FTSE 100 record: A benchmark for the UK's recovery?

FTSE 100 Image copyright AFP

Hardly a news bulletin goes by without mention of the FTSE 100's fluctuating fortunes.

For more than 30 years, the London index of leading shares has measured the most valuable publicly listed companies in the UK, and its milestones, such as the record high of 6,949.63 reached on Tuesday, make headlines far beyond the City's skyscrapers.

But what can a peak on the FTSE 100, often described as a "bellwether for the UK economy", tell us about the overall health of the country's finances?

"The first thing to point out is that the FTSE is a very global index," says Louise Kernohan, an investment manager at Aberdeen Asset Management, itself a constituent of the FTSE 100.

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"Multinational companies account for a large proportion of the index as a whole."

'Beyond Britain'

Indeed, many of the firms listed do most of their business outside of the UK.

The mining sector, which has seven companies on the FTSE 100, does most of its trade abroad, for obvious reasons, and is affected more by economic conditions in Africa and South America than in the UK.

This means profits from international operations can give stocks on the FTSE 100 a boost even if the UK's economy is underperforming - and vice versa.

Which is partly why the UK's gross domestic product (GDP) grew by 2.6% in 2014, but the FTSE 100 contracted by 2.7%, to the dismay of investors.

It's no wonder then that the London Stock Exchange, where the FTSE indexes are listed, highlights its global credentials.

Image copyright PA
Image caption General view of the Stock Exchange trading floor in 1986, as computerised dealing begins marking the Big Bang reforms in the City of London.

"Although the FTSE 100 is often thought of as a yardstick for the UK economy," it says in a booklet designed to woo companies looking to list at the exchange, "its purpose is actually to capture the returns of the largest 100 companies domiciled in the UK.

"This index has fulfilled this purpose since its inception in 1984, providing a global measure that spans far beyond the UK economy."

Because of this international focus, some analysts suggest that the FTSE 250, an index of the 101st to the 350th largest companies on the London Stock Exchange, is a better measure of how British business is faring.

Indeed, the two indexes have very different trajectories, and the FTSE 250 closed at 17205.3 on Tuesday.

Still, the total value of FTSE 250 companies is barely a third of the 100 firms in the premier league stock market.

What is the FTSE 100?

  • Founded in January 1984, the FTSE measures the total share value of the top 100 companies listed on the London Stock Exchange
  • The index began with a base level of 1,000 points
  • The total value of the FTSE 100 companies is about £1.9tn - in 1985 it was £164bn
  • There has only been one day in history when the FTSE was not calculated, during the Great Storm of October 1987
  • Just like football's Premier League, companies can be promoted or demoted from the FTSE
  • Companies are weighted, with the bigger firms accounting for a larger proportion of the index
  • The 101st to 350th next most valuable companies are listed on a second-tier index, the FTSE 250

American comparisons

However, the UK's stock markets may generally have less of a connection to the wider economy than leading indexes in other countries.

Image copyright PA
Image caption The FTSE 100 endured a rocky 2014, but has been performing strongly this year

Research carried out by economists at PwC in 2013 found key differences between the effect of stock markets in the US and the UK.

"Take the dotcom crash," says John Hawksworth, chief UK economist at PwC and co-author of the report. "In the US, that prompted a recession, but in the UK, it only prompted a dip."

Likewise, the 1987 crash, known as "Black Monday", didn't immediately trigger a recession in the UK, as the economy grew for a couple of years afterwards.

The reason for this, Mr Hawksworth's paper speculates, is that American households tend to hold more shares directly, whereas the majority of UK shares are held by institutional investors, such as asset management firms and hedge funds.

Consequently, a bullish US index is more likely to directly increase individuals' wealth, who in turn spend more, ramping up the wider economy.

That might explain why in the US, the S&P 500 index is still used as a "leading indicator" by government forecasters.

Slow effects

Mr Hawksworth, with fellow PwC economist Yih Lin Teh, also compared unemployment rates and GDP growth in the US and UK with the fortunes of the respective leading stock markets over the last 40-60 years.

They found that upturns in the US stock markets took just three months to have a significant effect on unemployment rates and GDP growth, while in the UK, they took up to a year - although the impact was low.

Image copyright AP
Image caption Today, the combined value of FTSE constituents is about £1.9tn, more than 10 times the total of £164bn in December 1985, the first available data

But there are reasons for Britons to be cheered by a spike on the FTSE 100 - even if they don't have money in stocks.

Many without direct investments tied to the index may still benefit from its boom, as company pension pots and other funds are often tied to the list of top companies.

There is also the "confidence effect", whereby consumers and investors feel buoyed by a healthy stock market, and are more optimistic about their futures.

However, there is one thing to watch out for. Heady heights on the FTSE 100 are often followed by a fall.

"Markets tend to overshoot on the upside," warns Louise Kernohan.

"People become afraid of losing out rather than losing money."

Analysis: Prof Richard Sylla, Historian of Financial Institutions, NYU

In the US, stock market indexes are considered by the Department of Commerce to be one of the reliable "leading indicators" of where the economy is headed, and I suspect that is the case, formally or informally, in other developed markets/countries.

A series of new market highs might well measure an economy's recovery. But recent experience indicates that it might better measure a recovery of corporate profits via cost-cutting in an economy that, while expanding, may be doing so at a below customary rate after a serious downturn.

I think that is an apt description of what has been happening in recent years in the UK and the US. In other words, the corporate sector of an economy can be doing better than the economy as a whole.

One reason for that is many corporations do not operate just in their "home" economies, but all over the world.

Profits from international operations can buoy the stock in the home market even if "home" profits aren't doing so well because the "home" economy is underperforming.

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