City forecasts another good year for shares

City strategists predict 2006 will see the FTSE 100 continue its march higher but they warn that anyone hoping for a repeat of this year's 17 per cent rise in the value of the index will be disappointed.

On average, they expect to see London's leading share index rise by 6 per cent next year, with strategists at ABN Amro and Lehman Brothers most bullish about the outlook. In fact, Lehman is upbeat about European stock markets across the board in 2006. "We continue to maintain a bullish stance towards European stocks for 2006. The combination of still low valuations and the prospects that earnings will continue to grow suggests a continued positive stance," Ian Scott, the equities strategist at the US firm, said.

But he predicts that the UK market will outperform the rest of Europe, driven by lower interest rates on this side of the Channel (Lehman's in-house economics team anticipates UK rates of 3.5 per cent by the end of 2006) and a weak pound versus the euro, which aid the local currency performance of UK stocks. As far as downgrades to earnings forecasts go, Mr Scott is convinced that the worst is now behind the UK, especially in the retail sector where profit downgrades have been most harsh recently.

However, City strategists are by no means bullish across the board. Roger Cursley, at Investec Securities, predicts that the FTSE 100 will lose ground next year and finish at 5,500. He suggests that downgrades to earnings forecasts are on the way in the year ahead and warns that the particularly strong rally by the blue-chip index in the past few months (the FTSE 100 has risen by 10 per cent since the middle of October) means that it has already factored in a lot of good news.

The Investec strategist also fears that the oil and gas, and mining sectors could prove to be major drags on the FTSE 100. The two have been great performers in the year to date but any retreat by the duo will cost the blue-chip index dearly. Combined, they account for one-quarter of the FTSE 100.

A look back at the forecasts made by brokers this time last year shows that on the whole they were too cautious. Deutsche Bank and Investec Securities came closest with their forecasts. Both tipped the blue-chip index to end 2005 at 5,400. Yesterday, on the last full trading day of the year, it closed at 5,638.

Deutsche expects to see the FTSE 100 finish next year at 6,000. It believes that the bulk of this rise will be registered in the first half of next year, with macroeconomic factors such as interest rate cuts by the Bank of England supporting any gains. Charles de Boissezon, a strategist at the German broker, is particularly bullish about the retail, banking and pharmaceuticals sectors but he urges investors to avoid utilities, food producers and finance companies.

Over the past 12 months, merger and acquisition activity has been a key driving force behind rising shares prices. In the last quarter alone, household names such as O2, Pilkington and P&O have all been on the receiving end of takeover offers. Mike Lenhoff, the chief strategist at Brewin Dolphin Securities, does not see this trend letting up in any meaningful way during 2006. He predicts that M&A activity, along with continued earnings growth and ever bigger share buy-backs, will push the UK market up to 6,100 by the year end.

Mr Lenhoff said: "We think the outlook for 2006 is for a pick-up in the aggregate growth rate for the major economies and stable inflation. Against this backdrop, we expect a satisfactory year for bond markets and a good year for equities".

Nikkei surges to a five-year high

Japan's Nikkei share index has surged to its highest level in five years and is on track for the biggest yearly gain since the mid-1980s asset bubble, providing further evidence that the economy has turned the corner.

The index topped the 16,400 mark yesterday for the first time in five years, buoyed by demand for Japanese technology shares. It finished up 149.59 points at 16,344.20, the highest close since September 2000.

With only one day of trading left in 2005, the Nikkei has risen 42.3 per cent so far this year, its best performance since 1986. The broader Topix index is up 45 per cent, the biggest increase since 1999.

Yesterday's increase came as a survey showed that manufacturing expanded at its fastest pace in two years. The NTC Research/Nomura/ JMMA Purchasing Managers Index, which gives a snapshot of manufacturing activity, reached its highest level since December 2003. Analysts said that points to another 1 per cent plus increase in industrial production in December. In November, output rose 1.4 per cent as factories boosted production for a fourth consecutive month, according to government figures yesterday.

Japan's economy has bounced back after a long period of stagnation as higher investment and consumer spending have offset a slowdown in exports. Even exports now show signs of picking up thanks to strong demand from China. Akiyoshi Takumori, the chief economist at Sumitomo Mitsui Asset Management, said: "We can say that the economy has finally emerged from a soft patch."

Trading was relatively thin before the year-end holidays, so individual investors accounted for much of the market's force after receiving their Christmas bonuses.

Shares in electronics firms such as Sony were attracting more investors, after lagging behind the top gainers all year. Tech stocks and other exporters such as Toyota also received a boost from the weaker yen, which hit a two-week low against the dollar after strong US data.

Julia Kollewe