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 rate hikes are coming to an end and inflation has peaked.

The start of the year continued its good performance from 2022. The composition of the blue-chip index, which is heavily weighted towards large-cap energy and banking stocks, helped the blue-chip index climb higher as interest in growth stocks waned.

Where other indices struggled last year, the FTSE 100 ended flat and was up about 4 percent in terms of total returns including dividends.

Now it looks like the FTSE’s fortunes will continue into 2023, but does this mean it’s still a cheap market or that rising share prices have made it expensive?

We look to see if investors can still get a bargain in the UK or if they should look to the FTSE 250 or emerging markets for a better deal.

Will UK equities remain cheap?

While UK equities may have regained favor over the past year, they remain largely unloved despite outperforming other global markets.

Investors dropped UK equity funds last year amid political turmoil and economic uncertainty and the trend won’t continue into 2023 – investors withdrew more than $800 million from UK-focused stocks last month.

It is ironic given the strong performance of the FTSE 100 and trading at a much lower valuation than its peers.

But with the FTSE 100 hitting a new all-time high, some investors may worry that a record high for the FTSE could be a sign that equities are expensive now and it’s not the time to buy or hold.

However, Bestinvest managing director Jason Hollands says that ‘the current level of the FTSE 100 should not be a cause for concern’ and that the larger UK companies are in fact ‘very attractively valued’.

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

But to now match that earlier peak in real terms – adjusted for the impact of inflation – the FTSE 100 would now need to be around 9,450.

“That’s about 18 percent higher than where it is now, so the current level of the FTSE 100 should not be seen as a red flag or deter anyone from investing.”

A better measure of whether the FTSE 100 is cheap is to look at the P/E ratio, which measures the relationship between companies’ current market valuations and their expected earnings.

The FTSE 100 currently trades at 10.5 times the 12-month forecast earnings of its components, compared to a P/E ratio of 15.2 times for global equities.

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

Darius McDermott, managing director of Chelsea Financial Services added: “In terms of price-to-earnings, the FTSE 100 index is cheaper than three and five years ago, regardless of current numbers.”

Another positive point is that UK equities offer an attractive dividend yield of around 4%.

Schroders data, running through January 31, 2022, shows the UK leading the way, with emerging markets following with a return of 3.2 percent and the US at 1.6 percent.

It’s a “healthy yield premium of 3.05 percent that 10-year gilts have fallen back to since their post-mini budget peak,” says Hollands.

In recent years, many investors have dismissed UK blue chip stocks as ‘boring’ because they were unfamiliar with exciting sectors such as technology and social media.

But in a more difficult economic environment, solid companies that generate reliable dividends are worth considering. Boring is the new sexy.

“With abundant exposure to energy, commodities, consumer staples and healthcare companies, the FTSE 100 looks good for the current environment.”

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

If oil and gas, financials and consumer staples have another strong year in the face of continued inflation and high energy prices, the FTSE 100 will benefit.

But now it is widely believed that inflation has peaked. Inflation slowed to 10.1 percent last month, from 10.5 percent in December and well below its peak of 11.1 percent in October.

It suggests that 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 components of the index were not suited to the low inflation and low interest rate environment that has characterized the market since 2008.

Instead, it was supported by continued inflation and higher interest rates, which boosted banking stocks in particular.

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

It is important to remember that the FTSE 100 is not an indicator of the wider economy and that the companies earn 79 per cent of their revenue outside the UK.

While the UK has not entered a recession so far, investors should instead look at where the FTSE 100 is most exposed to get a better understanding of where the index could head this year.

A high exposure to energy and commodities companies should serve the index well, especially as many believe we are now in a new demand ‘supercycle’.

Hollands says: ‘It’s also worth pointing out that the so-called ‘British’ companies of the FTSE 100 have significant exposure to Asia, including around 13% of their earnings from China.

“The Footsie therefore appears well positioned to benefit from the likely recovery in the Chinese economy and broader emerging markets following the lifting of tight COVID restrictions in December.”

McDermott adds: “The key is to remember that stock markets tend to outrun economies – this means that by the time a country goes into recession, the stock market has already bottomed out and is on its way to recovery.

“There is no real correlation between GDP growth and stock market performance, but when companies and individuals feel better, they are more likely to consume – and consumption is a large 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 is not reflective of UK PLC and the FTSE 250 is often seen as more reflective of the ups and downs of the domestic economy.

FTSE 250 shares currently have a price/earnings ratio of 12.2 times.

McDermott says, “While this is higher than their large-cap cousins, it’s low relative to the longer-term average and on another metric – price-to-book value – they’re 1.2 times cheap, so there’s already a lot of been negativity. factored in, which means that a possible further recovery remains upside down, should the economic news turn out better than expected.’

But given the exposure to domestically-focused companies, it should better reflect any deterioration in the economy in the coming months.

While the UK has so far avoided a recession, the IMF has warned that the UK will lag behind the G7.

Even when inflation has peaked, it will remain incredibly high, which will have a knock-on effect on consumer confidence, especially if the Bank of England continues to hike interest rates.

Similarly, further tax increases 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 of a recession. If you think we’re headed for a deep recession, then midcaps may not necessarily be the place to be for the foreseeable future.

But if the markets recover faster, 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.”