The outlook for UK financial markets after Brexit - Capital Economics
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The outlook for UK financial markets after Brexit

Global Markets Focus
Written by Jonas Goltermann
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Despite lingering uncertainty around the next phase of the UK’s exit from the EU, we think that there is more upside for sterling, Gilt yields, and UK equities.

  • Despite lingering uncertainty around the next phase of the UK’s exit from the EU, we think that there is more upside for sterling, Gilt yields, and UK equities.
  • The UK is set to leave the EU on 31st January, but the risk of a disorderly end to the transition period in December continues to weigh on UK financial markets. We think that the UK and the EU will eventually agree some sort of fudge that avoids a disorderly outcome.
  • Over recent years, sterling has been driven in large part by the twists and turns around Brexit. As the risk of a no-deal exit fell towards the end of last year, the pound rose. But investors are now positioned in favour of sterling, which suggests that there is less scope for another large rise in the near term.
  • The end of the transition period in December has become the new key deadline. Investors remain worried about the prospect of the UK reverting to trading with the EU on so-called WTO terms. Until there is more clarity on the UK-EU negotiations, 2020 is likely to be another bumpy ride for the pound.
  • Gilt yields have tended to be driven more by global developments than Brexit. We think that government bond yields in the US will rise a bit this year but fall a touch in the euro-zone, as the Fed stays on hold while the ECB eases policy again later this year. We expect the Bank of England to remain on hold this year and hike once in 2021, pushing Gilt yields up gradually.
  • Even after a rebound over the autumn, UK equities have underperformed their peers significantly since the 2016 referendum. That is particularly the case for those companies that are most exposed to the domestic UK economy. The valuation of UK equity markets remains low compared to where it was on the eve of the referendum, even as the valuations of other equity markets have risen since then. This suggests that there is still plenty of scope for UK equities to continue to catch up with the rest of the world.
  • Our forecast is that equities globally will not fare nearly as well as in 2020 as they did in 2019. Investors’ rosy expectations for earnings are likely to be disappointed and a further boost to valuations from a fall in discount rates looks unlikely. But we think that a gradual unwinding of the ‘Brexit discount’ on UK equities means that they will fare better than most. (See Table 1.)

Table 1: Capital Economics Key Market Forecasts – UK vs. US & Euro-Zone

2017

2018

2019

24th Jan.

2020f

2021f

Interest Rates

Bank Rate (year-end, %)

0.50

0.75

0.75

0.75

0.75

1.00

UK 10-year Gilt yield (year-end, %)

1.19

1.27

0.83

0.61

1.00

1.25

US 10-year Treasury yield (year-end, %)

2.41

2.69

1.91

1.76

2.00

2.00

German 10-year Bund yield (year-end, %)

0.42

0.25

-0.19

-0.29

-0.50

-0.50

Currencies

$/£ (year-end)

1.35

1.28

1.32

1.31

1.35

1.40

€/£ (year-end)

1.12

1.11

1.18

1.19

1.29

1.33

Equities (Local Currency)

FTSE 100 (year-end)

7,688

6,728

7,542

7,604

8,000

8,700

FTSE 100 (annual change, %)

7.6

-12.5

12.1

0.9*

5.1**

8.7

S&P 500 (annual change, %)

19.4

-6.2

28.9

2.9*

-0.8**

6.1

Euro Stoxx (annual change, %)

10.1

-14.8

23.0

1.8*

2.2**

6.0

Sources: Refinitiv, Capital Economics * YTD; ** From now until end-2020


The outlook for UK financial markets after Brexit

This Focus is an adapted version of a presentation given at the Capital Economics UK Forecast Forum held in London on 21st January 2020.

This Focus considers the outlook for UK financial markets after Brexit and the recent election. The first section deals with sterling; the second covers Gilts; and the third looks at UK equities.

Sterling

In recent years, sterling has been driven in large part by the twists and turns around Brexit. The betting odds of the UK leaving the EU without a deal in 2019 and the dollar/sterling exchange rate tracked each other closely for much of last year. (See Chart 1.) As the odds of a no-deal exit increased, sterling fell, and vice versa. Investors focused on the risk that a disorderly exit from the EU would damage the UK economy and force the Bank of England to loosen monetary policy. The two diverged in September, when the odds of a no-deal exit fell, and, of course, that risk did not materialise in the end.

Chart 1: $/£ & Bookmakers’ No-Deal Brexit Odds

Sources: Betfair, Refinitiv

Since the general election in December, Parliament has passed the Withdrawal Agreement, which means that the UK will leave the EU with a deal on 31st January. By itself, a simplistic reading of this chart suggests that this means that sterling ‘should’ now be trading around 1.36 against the dollar. But instead it is at 1.31. That is consistent with the idea that the end of the transition period on 31st December has become the new key deadline, and that markets remain worried about the consequences for the UK economy of leaving the EU on so-called WTO terms.

For example, while sterling rose after the decisive outcome of the election in early December, it fell sharply the next week when the government announced its intention to rule out a further extension of the transition period beyond the end of this year, which increases the risk of a disorderly outcome. This suggests that the year ahead is likely to be another bumpy one for the pound.

Another reason to think that sterling may not have much further upside, at least in the near term, is that sentiment towards it has already turned much more positive. The net position of non-commercial actors (a proxy for speculative demand) has moved sharply in favour of the pound. (See Chart 2.)

Chart 2: Speculative Positioning & $/£ Exchange Rate

Sources: CFTC, Bloomberg, Refinitiv

Speculators had been heavily short the pound ahead of both the original 29th March deadline, and during the summer when negotiations appeared to be at a dead-end. But as the situation improved over the autumn and following the election, they are now positioned in favour of sterling, for the first time in almost two years.

There is of course scope for speculators to build up even more bets on sterling. But we think that they are more likely to stay on the side-lines until there is more clarity on the UK-EU negotiations.

Taking a step back, it is worth considering whether the valuation of sterling suggests that it could rise much further. Chart 3 shows its trade-weighted exchange rate over the past decade and a half. Sterling is about 10% weaker than ahead of the referendum, and about 20% weaker than in mid-2015. So at face value, it looks like there is plenty of scope for sterling to rise further.

But back in 2015, the pound was arguably somewhat overvalued. And even after the significant depreciation over recent years, the UK continues to run a current account deficit of about 4 % of GDP, the largest ratio among the G7 economies. So it is hard to argue that sterling is all that undervalued now, although we think that it would probably be trading closer to its pre-referendum level, if the uncertainty around Brexit were removed entirely.

Chart 3: Sterling Real Trade-Weighted Exchange Rate*

Sources: Refinitiv

We think that in the end the UK and the EU will most likely agree some sort of a fudge that avoids a disorderly end to the transition period. (See our UK Economics FocusWhat to expect as the UK negotiates its future relationship”.) This suggests that sterling will eventually appreciate a bit further. Our best guess is that the exchange rate against the dollar will end the year at 1.35. And if Brexit uncertainty fades and the Bank of England raises rates in 2021, it could rise to 1.40 then in our view.

And because we expect the dollar to appreciate generally over the next couple of years, this forecast implies that we think that sterling will rise by more against other currencies. For example, against the euro we forecast that it will reach 1.29 by the end of this year, and 1.33 by the end of 2021. (See Chart 4.)

Chart 4: Dollar/Pound & Euro/Pound Exchange Rate

Sources: Refinitiv, Capital Economics

Gilts

Unlike sterling, Gilt yields have tended to be driven more by global developments, such as the US-China trade war and the marked slowdown in the global economy in 2019, which have pushed down interest rates everywhere. The yields on 10-year government bonds in the major developed economies have generally moved closely together, even if their levels are different. (See Chart 5.)

Chart 5: 10-Year Government Bond Yields (%)

Sources: Refinitiv

Looking ahead, we think that the global economy will turn the corner this year. At the very least, this suggests to us that bond yields are unlikely to revisit their lows from 2019. But we also think that the recovery will be slow and spread unevenly among the key economies. Our forecast is that the US will fare relatively well, while the eurozone – and China – continue to struggle.

In that context, we think that the Fed will keep interest rates on hold, while the ECB eases policy a bit further later this year. In contrast, investors are still discounting a further cut by the Fed, but no easing from the ECB. (See Chart 6.)

Chart 6: Interest Rates (%)

Sources: Bloomberg, Capital Economics

So if our policy forecasts prove correct, we think that 10-year government bond yields will rise bit in the US, to 2% by the end of the year, and fall a little in the euro-zone (both in the core and the periphery).

We expect that the UK economy will fare reasonably well and that the Bank of England’s next move will be to raise interest rates, although probably not until 2021. (See our UK Economics FocusWill the next move in interest rates be up or down?”.) That’s different from markets; investors are still discounting a cut by the Bank. (See Chart 6 again.)

This suggests that Gilt yields will rise. There is a strong relationship between the 10-year yield and the market-implied near-term policy rate. (See Chart 7.) So if we are right and the Bank does not cut rates this year, and hikes once next year, that implies that Gilt yield should rise a bit. Our forecast is that the 10-year yield will reach 1% by the end of this year, and 1.25% by the end of 2021.

Chart 7: UK Short-Term Rate At End-2021 & 10-Year Gilt Yield (%)

Source: Bloomberg

Equities

When it comes to UK equities, this is where we have the most upbeat story to tell.

They have underperformed their peers elsewhere significantly since the 2016 referendum. On a common-currency basis, UK equities have barely risen at all over the past three and a half years, even as their peers in the euro-zone and Japan have gained between 20 and 30% and US equities have risen by more than 50%. (See Chart 8.) Some of that gap is explained by the slump in sterling. But the rest is mainly down to a fall in the price/earnings ratio of UK equities, even as the P/E ratios of other indices have risen a bit.

Chart 8: MSCI Indices (USD, 23rd June 2016 = 100)

Sources: Bloomberg, Capital Economics

The underperformance of UK equities has been even more stark if we look at the companies that are most exposed to the UK economy. The FTSE 250, which includes mid and small caps, and the FTSE Local index, which includes only companies that generate at least 70% of their revenue in the UK, fared much worse after the referendum, compared to the FTSE 100 which is dominated by multinationals that earn most of their revenue abroad, and whose bottom lines have therefore benefitted from sterling’s fall.

A lot of that underperformance has unwound over the past three months. Since October, when expectations that the PM had reached a deal with the EU rose, the FTSE 250 and Local indices have fared much better than the FTSE 100, especially in the run up to the election. (See Chart 9.) All have outperformed equities in most other developed markets since October.

Of course, that reflects not only the reduction in uncertainty around Brexit, but also the removal of another important political uncertainty that probably weighed on UK equities until the general election. This was the risk of a Labour government led by Jeremy Corbyn, which would probably have been particularly bad for the financial and utilities sectors.

Chart 9: Change Since 23rd June 2016 (%)

Sources: Bloomberg, Capital Economics

A key question now is whether UK equities can continue to outperform, or whether most of the rebound is already behind us. One reason to think that there is scope for further outperformance is that the valuation discount of equities in the UK, reflected in the forward price-earnings ratio, still hasn’t closed the gap that opened up in 2016. (See Chart 10.)

Chart 10: Forward Price/Expected Earnings Ratios of MSCI Indices

Sources: Bloomberg, Capital Economics

So if the risk of a disruptive end to the transition period in December were removed, UK equities would have more room to outperform. If the forward P/E ratio for UK equities returned to where it was in mid-2016, it would raise the level of the index by about 25%. But some of the gap may prove permanent if Brexit leads to a less open UK economy and reduced earnings growth prospects for its companies.

Another reason that UK equities may continue to fare well is that there are recent examples of equity markets outperforming after a political shift to the right. The most prominent is the US, where equities got a small boost after President Trump’s election win in 2016, and a much larger one after he passed a major corporate tax cut a year later. (See Chart 11.)

Chart 11: MSCI USA & World ex USA
(8th November 2016 = 100)

Sources: Bloomberg, Capital Economics

But we don’t expect a corporate tax cut in the UK – the government actually cancelled a small planned cut during the election campaign. So we don’t anticipate a similarly large boost to UK equities.

Overall, our forecast is that equity markets globally will not fare nearly as well as in 2019. While equities everywhere rose sharply last year, much of that appears to be down to the substantial loosening of monetary policy globally, which has spurred an increase in valuations. Earnings growth was weak or negative in most markets, and in aggregate earnings fell globally.

While we think that earnings will recover slowly this year and next, another fall in yields on the scale of the one that drove up valuations in 2019 looks unlikely. This suggests to us that equity markets will make only modest gains of the next couple of years.

Our forecast for the UK reflects that global view, but also incorporates some further boost from closing the valuation gap as uncertainty around Brexit fades. We forecast the FTSE 100 to rise to 8000 by year end, and 8700 by the end of 2021. That is a substantially larger rise in percentage terms than what we expect from most other developed market equity indices. (See Chart 12.)

Chart 12: Change In MSCI Indices By End-2021, CE Forecast (%)

Sources: Bloomberg, Capital Economics

Conclusions

This Focus has made three key arguments. The first is that we think sterling will regain a bit more ground, but 2020 will probably still be a bumpy ride. The second is that we expect Gilt yields to rise, but not by all that much. And the third is that we think that the rebound in UK equites has further to run, and that they will continue to outperform other equity markets over the next couple of years.


Jonas Goltermann, Senior Markets Economist, +44 20 7808 4069, jonas.goltermann@capitaleconomics.com