How to protect against a fall in the fired-up FTSE

Mark Wharrier |03-Feb-2017

The FTSE 100 hit a record high in January, but its direction is now uncertain. Well resourced, skilled active managers can make the best use of expected volatility.

The FTSE 100 hit record all-time highs last month, leading some to fear that it may soon return to Earth with a bump.

The UK’s leading share index rocketed by almost 15% in 20161, then continued rising to reach record highs in January.

This performance was the combined result of a weak sterling following the Brexit vote; more positive economic data in the UK than the market had expected; recovering commodity prices; and the market’s anticipation of pro-spend policies in the UK, US and elsewhere.

Many advisers question whether or not this upward trend can continue if the UK government’s triggering of Brexit in March heightens uncertainty. This should keep sterling low and further support FTSE companies that gain much of their profit from overseas.

But others question whether the market is due a correction now. If Brexit negotiations go well, the pound could recover and investors with high weightings to the UK could suffer.

The FTSE is a rich market where opportunities for skilled managers will continue to abound

Protecting against a bubble

Previous rallies have been followed quickly by sharp corrections, as witnessed in 1999, 2008 and 2015. Will that happen this year and how can advisers seek to protect their clients?

Analysing basic fundamental data is of limited help, partly because we are in such unprecedented political territory. The recent rally seems to have been sustained by the momentum following the result of the US election – as markets see the new US president as pro-spend, pro-business – and not by fundamentals. So it is hard to predict how long the run can continue.

The price-to-earnings ratio of the FTSE 100 is well above its long-term average2. But there is wide variance within that – some companies still look good or fair value, which emphasises the importance of active stock selection.

The high PE ratio average is due to the overall rise in stock prices and the weak earnings posted by many FTSE companies recently. However, this earnings drop should be temporary, especially for the oil producers in the index as the oil price should maintain its recovery this year.

Meanwhile the cyclically adjusted price-to-earnings or (CAPE) ratio – which some think is a better gauge of long-term value – is below its long-term average3. By this measure, the market does not look overpriced.

Also companies are paying around 3.7% dividend yield4 which is broadly in line with the long-term average. However, there is a warning here as the ability of FTSE companies to cover their dividends has fallen recently.

Much will depend on the wider economic backdrop –many believe economic growth and inflation will accelerate in 2017, thanks to a shift from austerity to fiscal stimulus in the UK and further afield. But if that agenda falters, the FTSE could struggle.

From a sector perspective, mining, oil and gas look set for a better year in 2017, but the future of banks and insurers is less clear due to the uncertain effect of the Brexit negotiations.

Opportunity for active skills

These mixed signals combined with the wider context of Brexit talks, uncertain European elections, and Trump’s unpredictability look set to keep market volatility high again this year. Skilled, well-resourced active managers can do particularly well in such markets as they are able to take tactical advantage of changeable conditions having carried out fundamental research which makes them ideally positioned to analyse opportunities.

BlackRock’s wealth of resources enable it to understand the causes of the increasingly regular ups and downs in today's markets. Such resources help managers buy what they believe are good companies at attractive valuations during volatile periods; and identify those that can deliver long-term returns regardless of the economic or political backdrop.

They also help managers understand that expensive-looking stocks can be worth it if the company has a strong balance sheet and reliable cash flows – especially if it is also a market disruptor or is protected by barriers to entry.

Not overpaying for companies threatened by disruption is also crucial. Avoiding detractors is as important to performance as picking winners.

Overall, with more than 70%5of revenues generated outside the UK, we think the FTSE offers high levels of global and thematic diversity. These make it a rich market where opportunities for skilled managers will continue to abound.

Mark Wharrier
Managing Director and Portfolio Manager, BlackRock UK Income Fund
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1. Source: Thomson Reuters, FTSE 100 capital only return as at 31 December 2016
2. Source: Lazarus as at 20 January 2017
3. Source: CAPE long-term average
4. Source: Thomson Reuters as at 31 January 2017
5. Source: Morgan Stanley Global Exposure guide May 2015

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