The UK’s leading share index, the FTSE 100, has been enjoying an impressive rally since the end of March, climbing to levels last seen in January before the global equities and bond sell-off struck the markets.
The gains over the past two months make the FTSE 100 the best performing share index among the major world indices, which might come as a surprise given the recent soft data out of the UK, as well as the still uncertain outlook with regards to Brexit.
The FTSE 100 is up by about 12.5% from its low on March 26 when it slumped to a 15-month trough of 6866.94. The recovery was initially triggered by receding fears of a global trade war, but several factors have helped British stocks extend their gains to near four-month highs.
Other European indices have also posted a sharp recovery from the lows reached in late March when concerns about a global trade dispute and a faster pace of rate hikes by the US Federal Reserve had sent world equities plummeting in February and March.
Another surprise winner during the past couple of months is Japan’s Nikkei 225 index. In contrast, stocks on Wall Street have made only modest gains as soaring long-term Treasury yields weigh on US equities.
So what do European and Japanese stocks have in common that the US does not?
Lower government bond yields are one obvious answer, but the main culprit is a weaker exchange rate as the pound, the euro and the yen have all depreciated sharply against the resurgent US dollar.
Cable has seen a dramatic sell-off since mid-April, as a series of weaker-than-expected economic indicators out of the UK have left investors barely pricing in one rate increase by the Bank of England this year, in comparison to two rate hikes prior to the data.
The adjustment in market pricing has sent the pound tumbling from a 22-month high of $1.4376 to a four-month low of $1.3449 this week.
A weaker pound is also what drove the FTSE 100 to record highs after the Brexit referendum in June 2016 despite the shock result turning the rosy outlook for the UK economy to a gloomier one.
A cheaper currency tends to boost the overseas earnings of companies, thereby increasing their profitability in the short term and making their stocks more attractive to investors.
But while the FTSE 100 is dominated by companies with largely international operations, UK shares have also been benefiting from other developments over the past few weeks, namely, higher oil prices boosting energy shares, and a slew of mergers and acquisitions (M&A) deals.
Oil prices have rallied by over 15% since the start of the year, lifting not just shares in energy stocks but contributing to a broader rally in commodities. With energy and mining stocks being significant constituents of the FTSE 100, the index has been a big beneficiary of the oil price surge.
Although it is typical for the energy sector to follow crude oil higher, what is perhaps unusual about the latest rally is that markets aren’t yet worried about the surging prices generating a spike in inflation, at least, not outside the US.
Expectations of higher inflation tend to have a negative effect on equities as traders begin to bet on higher interest rates to combat rising price pressures. But even in the US, where sovereign bond yields have moved more notably to the jump in oil prices than in other regions, markets don’t appear to be too alarmed about the pace of price gains in oil just yet.
The other main driver of UK stocks in recent weeks is M&A activity. Major deals involving large cap companies such as Shire, Vodafone and Sainsbury’s have boosted the FTSE 100, helping it extend its gains to above the 7700 level.
The index has the potential to beat its all-time high of 7792.56 in the near term and challenge the 7800 level for the first time should the current bullish phase continue.
Further weakness in the pound in the coming weeks could set the ground for the index to head into record territory and make its way towards the psychological and landmark 8000 level.
However, with technical indicators pointing to an overstretched market (The RSI has entered overbought territory above 70), the FTSE 100 may be subject to a downside correction before it resumes its uptrend.
Any move south would likely see the index finding initial support at around the 7690 level, which has been both a resistance and support area in the past. Lower down, the next barrier is likely to come from just above the 7600 level, which acted as support back in January.
Looking at the more longer-term picture however, the FTSE 100’s performance will depend on the outcome of the Brexit talks between the UK government and the European Union.
Failure to reach a deal would be the worst possible scenario, which not even a plunge in the value of the pound would be able to fully offset the negative impact on stocks of such an outcome.
Ironically though, a positive conclusion to the Brexit negotiations is unlikely to provide the FTSE 100 with much of a boost as the pound would be almost certain to rally on the prospect of a good post-Brexit trade deal and a smooth and orderly transition.