This year has seen the FTSE 100 reach a record high of over 7,500 points. For many investors, this has been somewhat surprising, since the UK continues to face a challenging outlook. A minority government, Brexit and downgrades to GDP forecasts have all contributed to uncertainty regarding the UK's economic outlook.
Despite this, the FTSE 100 has continued to march higher. Even now, it seems to be relatively undervalued. With the prospect of a weaker pound, an improving global economic outlook and higher levels of inflation, a level of over 12,000 points could be ahead.
While the UK economy faces a difficult outlook, the future for the global outlook is bright. The US could benefit from increased spending and lower taxation from the current administration, while China continues to perform well as it shifts towards a consumer-focused economy. As the two largest economies in the world, they are the key drivers for that of the entire world. In addition, quantitative easing in the EU looks set to continue. This could enable it to deliver further growth and contribute positively to global GDP growth.
Since the FTSE 100 is made up of mostly international companies, the outlook for the global economy matters more to it than the performance of the UK. Therefore, the index's constituents look set to report high earnings growth irrespective of the domestic challenges faced by the UK. This could cause the index to make gains over the medium term.
The UK's main index could also gain from a weaker pound. While most of its constituents operate on a truly global basis, they often report in sterling. With the pound having weakened significantly versus a basket of major currencies since the EU referendum and now facing Brexit talks conducted by a minority government, there is scope for a further depreciation of sterling. This could create a currency adjustment which boost sales, revenues and valuations for many companies in the index.
As well as currency adjustments for company reporting, a weaker pound is also causing higher inflation. With the FTSE 100 yielding 3.7% at its current level, it remains a relatively attractive asset for income-seeking investors to hold. If inflation moves higher (as anticipated), then shares in the index may become more popular as investors find it more difficult to generate a positive inflation-adjusted income return. This could push the index's level even higher.
Clearly, a level of 12,000 points is significantly higher than the current level of 7,500 points. It would represent a gain of around 60%, which may seem overly optimistic.
However, with the S&P 500 having a dividend yield of just 2.2%, the FTSE 100 seems to be undervalued given the catalysts discussed above. If it had the same yield as the S&P 500, it would be trading at around 12,400 points, which highlights the growth potential which may lie ahead. Therefore, while volatile, the UK's main index may be a sound place to invest right now.
Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.