David Kuo: FTSE may dance higher, but the UK faces a painful rejig

Investment Insider

Predicting which way the UK's most influential stock exchange index will go is a perilous business, but, studied carefully, it also reveals a treasure trove of behavioural finance trends.

Towards the end of 2009, I made a calculated guess that the FTSE 100 would rise to between 6,000 and 7,000 points by the end of 2010. It was not a finger-in-the-air exercise but a computation based on the prospective profits that FTSE-100 companies would report over 12 months.

During the summer lull of 2010, when the index plunged as low as 4,800, the prediction began to look ludicrously optimistic. But that is what can happen when you try to foretell something as volatile as a stock market index. After all, while it is possible to make a reasonable assumption about how much profit companies may make in one year, it is difficult to gauge the valuation investors will place on those profits because valuation hinges on emotions. And emotions can swing from euphoria to despair in the time it takes a despotic leader to lob a handful of explosive shells into a neighbouring country.

But in spite of a turbulent year, the recent increase seen in share prices would seem to suggest that some appetite for risk is returning to the markets, which bodes well for this year.

This has been thanks in part to the Bank of England driving down interest rates so far that cash savings look deeply unattractive. Also, the realisation that inflation is eroding cash purchasing power has forced some savers to look for better returns elsewhere.

Inflation: a double-edged sword

Inflation on its own need not be a huge problem. The Government may welcome it, as it helps to whittle away the national debt in real terms. With modest inflation of 5 per cent, every £100 of national debt would be worth £50 in real terms after 14 years.

But under more benign economic conditions, it is hard to see how the Bank of England could ignore growing inflationary pressures. Rising prices in commodities such as oil, gas, wheat, soya and cotton are forcing up the costs that consumers pay for heat, energy, food and clothes. The increase in VAT on Tuesday is likely to lift the price of most household items, which could stoke more inflation. Eventually, the Bank of England will need to acknowledge the inflation pressures and raise the base rate.

However, if household incomes can keep pace with rising prices, then we have less reason to worry. At best, household income may only rise in line with the consumer prices index – the lower measure of inflation. But the retail prices index tells a different story, and better reflects the inflation experienced by you and me.

Lower wage increases and higher expenditure on household essentials could squeeze discretionary household spending, and heap more pressure on the high street. If so the retail sector is likely to see sales crimped, margins crushed and profits depressed.

Consumer spending

A slowdown in spending is likely to dampen economic growth, given some two-thirds of the economy relies on consumer spending. This would suggest that the UK economy could, at best, be sluggish and perhaps not grow at all.

That said, the stock market is unlikely to reflect this. The FTSE, which is more an international than a UK barometer, could power ahead on the back of global recovery. Barring another catastrophe, I believe it could reach 7,000 points or higher by the end of 2011, if shares are assigned a better valuation.

What is likely to play an increasingly important role is the performance of countries on the other side of the Channel. Niggling doubts about the debt problems in Europe could prevent investors becoming too enthusiastic, so the coming months will be telling.

The world economy should continue to tiptoe out of the slowdown. The FTSE should dance higher to reflect global growth, while the UK economy will need to go through a painful period of adjustment before it can join the party.

David Kuo is director of financial website Fool.co.uk