LONDON (Reuters) - Britain’s blue-chip FTSE 100 is primed to reverse a year of underperformance and outpace European peers in early 2013 if its heavyweight mining sector receives an anticipated boost from Chinese growth.
European Central Bank action to defuse the euro zone debt crisis has helped lure investors back to European equity, but while the FTSE has underperformed major continental bourses so far during this rally, it should recoup lost ground next year.
A reduction in bets on London-listed stocks falling and an increase in cash put to work in the mining sector, which, like other cyclical sectors, generally rises or falls with the economic cycle, both point to a positive start to the new year.
The miners will be key to the FTSE's fortunes .FTSE. They make up 12 percent of the index -- much more than on rival continental indexes -- and sharply underperformed in 2012 on concern about slowing metals demand from China.
The pan-European STOXX Europe 600 Basic Resources Index .SXPP, which includes UK-listed miners, is flat this year against a 14 percent rise in the broader STOXX Europe 600 , so this lag has disproportionately hit the FTSE.
But funds are flowing back into the sector, suggesting better Chinese economic data is starting to give it a lift.
“A China recovery in particular should very much benefit cyclicals, and it should lead to a potential outperformance in the FTSE in 2013,” James Butterfill, global equity strategist at Coutts, said, adding that miners were the most sensitive sector to global growth concerns.
The UK’s underperformance has been stark.
The total return, which includes capital gains and dividends, on the FTSE 100 this year has been 9.4 percent, compared with 17.7 percent on France's CAC .FCHI and 26.1 percent on Germany's DAX .GDAXI.
Euro zone financials benefited disproportionately from a rally that began in July after ECB President Mario Draghi pledged to defend the euro, later unveiling a plan for the ECB to buy the bonds of indebted euro zone states.
UK banks, less exposed to euro zone debt than counterparts in the currency bloc, have gained less from the ECB pledge.
This, along with less exposure in the UK to sectors that gain from economic optimism, were important factors in the FTSE’s underperformance, Kokou Agbo-Bloua, European head of equity and derivative strategy at BNP Paribas, said.
Financials account for just 16 percent of the FTSE 100, compared to 19 percent in the rest of Europe, according to FTSE. So, despite UK banks outperforming those in the euro zone on a year-to-date basis, the relative impact on the FTSE is lower.
“Some of the sectors where we’re massively overweight have underperformed very significantly, and we’ve also been handicapped by not being heavily enough exposed to some of the sectors that have done well,” Philip Lawlor, Managing Director of Research and Analytics at FTSE, said.
“It’s been a double whammy.”
One such overweight sector is mining .FTNMX1770, which lost 9.1 percent this year after shedding nearly 30 percent in 2011 and is three times more heavily weighted on the FTSE 100 than the STOXX Europe 600 .
However, China factory data for November showed industrial activity accelerated for the first time in over a year, while government data on industrial output last month showed it rising at the fastest annual pace in eight months.
“The recent positive data and industrial activity in China is also creating support for a sector that has been underperforming recently,” Agbo-Bloua said, with EPFR global data showing that Commodities Sector Funds were the standout in terms of attracting fresh money towards the end of November.
Returning fund flows have yet to drive up the price of betting on a rise in the FTSE 100 in the options market, however, meaning that now may be a good time to buy.
“The FTSE has one of the best levels of risk reward,” Agbo-Bloua at BNP Paribas said.
The scale of predicted future price movement, or volatility, is very low, which makes the premium that is paid on options more attractive, with the FTSE 100 about a quarter cheaper than the Euro STOXX 50 .STOXX50E, according to BNP Paribas.
Additionally, data on short selling, in which investors sell borrowed shares in the hope of buying them back more cheaply, shows they are no longer betting on the FTSE underperforming Europe. The number of FTSE shares borrowed is down just under 30 percent since September 1, indicating reduced short interest.
This decline is across enough companies in the FTSE 100 .FTSE and spanning enough sectors to suggest a trend broadly reflective of the market, according to Karl Loomes, market analyst at SunGard's Astec Analytics.
“And if short interest in a market is declining, that could indicate returning confidence in that market.”
Editing by Simon Jessop and Nigel Stephenson