Will central banks cause the FTSE 100 to stagnate?

The FTSE 100 index could struggle as loose monetary policy continues to taper off, according to consultancy Capital Economics, who warned this could put stock market valuations under pressure.

This comes as the final article in a series which focuses on the research company’s latest report titled ‘Will the FTSE 100 continue to climb?’. Within it, assistant economist Andrew Wishart outlined four main reasons why he believes the blue-chip index will achieve no more than a sideways performance for the rest of 2017.

In our fourth article, we have focused on his thoughts regarding monetary policy movements this year and why this could lead to lacklustre FTSE 100 returns.

“Admittedly, we have argued that the required return from equities may now be structurally lower than in the past given secular decline in real interest rates and “risk-free” yields,” he said. “Indeed, the yield on 10-year inflation-protected gilts has fallen to -2 per cent recently, which has made the earnings yield of the stock market appear quite generous.

“Nonetheless, a cyclical rise in real yields on UK gilts would still drive up the earnings yield that investors require to hold riskier assets such as equities. And we think that this will happen next year as the Bank of England tightens earlier than markets expect.”

Performance of index over 10yrs

Source: FE Analytics

Alan Custis, head of UK equities at Lazard, said signs of a weakening economy are clearly starting to emerge, principally through spending power and the increasing levels of debt that consumers are undertaking.

“The amount of debt consumers have taken on has been well-covered – I think banks are now very mindful of that level of debt and we’re now potentially walking into a tightening monetary scenario which would be the first time in a decade,” he said.

“People are more levered now and more sensitive to rate rises than they have been historically. A lot of things people buy now seem to be on a monthly budget, whether it’s phones, cars, mortgages or other items.

“I think we’re yet to see how rates going up may affect consumer spending, but certainly what we’ve seen is the consumer reining in their spending habits so far in anticipation of this.”

As a result, the manager of the four crown-rated Lazard UK Omega fund is nervous of holding too much exposure to domestic-facing stocks further down the cap spectrum.

“By default, you could see relative outperformance by the FTSE 100 versus the FTSE 250 which may not be purely driven by currency; it may be that the FTSE 100 is just more insulated from any weaknesses that we may see in the UK economy which could be exacerbated by rate rises,” Custis added.

Performance of indices over 5yrs

Source: FE Analytics

Adam Laird, head of ETF Strategy, Northern Europe at Lyxor, said it is of course impossible to make any bets on timing when it comes to monetary policy.

“Though inflation has been creeping up in the UK, we’ve not seen any rate hikes yet. And the current low rate environment highlights one big reason behind the popularity of the UK market – income. The FTSE 100 is an evergreen part of income portfolios, with yield close to 4 per cent,” he pointed out.

Richard Penny, manager of the L&G UK Special Situations Trust, said the FTSE’s yield is neither cheap nor expensive. However, he said it is heavily-concentrated in a few names and that, elsewhere in the market, many shares’ prices seem to have correlated with macro events.

“The Trump administration’s spending plans were seen as inflationary and positive for equities. Rising US interest rates may be negative. If anything, the second half of 2017 should see more of a stock picker’s environment than the previous year, which has been heavily influenced by macroeconomic factors,” he explained.

Kempen Capital Management portfolio manager Robert Scammell said that, while tighter policy does impact equity valuations, the higher earnings that come from a stronger economic outlook and higher inflation could well mitigate the impact of higher policy rates.

“In the UK we have seen some momentum building for an increase in policy rates and the MPC recently voted to keep policy stable by five to three, the closest vote for many years,” he explained.

“However it is worth remembering that a rise to 0.5 per cent would only take policy back to where it was for over seven years after the crisis. This would hardly be a catastrophe for equity valuations.