Since the beginning of February, the UK’s leading index, the FTSE 100 (INDEXFTSE: UKX), has dropped around 10% from its all-time high of 7,770.
There have been two key reasons why it has set off on the back foot this month. First of all, equity markets around the world have started to slide as investors take some profits off the table following substantial gains in January, and second, a stronger pound has weighed on sentiment.
Indeed, over the past two years, as the value of the pound has fallen against other currencies, the FTSE 100 has pushed higher because the majority of revenues from the index’s constituents are booked in different currencies. As the pound has weakened, profits in sterling terms have increased, justifying higher stock prices. For companies that report earnings in dollars, such as HSBC, the FTSE 100’s largest constituent, this could mean lower profits in 2018 following last year’s record performance.
Still, as mentioned above, the FTSE 100 is a global index, which means that it could rally to a new all-time high later this year, no matter what happens with British politics.
A play on global growth
Around four-fifths of FTSE 100 revenue comes from outside the UK, which means that the index is more sensitive to movements in the global economy than it is to developments at home. And right now, the global economy is really heating up with economic growth expected to return to pre-crisis levels in all regions next year.
Indeed, at the beginning of 2018, the World Bank lifted its forecast for global economic growth to 3.1%, the first time since the financial crisis that growth is reportedly operating at its full potential.
This is great news for global banks such as HSBC, as well as the index’s second and fourth largest constituents, BP and Shell, which will benefit from higher oil prices this year, as well as higher profit margins following the cost-cutting efforts that have taken place over the past few years.
The best income investment around?
It’s not just rising profits that could propel the FTSE 100 higher in 2018. Dividends paid out by UK companies hit a record last year, and today the FTSE 100 supports an average dividend yield of 4%, significantly above its historical average. For example, over the past decade, the index’s yield has averaged 3.5%. If the index trades up to the same level today, it could be worth at least 8,300, 6% above its all-time high.
What’s more, the CAPE (cyclically adjusted price-to-earnings ratio) valuation of the FTSE 100 is around 15.5, making it one of the world’s cheapest developed equity markets. CAPE compares average annual earnings over 10 years adjusted for inflation and is considered a more reliable indicator of value than the vanilla P/E ratio. Compared to the UK, the US market is trading at a CAPE ratio of 33, and Europe’s markets are trading at around 20.