Of all the outlandish claims during the EU referendum last year, it is fair to say nobody claimed that there would be a boom in the City and the stock market would take off in the event of a Leave vote. Yet that does appear to be happening. The FTSE 100 touched a record of 7,337 just after Christmas and is now hovering just below that level, at around 7,200.
I am no market prophet, but here is a theory increasingly doing the rounds in the more adventurous corners of the City: that the FTSE could hit 8,000 by the end of the year, and even 10,000 by the end of the decade.
Initially, the surge in the stock market was dismissed as a mechanical follow-on from a weak pound. Since UK-listed companies make around two thirds of their revenues overseas, the post-referendum decline in sterling would lead to a one-off surge in profits and hence dividends. Simple.
Yet that theory can no longer be entirely sufficient – for the very good reason that sterling has recovered in the last few weeks after hitting a low of $1.19 in December and is now at $1.26. The stock market, meanwhile, has held on comfortably to its gains.
How is this possible? And how could the index continue to rise given the perpetual talk of economic uncertainty, protectionism and the like? As one anonymous reader called “Barrywhite” commented on the Financial Times website this week, “The FT … is more depressing than a Sunday afternoon at home, alone, with a bottle of cheap cider watching the Eastenders omnibus.”
There are four reasons for the stock market’s performance. Two obvious, and two less so.
First, central banks, notably the Bank of England, have effectively signalled that they are going to tolerate a bit of inflation and keep interest rates low in order to promote economic growth.
Last week, the Bank produced its quarterly inflation report, which shows that it expects inflation to keep rising to nearly 3 per cent by 2018. That is substantially above target, and yet the Bank has chosen the keep the base rate down at 0.25 per cent and to maintain the level of its bond purchases via quantitative easing at £435 billion.
Second, leaving aside the quantity of cheap money going into financial markets, investors have responded to this signal from central banks by rotating out of bonds and into equities.
Unlike bonds, which pay a fixed coupon, companies can increase their dividends. So if you think inflation is on the way, buying shares in, say, mining companies is a good way to hedge the risk.
This is a variation of the so-called “Trump trade”. Investors believe that not only is the US Federal Reserve raising interest rates more slowly than expected, but that the new US administration is going to pump money into the economy via tax cuts and infrastructure spending.
In the UK, such a rotation is especially welcome. It is little appreciated how far UK pension funds have deserted the stock market in recent years in favour of Government bonds or gilts. Only 3 per cent of shares in UK-based, UK-listed firms are now owned by our pension funds; overseas investors own more than half. If British pension funds shift their allocations back into equities, the impact would not only be desirable but potentially quite substantial.
There are, however, two other reasons the stock market could continue to climb, which are more subtle and less well understood.
The first is that the whole underlying premise that Brexit would prove at least a short-term economic setback is being questioned. This analysis was based on the widespread (and not unreasonable) view that business investment and hence productivity growth would be held back by uncertainty.
Indeed, the independent Office for Budget Responsibility repeated this at the time of the Autumn Statement, when it claimed business investment could fall by £27 billion in the wake of Brexit.
Yet this has not been borne out by the facts. The latest numbers for both gross fixed capital formation and business investment, published late last year, showed that although there had been a hiatus before the referendum, investment is now actually recovering. Consumer sentiment also remains robust and UK car registrations hit a 12-year high in January.
It seems that projects put on hold are now being approved – and that while uncertainty is a factor, the fall in sterling has offset this by making British assets cheaper for foreign investors.
The second, more complex point is this. For the last 20 years, the FTSE 100 has traded broadly in line with Europe at an average multiple of 13 times earnings, or company profits per share.
Wall Street, by contrast has traded at a more generous multiple of 19 times earnings. This reflected the more dynamic nature of American capitalism, and is why the Dow Jones and S&P indices hit records in the last few years, long before the FTSE 100 finally surpassed the pre-dot-com peak of 1999.
It is possible, following Brexit, that if Theresa May and her government pursue a pro-enterprise, deregulatory agenda here, the FTSE 100 could decouple from EU stock markets and instead re-rate to a more expensive American multiple.
There are already signs that companies themselves are being more brave and imaginative: I was, for instance, struck by Tesco’s merger with Booker, the wholesaler. Nobody saw that coming. It shows signs of corporate brain activity.
One thing we have learnt in the last 12 months is that making predictions is a mug’s game. The unexpected can happen and things can go spectacularly wrong.
It remains possible that investors will indeed take fright about UK economic uncertainty. There is very little evidence, yet, that Mrs May and her ministers are interested in a pro-enterprise agenda. Rising inflation and apparent confusion over monetary policy at the Bank of England are a serious concern. Interest rates could spike suddenly.
That said, bull markets always climb a wall of worry – and few can remember one as worried as this one. That, in its own way, is further grounds for optimism.
