisive central bank and modest UK economic growth as it reaches further new highs. There are three good reasons why the index could keep going, too, and launch a fresh assault on the 8,000 mark – although investors also need to be aware of the potential downside and what could still go wrong,” says AJ Bell Investment Director Russ Mould.

The case for further gains

1. Dividend yield

“According to consensus forecasts the FTSE 100 offers a 4.0% dividend yield for 2018, with total payments to shareholders expected to rise by 7% this year to a record £88.3 billion (nearly double the total payment made in 2010).

“That 4% easily beats cash in the bank and inflation. It also beats the yield available on the 10-year Government bond, or Gilt, which is often used as a benchmark for the so-called ‘risk-free rate’ by which all investment returns can be judged.

“The UK 10-year Gilt yield is currently around 1.50% so the FTSE 100 beats that by 250 basis points, or 2.5 percentage points. A yield premium of around 200 basis points, or two percentage points, has tended to provide support to the FTSE 100 index in the post-crisis era (even if we must all accept that the past offers no guarantee for the future).

Ch1

Source: Thomson Reuters Datastream, Bank of England

2. The weaker pound

“The Bank of England’s decision to leave interest rates unchanged at 0.5% is having two effects – the first is to keep returns on cash and bond yields low, boosting the relative attractions of stocks.

“The second is to drive the pound down, especially against the dollar, and this is also providing support for UK-quoted stocks.

“Around two-thirds of the FTSE 100 index’s earnings come from overseas, so the lower the pound goes, the more those foreign earnings are worth when they are translated into sterling.

“This explains why the FTSE 100 did so well in 2016 and early 2017, as the pound fell in the aftermath of the EU referendum vote, stalled badly as the pound rallied in early 2018 (amid tougher talk on interest rates from the Bank of England) and then rallied again when Governor Mark Carney and the Monetary Policy Committee failed to deliver on tighter monetary policy on 10 May.

Ch1

Source: Thomson Reuters Datastream, Bank of England

3. Oil

“Oil is important to the FTSE 100. According to consensus analysts’ forecasts, BP and Shell between them represent 25% of total FTSE 100 sales, 14% of profits and 20% of dividends for 2018. They are also expected to provide one quarter of FTSE 100 profit growth in 2018 on their own and while their dollar-denominated dividends are currently forecast to come in flat at $0.40 for BP and $1.88 for Shell, a weaker pound could help make those payments worth more in sterling.

“The higher the oil price goes, the safer those dividend payments look, too, and that helps to underpin the overall yield from the FTSE 100 index.

 

2018 dividend

% of FTSE

2018E

2018E

 

£ million

total payout

yield

dividend cover

Shell

11,610

13.2%

5.0%

1.25x

HSBC

7,603

8.6%

5.2%

1.38x

BP

5,938

6.7%

5.1%

1.06x

BAT

4,663

5.3%

5.4%

1.52x

GlaxoSmithKline

3,967

4.5%

5.4%

1.34x

Vodafone

3,564

4.0%

6.8%

0.74x

Lloyds

2,977

3.4%

6.2%

1.75x

Rio Tinto

2,701

3.1%

4.7%

1.64x

AstraZeneca

2,566

2.9%

3.8%

1.22x

Glencore

1,943

2.2%

3.9%

2.41x

Source: Digital Look, consensus analysts’ forecasts

The case for caution

“The very fact that the FTSE 100 has gone from friendless in March to the front pages in May would perhaps warn against getting too carried away, also for three reasons:

1. The best time to buy is when no-one else is.

“The time to buy securities is when no-one’s interested, not when everyone is, so the fact that the FTSE 100 started this year out in the cold but is now seen as a hot property again should at least give investors pause for thought. The index now trades at a new all-time high, after all, so simple maths says that it offers less value – and potentially less upside – than it did at its closing low of 6,889 in March.

Ch1

Source: Thomson Reuters Datastream

“There is always the chance that the three key sources of recent support for the index fade away.

“What happens if the Bank of England’s latest move in its interest rate hokey-cokey is to put up headline borrowing costs? That might boost the pound and lower the value of overseas earnings. It could also drive bond yields higher and make it easier for investors to generate yield from their portfolios without taking on the capital risk offered by stocks. What happens if the price of oil goes down again? That could again chip away at earnings and dividend growth for the wider UK market.

2. The FTSE 100 is a heavily skewed index

“As the substantial role played by oil implies, the FTSE 100 is heavily skewed in terms of its market cap, income and dividends to just a dozen or so stocks and three or four sectors: financials (and banks in particular) and miners, as well as BP and Shell.

“Any investor in UK stocks, especially those who put their money to work via a passive tracker, must therefore be comfortable with these firms and sector’s prospects.

“For the moment, banks (as the economy chugs along and regulatory pressure and conduct fines start to fade away), miners (rising commodity prices) and oils (rising price of crude) all look set fair but they are all volatile, unpredictable industries and nothing can be taken for granted.

Percentage contribution to aggregate FTSE 100

 

2018E

 

 

2018E

 

profits

 

 

profits growth

Financials

25%

 

Financials

30%

Consumer Staples

14%

 

Oil & Gas

25%

Oil & Gas

14%

 

Health Care

17%

Mining

14%

 

Consumer Staples

15%

Consumer Discretionary

10%

 

Consumer Discretionary

7%

Industrial goods & services

8%

 

Industrial goods & services

4%

Health Care

8%

 

Utilities

2%

Telecoms

3%

 

Technology

2%

Utilities

3%

 

Telecoms

1%

Technology

1%

 

Mining

0%

Real estate

0%

 

Real estate

-2%

Source: Digital Look, consensus analysts’ forecasts

3. Dividend cover

“Although the FTSE 100’s dividend yield is attractive, it may not be entirely safe. Forecast earnings only cover forecast dividend payments by 1.7 times – although that is higher than of late it is still below the 2.0x times cover ratio that provides some comfort should anything suddenly go wrong.

“The yield premium relative to bonds may look attractive but if dividends are cut (say in the event of a sudden economic downturn), or bond yields go up (because the Bank of England screws up its courage and raises interest rates) then that relationship could change.

“The good news, for the moment at least, is that dividend cuts have become much rarer after a bad run of reductions in 2015-2016. In 2017, only Provident Financial (since ejected from the index), Pearson and Sainsbury cut their shareholder distribution among FTSE 100 members.”

Ch1

Source: Company accounts, aggregate consensus analysts’ forecasts

These articles are for information purposes only and are not a personal recommendation or advice.


The chart of the week is written by Russ Mould, AJ Bell’s Investment Director and his team.