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Is the FTSE 100 index on borrowed time?


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The FTSE 100 is benefitting from rocketing commodities, oil, and interest rates that may ultimately become its downfall.

ftse 100
Source: Bloomberg
 
 

The FTSE 100 index has remained remarkably resilient this year, down 4% year-to-date. While it spent Friday morning surfing dangerously close to the symbolic 7,000-point watermark, it ended last week at a relatively healthy 7,209 points.

For perspective, the S&P 500 is down 18.5%, while the NASDAQ Composite has fallen by 26.7%. Most other international indices aren’t faring much better.

However, competitors like the NASDAQ are stuffed with tech stocks which underwent a stellar run during the covid-19 pandemic era of loose monetary policy. This has left it much more rope to correct as the fiscal landscape changes.

And it’s worth noting that a NASDAQ investor who bought into the index just before the pandemic struck would even now still be significantly better off than one who stuck to the FTSE 100.

FTSE 100: banks, oil, and mining

However, the FTSE 100’s sector composition has made it a strong choice so far this year.

The index’s big four banks — HSBC, Barclays, Lloyds, and NatWest — are set to be prime beneficiaries of rising interest rates. The Bank of England has already increased the base rate five times in the last six months to 1.25%; market pricing has them rising again to at least 2.25% by the end of the year. Capital Economics thinks it could even increase to 3% in 2023.

Meanwhile, the FTSE 100 oil majors — BP and Shell — are making so much money that BP CEO Bernard Looney has likened his outfit to a ‘cash machine.’ And both companies foresee increased profitability despite windfall taxes on North Sea profits. With Brent Crude still above $100 a barrel, the oil benchmark has remained elevated for months, even before Russia’s invasion of Ukraine.

Then there are the miners benefitting from sky-high commodity prices — Rio Tinto, Anglo American, Glencore, and Fresnillo — which, despite several serious PR hiccups, are only expected to generate ever more revenue as the mining super-cycle continues.

The FTSE 100 also boasts strong stocks with numerous defensive qualities, including pharmaceutical giants AstraZeneca, GSK, and HIKMA. History shows that the demand for new vaccines and drugs remains constant regardless of the economic state of the world.

The same is true of tobacco stocks British American Tobacco and Imperial Brands, as well as food sector companies like Tesco, Sainsbury’s, and Unilever. Likewise, utilities stocks including National Grid, SSE, and Centrica, and telecom stocks like BT and Vodafone are also highly defensive; consumers have little choice but to utilize electricity and gas in the 21st century.

In fact, only a handful of stocks within the FTSE 100 are outright struggling.

Most are travel-dependent stocks like IAG or Rolls-Royce, the former of which is besieged by a PR nightmare, labour crunch and potential strike action. However, given the lengthy airport queues and optimistic forward-looking corporate statements, demand for travel remains high, while the current problems are likely to disappear over the medium term.

The major FTSE 100 housing stocks — Rightmove, Persimmon, Taylor Wimpey, and Barratt Developments — are also suffering, with a market slowdown widely expected as interest rates rise, given that the average English home is now worth a record £299,249.

Another notable faller is the tech-heavy Scottish Mortgage Investment Trust, down 43% year-to-date. However, it’s worth noting that the trust is still up compared to its pre-pandemic value, and has outperformed the wider FTSE 100 over a five-year timescale.

But overall, the FTSE 100 is in strong shape compared to its peers. But as storm clouds appear on the economic horizon, one powerful risk factor could bring down the UK’s premier index.

bank of england
Source: Bloomberg

FTSE 100: UK recession, global recession

CPI inflation is at a decades-high 9.1% and expected to exceed 11% by October. For perspective, an employee that has not acquired a raise this year will lose over a month of real terms buying power over the next 12.

And with essentials including fuel, energy, and food rising at a near-unprecedented speed, consumers are also being squeezed by rising interest rates that are making mortgages, credit cards, and other loans more expensive.

Chris Williamson, chief business economist at S&P Global Market Intelligence, thinks ‘the economy is starting to look like it is running on empty’ as companies report a ‘near-stalling of demand.’ Outgoing CBI President Lord Bilimoria argues the UK is ‘definitely’ heading for recession.

Worryingly, the ONS reports that 44% of adults were buying less food in May, up from 18% in January, and the core reason behind last month’s 0.5% drop in retail sales. British Retail Consortium CEO Helen Dickinson notes that ‘households reined in spending as the cost-of-living crunch continued to squeeze consumer demand.’

Meanwhile, data company GfK’s monthly survey of UK citizens found that consumer confidence is at the lowest it’s ever been since the survey began in 1974. For a frame of reference, this includes events such as the 1979 oil crisis, 1990s housing market crash, and 2008 credit crunch.

But the upcoming recession isn’t just a UK problem. Deutsche Bank CEO Christian Sewing thinks ‘we have a 50% likelihood of a recession globally.’ Citigroup analysts concur, warning it is an ‘increasingly palpable risk’ as ‘history indicates that disinflation often carries meaningful costs for growth, and we see the aggregate probability of recession as now approaching 50%.’

This is the catch-22 of sky-high oil and commodity prices, rising interest rates, and more expensive consumer staples. Short-term, it benefits the aforementioned FTSE 100 giants, especially as many of them operate on a global scale. But longer-term, it creates economic distress.

Of course, if the upcoming recession were to be confined solely to the UK, the FTSE 100 could well continue to outperform its international peers through 2022.

But with inflation rocketing and consumer confidence collapsing, there is a very real danger of demand destruction across almost every developed country across the globe.

It’s worth noting that in 2021, Morgan Stanley predicted demand destruction for oil would occur when the commodity hit $80 per barrel. While the bank recently admitted it got this forecast wrong, it’s possible that what it got wrong wasn’t the prediction, but the timeframe.

And with inflation predicted to 11% in October, interest rates to strike potentially 3% next year, and consumer confidence at all-time lows, the FTSE 100 may be on borrowed time.

Charles Archer | Financial Writer, London
27 June 2022

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