FTSE 100 soars above 8,000: Are UK stocks still cheap?

The FTSE 100 closed above 8,000 for the first time this week amid renewed optimism that an end to rate hikes is in sight and inflation has peaked.

The start of the year has continued it’s good performance from 2022. The make-up of the blue-chip index, which is heavily weighted towards large-cap energy and banking stocks, helped the blue-chip index push higher as interest in growth stocks waned.

Where other indices floundered last year, the FTSE 100 ended it flat and was up about 4 per cent in total return terms with dividends included.

Now it seems the FTSE’s fortunes are set to continue in 2023, but does this mean it’s still a cheap market or have rising share prices made it expensive?

We look at whether investors can still bag a UK bargain or whether they should look to the FTSE 250 or emerging markets for a better deal.

Will UK shares continue to be cheap?

While UK stocks might have swung back into favour over the last year, they still remain largely unloved despite outperforming other global markets.

Investors ditched UK equity funds last year amid political turmoil and economic uncertainty and the trend has not let up in 2023 – investors pulled over $800million from UK-focused equities last month.

It is ironic given how strongly the FTSE 100 has performed, and is trading at a much cheaper valuation than its peers.

But now, as the FTSE 100 reaches a new record high, some investors might worry that a record high for the FTSE might be a sign that shares are now expensive and it isn’t the time to buy or hold.

However, Jason Hollands, managing director of Bestinvest says ‘the current level of the FTSE 100 should not cause any concern’ and Britain’s larger companies are in fact ‘very attractively valued.’

He adds: ‘The level of an index also doesn’t adjust for inflation over time, either. For example, until it recently broke new ground, the previous peak for the FTSE 100 was on 22 May 2018 when it closed at 7,877. 

‘However, to be equivalent to that previous peak in real-terms now – adjusted for the impact of inflation – the FTSE 100 would need to be at around 9,450 points now.

‘That’s around 18 per cent higher than where it currently is, so the current level of the FTSE 100 should not been seen as a red flag or deter anyone from investing.’

A better measure of whether the FTSE 100 is cheap is looking at the price/earnings ratio which measures the relationship between the current company market valuations and their expected profits.

The FTSE 100 is currently trading on 10.5 times the 12-month forecast earnings of its constituents, compared to a price/earnings ratio of 15.2 times for global equities.

It represents a 33 per cent valuation discount to the rest of the world, and below its own long-term average of 12.5 times.

Darius McDermott, managing director of Chelsea Financial Services adds: ‘At a price to earnings level, the FTSE 100 index is cheaper than it was three and five years ago, regardless of the headline numbers we are currently seeing.’

Another positive is that UK stocks provide an attractive level of dividend yield at around four per cent.

Schroders data, which runs up to 31 January 2022, shows the UK leads the way, with emerging markets following with a yield 3.2 per cent, and the US trailing at 1.6 per cent.

It’s a ‘healthy premium to the 3.05 per cent yield that 10-year gilts have sunk back to since their post-mini budget spike,’ says Hollands.

‘In recent years, many investors have dismissed UK blue chip shares as ‘boring’, lacking exposure to exciting sectors like technology and social media. 

‘But in a more trying economic environment, solid companies churning out reliable dividends are well worth considering. Boring is the new sexy.

‘With an abundance of exposure to energy, commodities, consumer staples and healthcare companies, the FTSE 100 looks well placed for the current environment.’

What happens to the FTSE 100 if inflation slows and the economy recovers?

If oil and gas, financials and consumer staples are set for another strong year in the face of sticky inflation and high energy prices, the FTSE 100 stands to benefit.

But inflation is now widely accepted to have peaked. The inflation rate slowed to 10.1 per cent last month, down from 10.5 per cent in December and well below the 11.1 per cent peak in October.

It suggests the Bank of England’s tightening cycle will soon come to an end, which will have a knock on effect on the FTSE 100.

The index’s constituents were not suited to the low-inflation, low-interest environment which characterised the market since 2008. 

It has, instead, been buoyed amid sticky inflation and higher interest rates, which have particularly boosted banking stocks.

The BoE’s Andrew Bailey has said UK inflation will fall rapidly this year as energy prices drop

So what does this all mean for UK shares and their valuations?

It’s important to remember that the FTSE 100 is not an indicator of the wider economy and its companies make 79 per cent of revenues outside the UK.

While the UK has avoided dipping into a recession thus far, investors should instead look to where the FTSE 100 is most exposed for a better understanding of where the index might head this year.

A high exposure to energy and commodities companies should stand the index in good stead, particularly as many believe we’re now in a new ‘super-cycle’ of demand.

Hollands says: ‘It is also well worth pointing out that the supposedly ‘British’ companies of FTSE 100 have significant exposure to Asia, including around 13% of their revenues derived in China. 

‘The Footsie therefore looks well-placed to benefit from the likely rebound in the Chinese economy and wider emerging markets resulting from the ditching of severe COVID restrictions in December.’

McDermott adds: ‘The key is to remember that stock markets tend to move ahead of economies – this means that by the time a country goes into recession, the stock market has already bottomed and is on a path to recovery.

‘There is no actual correlation between GDP growth and stock market performance, but if companies and individuals are feeling better off, they will become more likely to consume – and consumption is a big part of the index. 

‘Even an area like banks should be well placed while interest rates are higher – as many are taking margins on cash.’ 

Is the FTSE 250 a good investment?

The FTSE 100 doesn’t reflect UK PLC and the FTSE 250 is often considered more reflective of the fortunes of the domestic economy.

FTSE 250 stocks are currently on a price/earnings multiple of 12.2 times.

McDermott says: ‘While this is higher that their large cap cousins, it is low compared to the longer-term average and on another measure – price-to-book – they are cheap at 1.2 times, so a lot of negativity has already been factored in, leaving potential further recovery upside should the economic news turn out better than expected.’

But given its exposure to domestically-focused companies, it will better reflect any worsening of the economy in the coming months.

While the UK has managed to avoid recession thus far, the IMF has warned the UK will be a laggard among the G7.

Even if inflation has peaked, it still remains incredibly high, which will have a knock-on effect on consumer confidence, particularly if the Bank of England presses ahead with a further rate hike.

Similarly, further tax hikes in April will have a serious impact on the amount people take home each month.

So, is the FTSE 250 an attractive investment?

McDermott says: ‘A lot depends on your view on recession – if you feel we are set for a deep recession, then even if mid-caps have been hammered they may not necessarily be the place to be in the immediate future.

‘But if markets recover faster, then you risk missing out on significant upside returns. The old saying ‘it’s about time in the markets, not timing the markets’ comes to mind.

‘The other thing I would say is that while it is more domestically focused, FTSE 250 companies are well established and many have strong balance sheets to handle a recessionary environment.’