Onwards and upwards: The City has a bullish outlook for 2011, with some predicting the FTSE will pass 7,000

As champagne corks flew across the UK on Hogmanay, it's likely the celebrations were particularly lively in Weir Group boss Keith Cochrane's household, after the Glasgow-headquartered engineering firm stole the crown as the FTSE 100's biggest riser of the year, gaining 150 per cent.

Rupert Soames, chief of temporary power provider Aggreko, may also have allowed himself a tipple or two after the firm saw its shares end the year up more than 60 per cent following a string of contract wins, including a deal for next year's 2012 Olympic Games in London and last summer's World Cup in South Africa.

But with many economists still unwilling to pin their colours to the mast of sustainable recovery, many arrived at their desks last week not quite certain what 2011 would hold.

One man who did start the new year in a highly confident mood, however, was Keith Skeoch, chief executive of Standard Life Investments (SLI).

After correctly predicting in August that the FTSE would end 2010 above 6,000 - a forecast that was met with a measure of scepticism at the time - Skeoch has put his money on the index reaching 6,900 by the end of the year - just a shade off the record 6,950 achieved during trading on 30 December 1999 before the dotcom bubble burst.

Within minutes of the bell ringing out across trading floors on Tuesday morning, it became clear that, once again, Skeoch might be on to something.

The markets started 2011 with a bang, ending on Tuesday up 113.93 points after a bull rally that saw the index jump almost 150 points at one point in the day.

Optimism flooded the Square Mile and the trading floors of other major investment centres including Edinburgh and Glasgow, as talk turned to optimistic data from across the Atlantic and the FTSE potentially breaking the 7,000 mark this year.Graham Secker of Morgan Stanley has joined Skeoch in the bull camp, predicting that the FTSE could reach a historic high of 7,000 if the economy outperforms expectations and interest rates remain low for the rest of the year.

The FTSE's recent performance has also caught the eyes of Royal Bank of Scotland analysts Ian Richards and Graham Bishop, who say the equity markets will "trade strongly, potentially very strongly, through 2011".

But with uncertainty still hanging over a number of sectors, not least construction and retail, will 2011 really be a record year for the FTSE 100? And what is driving investors' renewed enthusiasm for equities?

SLI expects undervalued stocks such as BP, Vedanta Resources, Barclays, Dixons and builder Galliford Try to spearhead the rally this year.

BP showed early signs of becoming a market leader on Tuesday when it topped the day's chart of the biggest risers on suggestions that the size of the compensation fund set aside for the victims of the Gulf of Mexico oil spill disaster may have been optimistic. Standard Life believes the litigation costs in relation to the Deepwater Horizon disaster may have been "overdone".

The banks are expected to rally after a weak 2010, with many UK institutions looking cheap compared with their European peers.

Miners are also expected to benefit from surging commodity prices, while a stabilising construction market, particularly south of the Border, has caused some investors to return to housebuilders who have successfully weathered the storm of the past few years such as Galliford Try.

While the market continues to be dogged by a few disaster stories - in particular HMV, which is expected to close hundreds of stores this year and perhaps offload its Waterstone's books chain - traders point out that, in general, corporate earnings have recovered and the equities market is enjoying a revival in merger and acquisition as well as flotation activity.According to Jim Wood-Smith, head of research at Williams de Bro, these factors combined have sparked a turnaround in investment views, with many analysts and commentators once again looking favourably upon equities.

"Buying equities now appears to be the consensus call," he says. "The majority of strategists, commentators and economists who were terribly negative during 2010 have now turned considerably more bullish on the equity market. The consensus position is now to sell bonds and buy equities."

Wood-Smith also points out that while interest rates remain low, the bank rate investors receive on their money is "close to nil", encouraging more wealthy individuals and big institutional investors to consider equities once again.

Henry Dixon of Matterley Asset Management, part of the Charles Stanley Group, says there has been a "serious" shift in asset allocation towards the equities market over the past month, particularly among institutional investors.

"At the institutional level we think that after a decade of net selling there is finally a willingness to increase allocations to equities," he says. "This is both a function of the lack of value in bonds and gilts and also the recent move by governments to change the inflation rates of pension payments from RPI (Retail Prices Index] to CPI (Consumer Prices Index].

"Speaking to actuaries and people within the life (insurance] industry it is clear that this last point crucially extends the time frame that asset allocators can plan for.

"As this unfolds, we think that relative valuation of equities will make them a clear winner. Indeed, the conversations we have with programme trading desks at investment banks confirm that this trend is under way."

While most forecasters believe the FTSE will make considerable headway this year, the arch bulls such as Skeoch and Secker remain few and far between.

Richard Dingwall-Smith, chief economist at Scottish Widows Investment Partnership (SWIP), says investors are "right to be optimistic" but it could be another year before the FTSE breaks 7,000.

"What's driving it (the current rally] is the combination of monetary policy remaining loose at a time when people are starting to be more optimistic about the US."

Record jobs figures from across the Atlantic ensured the FTSE was in positive territory by the close of play on Wednesday, with US private sector employers creating 297,000 jobs in December - three times the amount predicted by Wall Street economists.But Dingwall-Smith advises caution. He says the FTSE, which is heavily affected by US data due to the reliance of many top-flight firms on American sales, has a history of "over-reacting" to news from across the Pond, whether it be positive or negative.

"Markets over-reacted to the US last year - they had quite a setback," he says. "We might now be slightly over-reacting to the signs that the US is getting better.

"The FTSE reaching 7,000 this year looks to be pushing it a bit. The balance of risks is probably still to the downside. We haven't completely left the financial crisis behind - that's a background concern."

By 2012, however, 7,000 could be a reality, Dingwall-Smith says. "In time, the chances are we will eventually reach 7,000." SWIP's forecast is that the FTSE will reach 6,400 by the end of the year.

Williams de Bro is also more cautious than the likes of SLI, forecasting a year-end figure of 6,500.

Wood-Smith points out that although other asset classes are currently trailing equities, and investors have plenty of cash to plough into FTSE companies, it would take a monumental performance from all sectors to achieve the circa 17 per cent rise needed to get within touching distance of 7,000.

"The FTSE 100 index is still dominated by a small number of very heavily weighted sectors: oil and gas, miners, banks, pharmaceuticals," he says.

"To have the FTSE breaking 7,000 you need all four of those sectors going up. The miners have already performed exceptionally well. The banks, we know, have specific problems in the UK. With oil and gas, what's great news for them - ie high oil prices - is bad news for the rest of the market, and the pharmaceuticals are terminally dull."

While the spectre of a European sovereign debt crisis still hangs over European equity markets like the sword of Damocles, the FTSE's fortunes this year will also hinge on inflation expectations, according to Wood-Smith. If inflation remains high, investors will continue to turn their backs on bonds in favour of equities, he says. But there remains a small school of economists in the Square Mile who believe a deflationary crisis is looming on the horizon.

Interest rates will also be closely watched, and concerns that the Bank of England will move sooner rather than later to raise the cost of borrowing caused markets to fall back and the FTSE to dip below 6,000 on Friday. The FTSE's fortunes this year may be stoking different levels of excitement across Britain's trading desks, but on one point nearly all agree: 2011 will be a far happier year for the markets than the last.