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2012 FTSE Outlook

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Looking Back

In common with other global indices, the FTSE100 began 2011 in good shape. Beginning in mid-2010, the index enjoyed a major rally on the back of expectations of a fresh stimulus program from the U.S. Federal Reserve. However, the FTSE fell sharply in early March following the Japanese earthquake and tsunami. It subsequently recovered and in early May, GFT's UK100 price touched an intra-day high of 6,136 - its highest level in three years. This general bullishness in equities came in part from an improvement in global economic data. Investors saw evidence that a recovery was taking place, believing that the unprecedented monetary stimulus that was unleashed during the financial crisis was finally feeding through from financial institutions to the wider economy. Despite concerns about the Eurozone debt crisis, there was a general feeling that the difficulties in the peripheral countries (Greece, Ireland, and Portugal) were contained. This was helped by the creation of the European Financial Stability Facility (EFSF) - a fund designed to provide assistance to troubled Eurozone countries.

In April, after months of denial, Portugal threw in the towel and joined Greece and Ireland in requesting help from the EU and IMF. It was given a €78 billion bailout, but its failure turned the spotlight on Spain, a much bigger country, and one which many analysts consider impossible to rescue, at least under current EU treaties.

The FTSE100 struggled to make further headway. At the end of July, the escalating European debt crisis and the downgrading of the U.S. credit rating (following the political wrangling over the country's debt ceiling) led to a vicious stock market sell-off. The index fell 20% in a fortnight. It managed to make a decent recovery over the next 10 weeks, but as we approach year-end, the FTSE100 is struggling once again and is now below the 50% retracement level of this year's May/August pull-back.

The Multinational FTSE100

The companies that make up the FTSE100 represent around 84% of the whole London Stock Exchange in terms of market capitalisation. But it is important to remember that the FTSE100 is not a pure play on the UK. While it is a good barometer of general investor confidence, the broader-based FTSE 250 is a better measure of the underlying health of the British economy.

Five of the current 10 largest constituents are either miners or oil and gas companies. Others in the top 10 include the banking giant, HSBC, telecoms group Vodafone, and pharmaceuticals conglomerate GlaxoSmithKline. The top 10 stocks represent around 46% of the value of the whole index and overwhelmingly, the weighting within the index is towards multinationals that make their profits overseas. On a sector basis, financials, miners, oil, and gas make up around 55% of the index.

Exposure to an Economic Downturn

With these essentially cyclical stocks (that is, stocks that fare best when the global economy is growing) making up 55% of the index, the FTSE100 will face serious headwinds if there is a global economic slowdown in 2012. For some of the UK's biggest financial institutions, there are still many unresolved issues; not the least of which are the toxic assets still tucked away and valued at unrealistic levels. This could prove to be a drag on the FTSE100, given the financial sector's contribution to the economy and its exposure to European banks and sovereign debt.

The profitability of the mining sector is intrinsically linked to global growth. With austerity measures being introduced across Europe, the recovery in the U.S. still in doubt, the UK suffering from rising unemployment, low-wage growth, and most importantly, worries of a sharp slowdown in China, the mining industry faces significant challenges. In addition, corporate deleveraging and private debt repayment is on-going. It's only the willingness (so far) of the major central banks to engage in variations of quantitative easing that is making this process less painful. However, there is a limit on how much central banks can grow their balance sheets before bond holders get restless and demand higher yields. This would push up borrowing costs and threaten the ability of highly-indebted developed countries to issue fresh debt or roll over existing liabilities at an affordable rate.

Current Assessment

This still depends to a great extent on one's view the global financial crisis and policymakers' responses to it. There are plenty of influential economists who continue to predict a "normal" recovery from what they believe was a cyclical recession. But there are others who say that the events of three years ago weren't simply a response to a bust following the boom in a normal economic cycle. Nor was it a typical banking crash. It was a full-blown financial crisis exacerbated by an oversupply of credit and excessive leverage leading to overpriced assets, specifically those linked to property. In addition, there was a reliance on risk models, ratings agencies, and regulators which was unfortunately shown to be misplaced. The problem is that little has changed, other than a banking crisis has morphed into a sovereign debt crisis.

Three years on, it is now clear that quantitative easing is not the temporary measure that many of us expected it to be. The U.S. Federal Reserve has undertaken QE1, QE "lite", QE2 and "Operation Twist". Many economists expect QE3 to be launched soon. While the European Central Bank has so far refused to become the Eurozone's "lender of last resort", it is still actively buying up the bonds of troubled countries in the secondary market. Meanwhile, the Bank of England's Monetary Policy Committee added to its original £200 billion asset purchase program in October. Not only was the MPC's QE2 announced earlier than anticipated, but at £75 billion, the package was 50% bigger than most analysts predicted. The expectation of additional central bank stimulus is providing support for equities.

Looking Forward

There has been a steady succession of downgrades to the outlook for UK growth. As 2011 drew to a close, analysts at Standard Chartered (the top-ranked forecaster over the last two years) joined in the general pessimism and predicted that the UK would fall back into recession in 2012, with the economy shrinking by 1.3%. UBS, Capital Economics, and Legal & General Investment Management are also forecasting a fall in UK growth.

Global demand remains weak especially from the UK's two biggest trading partners, the U.S. and Europe. While developing countries are still registering strong levels of growth, Ernst & Young's ITEM Club points out that only 5% of UK exports go to the BRICs (Brazil, Russia, China, and India). This compares badly with Germany, the U.S., and Japan where the numbers are 10.6%, 11.1%, and 20% respectively.

Despite this, it is regularly pointed out that the UK is in a relatively enviable position. It has an independent central bank which is responsible for monetary policy, and which can undertake quantitative easing. In this respect, the UK has more in common with the U.S. than with Germany or other Eurozone countries. Yet, the UK has experienced a sharp rise in inflation with CPI hitting 5.2% in September. BoE Governor Mervyn King has repeatedly said that inflation would soon turn lower, yet he has been regularly confounded in his expectations. Nevertheless, the BoE predicts that CPI will fall to 1.5% annualized by mid-2012, which would give the MPC all the room it needs for additional QE.

As 2011 drew to a close, Bank of England Chief Economist Spencer Dale stated that the central bank was prepared to add further stimulus to counter the stalling of economic growth. He cited the on-going crisis in the Eurozone as the prime headwind for growth. He also noted that it was unclear if the measures taken at the EU summit in early December would prove to be a "credible response." But he also said that domestic monetary policy was limited in insulating the UK's economy from external events. This is likely to be positive for UK equities in general. But the heavy weighting of multinationals in the FTSE suggests that events in Europe are more of a concern. After all, the index's main constituents make their profits overseas. In conclusion, while the UK's growth forecasts are dismal, at least it isn't in the Eurozone. But this may not help the FTSE100.

- David Morrison contributed to this article

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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