EquitiesApr 8 2015

Equities on the mend

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Equities on the mend

But away from the popping corks and clinking glasses, a number of naysayers have questioned the significance of hitting the landmark.

While it is true that an arbitrary milestone should not have any bearing on underlying fundamentals, there remains a strong case for the FTSE 100 continuing its climb toward the next millennial milestone. Equities will remain choppy, and volatility may indeed increase, but we see plenty of leg room for investors to make further gains over the next few years.

Recent market gains owe much to low interest rates. In particular, loose monetary policy and quantitative easing, sustained by Federal Reserve caution, suggest that a rate hike is still some time off. Low rates across different fixed-interest assets and benign yield curves provide firm foundations for further equity market gains.

While the FTSE 100 reflects the prospects of many truly global businesses, positive economic news from the UK also has an impact on the outlook. UK GDP figures have been pointing in the right direction, and the ONS has revised up Q4 2014 growth, adding cause for optimism. Businesses exposed to UK consumers are also expected to benefit from the temporary low inflation brought about by lower oil prices which is effectively putting money back into people’s pockets.

Some still question the equity market’s sustainability, and their caution might not be misplaced, given that, following initial strength last week, the FTSE 100 has since fallen below 6,800.

However, one key measure of market value, the prices/earnings ratio, indicates that equities are not overvalued. We can see a gilts price/earnings ratio of 65.9 against an equity price/earnings ratio of 15.5 for the FTSE 100. This suggests that the FTSE 100 continues to offer good relative value, especially considering that equity P/E ratios have declined since 1999/2000, while gilt P/E ratios have tripled.

Yields may provide clues about value, but they do not tell the whole story

In addition if we look at income yields, FTSE 100 stocks and UK government gilts have reversed their historic relationship since 1999/2000.

As the table shows, quantitative easing and low inflation have depressed gilt yields from 5.48 per cent in December 1999 to around 1.52 per cent now, while during the same time period the dividend yield from FTSE 100 stocks has risen from 2.35 per cent in to above 3.5 per cent. These dividend payments look sustainable across the FTSE 100 in aggregate which should underpin equity values.

10-year gilt yieldFTSE 100 dividend yield
Dec 30 19995.48%2.35%
Mar 20 20151.52%3.5%

Yields may provide clues about value, but they do not tell the whole story, and it is important not to overlook inflation when thinking about value. Dividend payments from equities across the FTSE 100 typically rise in line with inflation and GDP growth over the medium term, providing implicit protection against rising prices.

While CPI inflation is currently near zero, we should be prepared for a reversion over time to the annual mean near the Bank of England’s 2 per cent target, which favours assets with attractive yield and growth potential.

Further gains in the FTSE 100 rest on three supporting pillars: loose monetary policy, attractive relative value, and earnings growth. While not all of these are safe bets, the FTSE’s record high itself signals increasing market confidence across these pillars and the psychological significance of breaking through the 7,000 level – untouched by the dot.com bubble and bull run of 2003-2007 – goes a long way to hearten investors.

Despite this overall upward trajectory, equity markets will likely be more volatile compared with the benign 2010/2015 period. Risks include euro contagion, including the pressing need for Greece to reach agreement with its creditors on structural reforms; the S&P500 potentially seeing a correction from current elevated levels; and oil price volatility – all of which could all throw up adverse surprises.

Closer to home, there is also a general election contest to come, which is unlikely to deliver a big majority for any political party. With so many possible outcomes it would be unwise to make a prediction on the result, but it is likely that the election will be followed by a period of political uncertainty which the markets will not welcome.

The market may not be jumping for joy as the FTSE 100 passes 7,000, but we are seeing strong signals of underlying strength, showing signs of momentum. However, second guessing where the market will be 12 months from now is a risky business, and advisers and their clients should invest with longer time horizons, and not be deterred by short term events. By investing consistently over months and years, advisers and their clients can ride out temporary downturns.

Nick Dixon is investment director of Aegon UK

Key Points

The FTSE 100 finally stumbled across the 7,000 line on 20 March

Some still question the equity market’s sustainability, and their caution might not be misplaced

Equity markets will likely be more volatile compared to the benign 2010 to 2015 period