Second lockdown fears weigh on equities - Capital Economics
UK Markets

Second lockdown fears weigh on equities

UK Markets Chart Book
Written by Paul Dales
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The growing risk of a second national UK lockdown has spooked equity markets over the last week. We already expect the recovery to stall in Q4 and additional COVID-19 restrictions could easily throw it into reverse, which would hammer UK corporate revenues. What’s more, positive noises from the Brexit negotiators have caused the pound to jump, which devalues the overseas earnings of UK companies in pounds. As a result, the FTSE 100 has fallen to its lowest level since May. Assuming that another full national lockdown is avoided, then we think that the FTSE 100 will stop underperforming other developed markets and regain its pre-crisis level by the end of 2022.  But the risks to this forecast are firmly to the downside.

  • The growing risk of a second national UK lockdown has spooked equity markets over the last week. We already expect the recovery to stall in Q4 and additional COVID-19 restrictions could easily throw it into reverse, which would hammer UK corporate revenues. What’s more, positive noises from the Brexit negotiators have caused the pound to jump, which devalues the overseas earnings of UK companies in pounds. As a result, the FTSE 100 has fallen to its lowest level since May. Assuming that another full national lockdown is avoided, then we think that the FTSE 100 will stop underperforming other developed markets and regain its pre-crisis level by the end of 2022. (See Chart 1.) But the risks to this forecast are firmly to the downside.
  • LIBOR rates will rise if the Bank opts for more QE rather than negative interest rates.
  • Government bond yields will be kept very low by much more QE and an extremely low Bank Rate.
  • A stalling economic recovery could cause corporate bond spreads to widen again.
  • Low interest rates will keep equities attractive relative to bonds, but a national lockdown would hit earnings hard.
  • Sterling has been boosted by the resumption of Brexit negotiations and a lower chance of negative interest rates.
  • Our markets forecasts are on page 7.

Chart 1: Equity Indices

Sources: Refinitiv, Capital Economics


Interest Rates

  • There should be some upside for LIBOR rates over the next 6-12 months as the Bank of England opts for more QE rather than negative interest rates (NIR). But rates will stay very low for years to come. LIBOR rates have continued to fall in recent months, with the 6-month rate joining the 3-month and 1-month rates below the Bank Rate of +0.10% (2). The 12-month rate is 0.13% – its lowest rate on record (3).
  • This latest fall in 12m LIBOR is partly to do with a further narrowing in spreads, as the Bank continues to provide ample liquidity (4). However, it is mostly due to a further fall in market rate expectations (5). Admittedly, mixed messages from the Bank on the use of NIR has caused expectations to fluctuate in recent weeks (6). But the markets are currently pricing in a cut in Bank Rate from +0.10% to -0.10% by the end of next year (7).
  • We expect the Bank to use more QE rather than reaching for NIR this year. We forecast a further £100bn of purchases will be announced at November’s MPC meeting. The lack of NIR in the next 6-12 months could push up LIBOR rates a bit. But with no rate hikes likely for the next five years, LIBOR rates will stay very low for a long while yet.

Chart 2: LIBOR Rates (%)

Chart 3: 12-month LIBOR Rate (%)

Chart 4: Spread of LIBOR Over OIS Rates (bps)

Chart 5: Market Implied Path for Interest Rates in 1 Year’s Time Based on OIS Rates (%)

Chart 6: OIS Implied Market Rate Expectations (%)

Chart 7: Expectations for Bank Rate (%)

Sources: Refinitiv, Capital Economics


Government Bonds

  • We expect the central bank to announce much more QE than the consensus expects to ensure gilt yields stay very low and end this year at 0.15%. Fluctuations in interest rate expectations on the latest comments from the Bank of England regarding negative interest rates have driven gilt yields over the past month, but ultimately they are broadly unchanged relative to 5 months ago hovering around 0.2% (8).
  • The lack of big movement reflects that policy rates have pretty much reached what central banks consider to be their lower bound where they will probably stay there for some time. The same stability is evident in the UK and Europe too (9). Inflation expectations suggest that low gilt yields are not due to expectations that policymakers will fail to get inflation back up to target. Instead, it’s a result of expectations that real interest rates will have to stay well below zero to achieve that (10).
  • The Bank of England’s gilt purchases have slowed in recent months, which has led to larger increases in the net supply of privately held gilts (11). Previously, such increases have been associated with the spread of gilt yields over interest rate expectations rising (12). That’s another good reason to think that the Bank of England will undertake much more QE than the consensus expects next year (13).

Chart 8: 10-Year Gilt Yield & OIS Rate (%)

Chart 9: 10-Year Government Bond Yields (%)

Chart 10: Inflation Expectations & Real Yield (%)

Chart 11: Gilt Issuance & BoE Purchases (£bn per month)

Chart 12: Net Supply of Gilts & Spread of 10Yr Gilt Yield Over OIS Rate

Chart 13: Forecasts for Announced QE (£bn)

Sources: Refinitiv, Bank of England, Capital Economics


Corporate Bonds

  • The Bank of England’s activities have helped corporate bonds outperform equities. But the stuttering recovery means spreads could yet widen again. UK corporate bond yields have remained lower than before COVID-19 hit (14). But that is due to lower risk-free rates rather than spreads. While the latter have narrowed, they remain somewhat higher than at the start of the year, especially for riskier bonds (15).
  • That said, corporate bonds have done much better than domestic equities (16). That is probably partly a reflection of the sectoral make-up of the FTSE 100. But it also probably reflects the £10bn of corporate bond purchases the Bank of England has undertaken this year. Indeed, net corporate bond issuance in the year to date is higher than in 2019, but most of this has effectively been bought by the Bank (17).
  • Firms have also moved away from loan finance at the height of the crisis into equity and commercial paper financing (18). The Bank has purchased £15.8bn of the latter this year through the COVID-19 Corporate Financing Facility, exceeding net issuance of £6.6bn. Despite central bank intervention, some widening of corporate bond spreads may be in store. The activity PMIs edged down in September due to the softening recovery, and would point to wider spreads if they fall further as the recovery stalls (19).

Chart 14: Yields of ICE BofA ML IG Corporate Bond Index (%)

Chart 15: Option-Adjusted Spreads of ICE BofA ML IG Corporate Bond Indices (bps)

Chart 16: FTSE 100 & UK AA Corporate Bond Spread

Chart 17: PNFC’s Corporate Bond Issuance (£bn, YTD)

Chart 18: PNFC’s Net External Financing (£bn)

Chart 19: All Sector PMI & Corporate Bond Spread

Sources: Refinitiv, Capital Economics


Equities

  • UK equities should stop underperforming those in the US and elsewhere, but Brexit uncertainty and further lockdowns pose a downside risk. Unlike the US S&P 500, which has risen slightly since the start of October, the FTSE 100 has fallen to its lowest level since May (20). This probably partly reflects the resurgence in COVID-19 cases in the UK.
  • However, the threat of further strict lockdowns hasn’t fazed equity markets as much as it did in March. Volatility has fallen back to its pre-crisis level (21). And equity prices in sectors such as consumer services, which were hit hard in March, have barely changed since the start of October (22). The market also seems to care less about the Brexit negotiations than in 2019. The domestically-focused FTSE local index, which is sensitive to Brexit concerns, has moved in lockstep with the internationally-exposed FTSE 100 (23).
  • We still expect a slim Brexit deal to be agreed by 31st December 2020. And as long as a “circuit breaker” lockdown isn’t imposed on the rest of country, then the FTSE 100 may reach pre-virus levels by the end of 2022. Record low interest rates for the next few years will keep equities looking attractive relative to bonds (24). Even if a Brexit deal is not agreed, the boost to foreign earnings in sterling terms from a fall in the pound would prevent a big fall in the FTSE 100, as it did in the aftermath of the EU referendum (25).

Chart 20: Equity Indices (1st Jan. 2020 = 100)

Chart 21: FTSE 100 & Volatility

Chart 22: Local FTSE All-Share Sectors (% Change)

Chart 23: FTSE 100 & FTSE Local (Jan. 2020 = 100)

Chart 24: Equity Earnings Yield & Real Gilt Yield (%)

Chart 25: $/£ Exchange Rate & Relative FTSE Strength

Sources: Refinitiv, smarkets.com, Capital Economics


Sterling

  • The pound could rise from $1.32 now to $1.35 by the end of the year if the Brexit negotiations result in a deal, but a “no deal” Brexit could send the pound to $1.10 or below. The implied probability in betting markets of a no deal rose sharply after the Boris Johnson said that the UK should “prepare for a no deal Brexit”. But the start of “intensive” talks this week helped the pound to rise from $1.29 to $1.32 (26). On a trade-weighted basis, sterling has risen slightly in recent weeks (27).
  • The recovery in risk appetite and weakening in the dollar over the last few weeks has also helped to boost the pound (28). What’s more, comments from MPC member Dave Ramsden suggesting that now was not the time for negative interest rates benefited the pound, particularly against the euro (29).
  • That said, the Brexit negotiations are far from over. Indeed, in recent weeks investors appear to have started to position themselves for further falls in the pound (30). We think there may be something like a 60% chance of a Brexit deal being reached, which may allow the pound to rebound from $1.30 to $1.35. There may be a 40% chance of a no deal outcome. If that were a “cooperative” no deal the pound may fall to around $1.15. If it were “uncooperative”, where both sides fall out, then it could fall to $1.10 (31).

Chart 26: Probability of “No Deal” & $/£

Chart 27: Trade-Weighted Sterling (2005 = 100)

Chart 28: US Dollar Index & $/£

Chart 29: Relative Rate Expectations & €/£

Chart 30: Sterling Futures Net Position & $/£ Rate

Chart 31: $/£ Exchange Rate

Sources: Refinitiv, SMarkets, Capital Economics


UK Markets Forecasts

Table 1: Key Market Forecasts*

End period

Latest

21st Oct.

Q3 203

Q4 20

Q1 21

Q2 21

Q3 21

Q4 21

2020

2021

2022

Bank Rate (%)

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

3 month LIBOR (%)

0.05

0.06

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

6 month LIBOR (%)

0.07

0.09

0.15

0.15

0.15

0.15

0.15

0.15

0.15

0.15

12 month LIBOR (%)

0.12

0.15

0.30

0.30

0.30

0.30

0.30

0.30

0.30

0.30

10 Year Gilt Yield (%)

0.20

0.19

0.15

0.15

0.15

0.15

0.15

0.15

0.15

0.15

FTSE 100

5760

5862

6200

6300

6400

6500

6600

6200

6600

7500

$/£

1.31

1.29

1.35

1.35

1.35

1.35

1.35

1.35

1.35

1.35

€/£

1.11

1.10

1.13

1.13

1.13

1.13

1.13

1.13

1.13

1.13

Sterling TWI

78.0

77.0

79.3

79.2

79.1

79.0

78.9

79.3

78.9

78.9

Real GDP (%q/q)1

-19.8

15.6

1.3

0.8

2.2

1.2

1.2

Real GDP (%y/y)1

-21.5

-9.5

-8.4

-5.3

20.7

5.7

5.5

-10.4

6.0

4.5

CPI Inflation (%y/y)2

0.5

0.6

0.5

0.5

1.5

1.6

2.0

0.9

1.4

1.5

RPI Inflation (%y/y)2

1.1

1.1

1.2

1.4

2.4

2.5

2.8

1.5

2.3

2.3

RPIX Inflation (%y/y)2

1.4

1.3

1.4

1.5

2.4

2.4

2.7

1.7

2.2

2.2

Sources: Refinitiv, Capital Economics. 1Latest is Q2 2020. 2Quarterly period average, latest is September 2020. 3Outturn data except for GDP

*Assumes that the current COVID-19 restrictions are tightened somewhat and last until April 2021. Assumes the UK and the EU agree a slim trade in goods deal by the end of the year. (See here.)


Paul Dales, Chief UK Economist, +44 (0)7939 609 818, paul.dales@capitaleconomics.com

Ruth Gregory, Senior UK Economist, +44 (0)7747 466 451, ruth.gregory@capitaleconomics.com

Andrew Wishart, UK Economist, +44 (0)7427 682 411, andrew.wishart@capitaleconomics.com

Thomas Pugh, UK Economist, +44 (0)7568 378 042, thomas.pugh@capitaleconomics.com

Bradley Saunders, Research Economist, bradley.saunders@capitaleconomics.com