The definition of a bear market is a decline of 20% from an index’s high. Following a number of months of decline, last week the FTSE 100 dropped around 14% lower than the peak level it reached in May. While still short of being a bear market, the index has nevertheless experienced a hugely challenging period which may not yet be at an end.
Despite the risk of further falls, the long-term prospects for the index continue to be relatively appealing. That’s especially the case as the UK experiences its most significant economic and political change in a generation. Although Brexit may seem to be a risk facing the index, it could prove to be a positive catalyst on its future performance.
Brexit uncertainty
Since 25% of the FTSE 100’s income is derived from within the UK, the potential for disruption caused by Brexit could cause a number of its incumbents to experience a period of difficulty. At the time of writing, it seems improbable that the Brexit process will be a smooth ride between now and the end of March 2019. There seems to be a wide range of dissenting voices in Parliament, and this could scupper the prospect of the current Brexit deal coming into effect.
Even if it does pass smoothly through Parliament, Brexit represents a significant change for the UK from an economic and political perspective. It essentially undoes decades of gradual progress towards a political and economic union within Europe, and could have a significant impact on a wide range of industries. As such, investors may naturally price in possible risks. While they may not come to fruition and Brexit could even prove to be a good thing for the economy in the long run, the uncertainty it’s causing may lead to falling valuations for UK-focused shares.
International potential
While a quarter of the FTSE 100’s income is generated from within the UK, 75% of it is derived from abroad. This means that the FTSE 100 is much more dependent on the outlook for the world economy, rather than the domestic economy. Internationally, the economic outlook is relatively upbeat. Although there are risks from a rising US interest rate and potential trade tariffs, the general consensus is that growth could continue to be high across a number of major economies beyond 2018.
Additionally, a weak UK economy may lead to further declines for sterling after a tough couple of years. This may cause a boost to earnings for FTSE 100 shares which report in pounds but operate mostly abroad. This could even mean that a tough outlook for the UK economy creates more favourable conditions for the FTSE 100, since it’s an internationally-focused index. For this reason, and the uncertainty which is being caused by Brexit, the FTSE 100 could offer investment appeal after its recent slump.
