Having survived the Brexit vote and shrugged off the Trump shock, the FTSE 100, perhaps even more than its transatlantic cousins, has revealed its deeper vulnerabilities via a tortuous rise of less than 2% this month.
The foremost weakness investors have been reminded of is its dependence on stable and preferably rising oil prices.
Hence the FTSE has been increasingly range-bound and yet nervy as investors eye this week’s discussions among big oil producing nations with some trepidation.
It appears to be of lesser importance that the deal that’s likeliest to emerge might not even do much to immediately limit supply.
After all, FTSE trading was sanguine when signs emerged that Iran, Iraq and Indonesia may demand deep concessions, and it’s been known for several months that Saudi and Russian production is back near cycle highs.
No, for the medium term, it’s most important that a deal happens at all: for the sake of oil prices, and, in turn, for the oil & gas stocks which constitute the FTSE’s single heaviest sector weighting, of around 14.7%.
It’s worth noting the blue-chip index pointedly stood aside from the ‘Trump-flation’ rallies which squeezed flows out of emerging market assets in favour of rebounding yields in The West.
We were sceptical of the sustainability of Trump-fuelled ‘flows to quality’. Parts of the ‘new model’ don’t stack up, including the FTSE’s own lack of participation.
This week, as U.S., Japanese and European yields find firmer ground, hand in hand with the dollar taking a breather from multi-year highs, it’s even easier to see what’s really holding the benchmark back.
A bit of Italexit
Meanwhile, the FTSE’s direct links to Italia Plc. are few and relatively tenuous, but UK shares are nonetheless also being buffeted by the realisation that Prime Minister Matteo Renzi has as good as lost the referendum.
Whilst bracing for a moderate Brexit-style market hit makes sense, the playbook for political shocks has been tested this year and offers fair reason to expect a relatively swift rebound.
Moreover, the primary mediator of stock market instability that could upend the FTSE, Italian banks, whilst not beacons of financial stability, are in better shape than last year. Similarly, since only one Italian Prime Minister has served a full term since 1945, an unexpected departure of Renzi is unlikely to unsettle markets for long, even if it fuels Italexit momentum.
The timing of another FTSE worry that’s gained traction at the start of the week, valuation, is perhaps not particularly surprising given other current anxieties.
For the moment, however, valuation is one of the lower priorities for us. Bearing in mind valuation benchmarks used by the largest and hence most influential investors tend to be subtler than ‘brute force’ price/earnings (P/E) ratios or similar, the FTSE still looks good value.
For one thing, whilst economically sensitive P/E variants like the Cyclically Adjusted Price Earnings (CAPE) model can raise alarm bells because they reveal market cap-to-GDP at seemingly unsustainable levels above 100%, it should be noted that broader British productivity is itself at record lows.
That exaggerates the extent to which corporate profits dominate GDP, especially considering that FTSE 100 corporate profits are mostly derived overseas.
Additionally, even after the big ramp in benchmark yields, at around 4%, the FTSE’s average yield is still higher than gilt yields, thereby offering some 200-250 basis points more value, and keeping the blue-chip market relatively cheap.
One valuation point that is more difficult to argue away is the FTSE’s widening aggregate uncovered dividend, which threatens to leave total of pay-out commitments higher than total earnings for the first time in at least 30 years, unless earnings rise soon.
Of all the FTSE’s current risks, that is the one we will watch most closely for the long-term.
Yes, we’d like some executive pay
Considering these weighty and pressing matters, government attempts, to be detailed on Tuesday, aimed at narrowing the pay divide between top executives and the rest of us are welcome, though the moves will probably be of neutral importance for FTSE investors for quite some time.
The 1.1% of value that will be withdrawn from the index’s ex-dividend shares on Thursday 1st December is a more prudent watch point this week.
Beyond that effect, and volatility from oil prices and Italy, our base case is that the FTSE 100 will, in the final weeks of the year, return to a pace that befits its current rising trend better.