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What the ECB decision means for the UK stock market and what I’d do now

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The UK stock market is climbing. From its lowest point on 23 March, the FTSE All-Share index has gained 29% of its value. The FTSE 100 has grown 28% over the same period.

In addition, the indexes received an extra boost shortly after 12:45 pm yesterday. That was the UK stock market responding to the European Central Bank (ECB) decision to leave rates steady and the emergency bond-buying stimulus in place.

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Inspired by economic optimism, investors liked what they heard. So, the UK stock market continues its bullish rise for now.

Effects on the UK stock market

At the same time, sterling weakened against both the euro and the US dollar as demand for assets denominated in euros and USD increased. For the many FTSE companies with assets, debt, and cash denominated in these two currencies, the values of these entities will rise too.

Indeed, there are many companies trading on the FTSE that will benefit from a weaker sterling. Diageo, the alcoholic drinks maker, and British American Tobacco, the cigarette producer, are among them. These companies generate the majority of sales outside the UK, so they will reap the benefits when sales are translated back into sterling. Firms in resilient sectors such as healthcare or industrials may also profit.

The FTSE is full of global firms. Even many mid-caps have large exposure overseas and are in a position to benefit. So, it’s not surprising investors are currently bullish about the UK stock market generally.

And then…there’s the yield curve    

However, two weeks ago the UK sold its first negative-yielding government bond. Low bond yields are becoming a permanent feature, so much so that cash now often earns a higher return. And as for shares, the lower the bond yield, the higher the price. Indeed, the only reason to buy a bond right now is to lock in a higher rate of return before you expect interest rates to drop again.

In other words, the yield curve is predicting a recession and a bear market. It has a history of doing exactly this. Moreover, it did so before the coronavirus pandemic took hold. To reinforce this view, the ECB is likely expecting tough times too. It issued the emergency stimulus and won’t comment on negative bond yields.

This may have negative implications for the UK stock market. To add to this, 10-year gilts are under 0.2%, the three-month money rate. This could imply a high risk of dropping share prices in the future.

The pessimistic outlook is further backed up by the recent forced cessation of business and the related dropping return on capital. Consequently, even if firms borrow at low rates to sustain themselves through the current hard times, earnings and profitability will likely be reduced. 

Personally, I think there is much reason to be cautious about the future of the UK stock market right now. However, there are currently some great companies listed on the FTSE, at attractive valuations when measured analytically. And there are some top dividend payers among them to help improve total shareholder returns, even in bad times.

That said, I will be holding some cash back for possible future bargains in the increasingly likely bear market to come.

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Rachael FitzGerald-Finch has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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