Since the UK voted to leave the European Union at the end of June, the FTSE 100 has been on one of its most impressive rallies of all time, extending the rally that began at the beginning of the year.
Indeed, over the past 12 months, the index has gained 15.7% excluding dividends. If you factor in the FTSE 100’s current dividend yield of 3.4% the index’s total return over the past 12 months has been around 19.1%.
Unfortunately, it’s more likely that the index will fall over the next 12 months than rise, as the recent rally has changed the dynamics of the UK’s leading index in such a way that company fundamentals no longer matter.
The index has changed
The majority of the index’s gains since Brexit have been down to the devaluation of sterling. In the weeks after the referendum result, the FTSE 100 rose by more than 10% despite the fact there was almost no change in underlying business fundamentals. As more than two-thirds of the FTSE 100’s profits come from outside the UK, most of the index’s constituents will likely see an earnings boost thanks to weaker sterling.
Still, for how much longer sterling will continue to have such a positive impact on the UK’s leading index is uncertain. Currencies are highly volatile instruments, and as we have seen over the past few weeks, sterling is now being influenced by every Brexit-related headline.
If the pound changes course and begins to increase in value against the dollar, then the movement of the FTSE 100 will most likely be dictated by the commodities markets. Commodity companies have always made up a significant proportion of the FTSE 100 and this remains true today. Companies such as Shell, BHP and Rio will dominate if sterling no longer drives the market.
As the commodity markets have been particularly weak for the past few years, having commodities rule the FTSE 100 will likely mean the index’s movements are even more unpredictable. Oil prices remain under pressure and as China’s economic growth slows, the demand for bulk commodities such as coal and iron ore is contracting.
Dominated by uncertainty
With so much uncertainty it’s more than likely that the FTSE 100 will fall year even if the most optimistic economic forecasts are proved right.
If the market regains confidence in the UK’s Brexit negotiating ability, the value of sterling will rise and this will send the FTSE 100 lower. If global economic growth picks up, then the outlook for commodity companies will improve but because Shell, BHP and Rio all trade at high teens forward earnings multiples, the shares already look fully valued, which will limit gains.
Of course, the index could surprise everyone by continuing to push higher, disregarding the fundamentals altogether, but this would only postpone the eventual correction. The higher the index goes, the more uncertainty builds, and markets hate uncertainty. Put simply, it can only be a matter of time before investors start to jump ship.
