City analysts are predicting a healthy rally for shares next year despite the deepening recession, with the FTSE 100 index expected to rise by an average of 18% to about 5,000.

Every year the Sunday Times Money section asks a panel of analysts where the Footsie will end the next 12 months. This year, forecasts range from just 4,300 — only 83 points above current levels — to 5,800, reflecting the unprecedented uncertainty about the market outlook.

The investment bank UBS is the most bullish of our panellists, predicting a 35% gain on the basis that interest-rate cuts will restore confidence to the markets.

The bank is also recommending clients increase their holdings in banks. HBOS, which owns Halifax Bank of Scotland, has been the worst performer in the FTSE 100 index this year with a decline of 91%, while Royal Bank of Scotland is not far behind with a fall of 88%.

UBS strategist Gareth Evans said: “We are cutting our holdings in pharmaceuticals to neutral and channelling the proceeds into banks. To reflect this change, we are swapping Scottish & Southern for HSBC.”

UBS was among the most bullish forecasters in 2008, though, and has been proved spectacularly wrong. It thought the Footsie would soar to 7,200 but it closed on Wednesday at 4,224, a fall of 35% since the start of the year and on course for its sharpest fall since 1974.

Most analysts agree the stage is now set for a rally, with shares looking cheap on most measures and fund managers sitting on big piles of cash that could quickly move into the markets if confidence picks up. The question is when this much-vaunted upturn will occur.

Gary Baker, an equity strategist at the investment bank Merrill Lynch, thinks it could be sooner rather than later. “Market sentiment, high cash levels and the prospect of fiscal stimulus in America in January point to a possible new-year rally in equities,” he said. “It suggests that going into 2009 with textbook defensive positions in a small number of sectors could be dangerous.”

Goldman Sachs, on the other hand, thinks the market could fall another 20% before the stock market troughs if investors start to worry about deflation — falling prices for goods and services.

Analyst Peter Oppenheimer said: “We believe that falls of 20% are possible if the market prices in a short-lived deflation scenario. Barring sustained deflation, we would expect a 30%-50% rebound from the market low over 6 to 12 months, starting in the middle of 2009.”

David Buik, our best 2008 forecaster — albeit with an overly optimistic prediction of 5,900 — expects a rally in the middle of the year. Stock markets tend to trough ahead of the economy, so by the middle of the year investors will be looking forward to economic recovery in 2010.

“The immediate prospects for the FTSE 100 in the first half of the year are not encouraging, despite the injection of fresh capital for banks by the government and a stimulus package of doubtful quantity. The first-quarter earnings season is likely to show an average drop in profits of about 15%. I then expect a strong rally in the latter half of 2009, resulting in the FTSE 100 reaching 5,000,” Buik said.

Morgan Stanley, the investment bank that told clients to quit shares for cash in November 2007, was the most bearish in our survey with a forecast of just 4,300.

Analyst Graham Secker said: “Equities look cheap, but the fragility of the financial and economic backdrop may continue to suppress risk appetite.”

UK investors are therefore being urged to sit tight — shares are likely to remain turbulent in the short term, but most analysts predict a rally in the medium term for brave investors who are prepared to ride out the uncertainty.

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