Economic weakness set to undermine equity rally

The recent surge in the FTSE 100 to just shy of its all-time high has fuelled speculation that a ‘great rotation’ of funds from bonds to equities is under way. But we struggle to see how the equity market rally will be sustained. Granted, the equity risk premium is probably still above its long-run average and long-term risk-free interest rates could fall even further if Mark Carney brings ‘forward guidance’ to the Bank of England. But if the euro-zone debt crisis re-escalates as we expect, then there seems to be little scope for the equity risk premium to decline further. Moreover, we think that the sluggishness of the global and UK economic recoveries will mean that profits fall short of investors’ expectations. Accordingly, we think the FTSE 100 could be closer to 6,000 than 7,000 by the end of the year.