Global jitters aggravated by no deal fears - Capital Economics
UK Markets

Global jitters aggravated by no deal fears

UK Markets Outlook
Written by Paul Dales
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The global shift away from risky assets and towards safer ones that seems to be underway will either be exacerbated by a no deal Brexit on 31st October or cushioned by a deal or a delay. Although a lot of bad news has already been priced into UK gilt yields and the pound, if a no deal Brexit became a reality we suspect the 10-year yield would drop to a new record low of 0.25% and the pound would fall to $1.15. But if we are right in thinking that the Bank of England would raise interest rates next year if there were a Brexit deal or more delays, there may be more upside to gilts yields and the pound than is widely perceived. A slump in global equity prices will probably mean that the FTSE 100 falls sharply this year either way.

  • The global shift away from risky assets and towards safer ones that seems to be underway will either be exacerbated by a no deal Brexit on 31st October or cushioned by a deal or a delay. Although a lot of bad news has already been priced into UK gilt yields and the pound, if a no deal Brexit became a reality we suspect the 10-year yield would drop to a new record low of 0.25% and the pound would fall to $1.15. But if we are right in thinking that the Bank of England would raise interest rates next year if there were a Brexit deal or more delays, there may be more upside to gilts yields and the pound than is widely perceived. A slump in global equity prices will probably mean that the FTSE 100 falls sharply this year either way.
  • Global & UK Overview – Interest rate cuts by overseas central banks are unlikely to prevent a further easing in global GDP growth. Add in another escalation of the US-China trade war and there’s every chance that the recent falls in global equity prices will morph into a decline of up to 15%.
  • Money Markets – While we think the markets are right to price in interest rate cuts if there’s a no deal Brexit, if there’s a deal or further delays we suspect the Bank of England will buck both the global trend and current expectations by raising interest rates or leaving them at 0.75%.
  • Bonds – There’s some scope for 10-year gilts yields to fall from their recent record low of 0.43% to around 0.25% if there’s a no deal Brexit. But a large upward shift would occur if there’s a deal or many more Brexit delays.
  • Equities – Regardless of Brexit, global factors may soon result in the FTSE 100 falling by a bit more than 5%. The fortunes of the FTSE Local index will be tied more closely to the Brexit outcome.
  • Sterling – If the financial markets were to fully price in a no deal Brexit, we estimate that the pound would weaken to about $1.15 (€1.05) or a bit below. At this stage, perhaps the bigger surprise would be if a Brexit deal were reached, in which case the pound could rebound to $1.40 (€1.22) by the end of 2021.
  • Commercial Property – Regardless of Brexit, we suspect that commercial property returns will be squeezed over the next couple of years, as a result of weakness in the retail sector.
  • Historical Context & Valuations – These charts put current conditions into a historical context.
  • Key Forecasts – We have provided three sets of financial market forecasts based on three different Brexit outcomes; a deal on 31st October 2019, a no deal on 31st October and many more delays to Brexit.

Global & UK Overview

Global fallout to be exacerbated or cushioned by Brexit

  • If there is a no deal Brexit on 31st October, domestic factors will further exacerbate the global shift away from risky assets and towards safer ones that seems to be underway. But if there’s a deal or a delay, they would cushion it.
  • We think that over the next six months investors will continue to shun risky assets in favour of safer ones. Admittedly, given that we don’t think the Fed or the ECB will deliver as many interest rate cuts as the markets expect, there is little scope for 10-year Treasury and Bund yields to fall much further. They may even rise before the year is out. (See Chart 1.)
  • But we doubt that lower rates will stave off a sharper slowdown in global GDP growth than is widely expected, particularly in the US. That’s why we suspect US equity prices will fall by around 15% by the end of the year and that equities elsewhere will follow suit. Such a surge in risk aversion would probably result in the US dollar strengthening against most currencies.
  • The FTSE 100 is unlikely to shrug off such a deep fall in global equity prices regardless of what happens with Brexit. (See Chart 2.) Although there’s already a lot of bad news priced into gilts and the pound, if there’s a no deal Brexit 10-year gilts could fall from 0.50% to a new record low of 0.25% while the pound could drop from $1.21 to $1.15. (See Chart 3.)
  • But equally, if a deal or a delay was pulled out of the hat, the prospect of the Bank of England bucking the global trend and raising interest rates (see Chart 4) would significantly push up gilt yields and the pound. That said, if an election led to a Labour government, even though there might be a softer Brexit, concerns over its anti-business policies would hold down sterling and equities.

Chart 1: 10-Year Government Bond Yields (%)

Chart 2: Equity Price Indices (Jan. 1st 2015 = 100)

Chart 3: 10-Year Gilt Yields & $/£ Exchange Rate

Chart 4: US, UK & Euro-zone Policy Rates (%)

Sources: Refinitiv, Bloomberg, Capital Economics

Money Markets

Markets have gone too far in ruling out rate hikes if there isn’t a no deal

  • While the markets have fully priced in a 25bp interest rate cut in the next year and appear to have ruled out rate hikes if there isn’t a no deal Brexit, we think there is some upside to rates if there’s a Brexit deal or delay. (See Chart 5.)
  • Interest rate expectations have fallen sharply in the UK, with investors now anticipating a 25bp cut from 0.75% by January 2020 and a 50% chance of a further rate cut by mid-2020. This has been driven by growing concerns over a no deal Brexit and a fall in global rate expectations. (See Chart 6.) It means the markets have now ruled out UK rate hikes even if there is a Brexit deal or many more delays.
  • And interbank lending rates have fallen, leaving LIBOR-OIS spreads unchanged. (See Chart 7.) So banks don’t seem too concerned about liquidity issues in a no deal Brexit. But there is a risk that if there’s a no deal, spreads widen just as they did after the EU referendum.
  • We agree that interest rates would be cut to at least 0.25% if there were a no deal Brexit. But if there is a deal or more delays, the UK could buck the global trend of rate cuts. After all, at 0.75%, UK monetary policy is loose. And the MPC’s projections suggest inflation will rise above the 2% target at some point.
  • That said, interest rates are unlikely to rise far or fast. The MPC has suggested that rates may need to rise to only 1.0% over the next few years, and even that is conditional on an improvement in the global outlook. We think inflation will rise even further than the Bank. As a result, we think that rates could rise to 1.25% by end-2021 if Brexit is repeatedly delayed and to 1.50% if there is a deal. (See Chart 8.) But the first hike wouldn’t come until mid-2020 in a deal scenario, and the risks to our forecasts in all scenarios lie to the downside.

Chart 5: Bank Rate Implied by OIS Rates

Chart 6: Market Expectations for Bank Rate in 2 Years Implied by OIS Rates* (%)

Chart 7: LIBOR-OIS Spreads (bps)

Chart 8: Expectations for Bank Rate (%)

Sources: Bank of England, Bloomberg, Refinitiv, Capital Economics

Bonds

Safe haven demand for gilts likely to unwind

  • We doubt gilt yields will sustain their current low levels. While a no deal Brexit would probably push down the 10-year yield from its recent record low of 0.43% to 0.25% in the near term, by the end of 2020 we suspect it will be higher regardless of how Brexit pans out.
  • Now that market expectations for looser monetary policy appear to have gone too far, particularly in the US, some of the rally in global government bonds is likely to be reversed. A rise in the 10-Year US Treasury yield, from 1.7% to 2.25% by year-end, would relieve some of the downward pressure on gilt yields. (See Chart 9.)
  • Moreover, at some point domestic monetary policy will push up gilt yields relative to yields on other developed market government bonds. Our view that the UK policy rate will go some way to catching that in the US if no deal is avoided would reduce the wedge that the Fed’s interest rate hikes have driven between the US and UK yields. (See Chart 10.)
  • The rise in inflation that would follow a no-deal Brexit has pushed up market inflation expectations in the UK relative to elsewhere. (See Chart 11.) However, we don’t think yields would fall on the back of lower inflation expectations if a no deal is avoided. That’s because this would be more than offset by a rise in the real yield as the prospects for growth improve.
  • Overall, we think a rise in global yields will prevent gilt yields from falling much if there is a no deal Brexit. And if Brexit is delayed or a deal is struck, the prospect of tighter monetary policy in the UK will push up gilt yields. (See Chart 12.) The election of a Labour government could push yields higher still if it results in a large unfunded rise in government spending as some fear.

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

Chart 10: US & UK Policy Rates & Bond Yields (%)

Chart 11: Market Inflation Expectations (%)

Chart 12: Market Interest Rate Expectations & Bond Yields (%)

Sources: Bloomberg, Refinitiv, Capital Economics

Equities

Vulnerable to US weakness

  • The recent falls in the FTSE 100 have reinforced our long-held view that the UK equity market would struggle this year against the background of a deteriorating global economy. We think that there is worse to come. But a recovery in UK equity prices still seems likely towards the end of next year, as global growth rebounds.
  • We continue to expect the US stock market to fall further before the end of 2019 and the FTSE 100 to be caught in the crossfire. (See Chart 13.) Indeed, the materials sub-sector in the UK that is very exposed to trade has already been hit hard over the past month. (See Chart 14.)
  • But there are a two reasons why we think that the FTSE 100 will fall by only 6% by end-2019, far less than the 12% drop that we project for the S&P 500. First, the MSCI UK index has underperformed the MSCI USA index since the start of the decade. (See Chart 15.) So UK equities may not have as far to fall. Second, the outperformance of the MSCI USA index relative to the UK index can be attributed to faster growth in corporate earnings. (See Chart 16.) Given our expectation that GDP growth will slow more in the US, earnings growth in the UK may soon start to outperform the US.
  • Meanwhile, although we expect gilts and sterling to be mainly driven by Brexit, we doubt this will be the case for the FTSE 100. If there’s a no deal Brexit, the boost to overseas earnings from sterling’s fall would help support the FTSE 100 – although small-cap UK equites would probably perform worse. If there’s a deal, a strengthening in the pound would work in the other direction. Politics could have a bigger bearing on equities if there is a Corbyn-led Labour government. The prospect of corporate tax hikes, tighter regulation and nationalisations could drag on most UK equities.

Chart 13: FTSE 100 & S&P 500

Chart 14: MSCI UK Equity Prices & Weights (12th Jul. to 12th Aug., %)

Chart 15: MSCI USA & UK Equity Price Indices

Chart 16: Average Annual Total Returns From MSCI Indicies* (%)

Sources: Refinitiv, Bloomberg, Capital Economics

Sterling

Schrödinger’s pound

  • By the end of 2019 sterling could be 5% higher or lower than it is now, but much like with Schrodinger’s cat, it won’t be until the Brexit box is opened that we will find out whether the pound will soar or slump.
  • The rising chances of a no deal Brexit have dragged down the pound to $1.21 and €1.08, a 5% fall since the end of May. The fact that investors’ net futures positions in sterling are now nearly as low as after the referendum suggests that a lot of the bad news is already priced in. (See Chart 17.)
  • But as the betting markets are only pricing in about a 40% chance of a no deal (this may not be a perfect measure but it’s unlikely to be that much higher) sterling would probably fall further in the event of a no deal. (See Chart 18.) We are sticking with our no-deal forecast of $1.15 by end-2019, and it could even fall further immediately after a no deal.
  • The flipside is that if there is a Brexit deal or even just another delay, then there is scope for the pound to strengthen. The currency markets have largely ignored the shrinking rate differential between the UK and the US since the start of the year. But if there were a deal then this relationship would probably reassert itself. And our forecasts for government bond yields in the US and the UK in a deal scenario imply that sterling could jump to $1.40 or even a little higher. (See Chart 19.)
  • Of course, there is a high chance that the Brexit “box” stays closed and Brexit is delayed again and again. This would probably result in fewer interest rate hikes and a smaller rise in the pound to $1.35 by end-2021. (See Chart 20.) And if there is a Labour government, the pound might get a boost from a softer Brexit. But this could be offset by concerns about anti-business policies, so overall, sterling might remain around its current level.

Chart 17: $/£ & “Speculative” Positioning

Chart 18: Probability of a No Deal Brexit & $/£

Chart 19: UK Less US 10-Year Yield & $/£ FX Rate

Chart 20: $/£ Exchange Rate

Sources: Refinitiv, Bloomberg, Capital Economics

Commercial Property

Property returns to weaken regardless of Brexit

  • Since late last year, commercial property has become more favourably priced compared to equities and bonds, mainly as equity and bond yields have fallen. (See Chart 21.) We think that property’s pricing advantage will weaken. This is because regardless of the Brexit outcome, we expect that all-property rental values will fall and yields will rise this year.
  • We expect that falls in retail rental values will continue to drag on the all-property average for the next year at least. In turn, even if a Brexit deal is secured, we expect all-property rental value growth to weaken. However, under any of our Brexit scenarios, we think that the economy could be growing by around 2% by 2021, which should support a recovery in all-property rental value growth. (See Chart 22.)
  • We also expect yields to rise, although when and by how much will depend on Brexit. That said, the bleak outlook for retail rental values is already putting upward pressure on yields. (See Chart 23.) We think that this process has further to run, regardless of Brexit.
  • If a deal is secured and Bank Rate is hiked in 2020 and 2021, as capital values are already stretched in many sectors, we expect a further rise in yields next year. If Brexit is repeatedly delayed, yields could increase a bit more in the near term. Under a no deal, we expect yields to spike temporarily as a result of the initial economic disruption. But further out, interest rate cuts will keep yields lower than otherwise.
  • The upshot is that the timing of the impact on capital values will differ in the near term. Over the next three years, we think that the cumulative fall in all-property capital values could be between 7% under a deal and 11% under a no deal. (See Chart 24.) In either case, we expect retail returns to be hardest hit.

Chart 21: All-Property Initial Yields Less Equity Dividend Yields & 10-Year Gilt Yields (Bps)

Chart 22: All-Property Rental Values & GDP (% y/y)

Chart 23: Equivalent Yields by Sector (%)

Chart 24: Cumulative Change in All-Property Capital Values (%)

Sources: MSCI, Refinitiv, Capital Economics

UK Historical Context & Valuations

Chart 25: UK Official Interest Rate (%)

Chart 26: UK 10-Year Index Linked Bond Yield (%)

Chart 27: UK Datastream All-Share Cyclically-adjusted Price to Earnings (PE) Ratio

Chart 28: UK 10-Year A Corp. Bond Spread (bp)

Chart 29: Sterling Trade-weighted Index (2005 = 100)

Chart 30: Equity Earnings Yield Less 10 Yr Gilt Yield (ppts)

Chart 31: Equity Earnings Yield Less All-Property Yield (ppts)

Chart 32: All-Property Yield Less 10Y Gilt Yield (ppts)

Sources: Refinitiv, Bloomberg, Bank of England, Capital Economics

Forecast Table – Brexit Repeated Delays Scenario*

Table 1: Key Forecasts in Brexit Repeated Delays Scenario*

End period

Latest

(12th Aug)

Q3 2019f

Q4 2019f

Q1 2020f

Q2 2020f

Q3 2020f

Q4 2020f

Q4 2021f

Short interest rates (%)

Bank Rate

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.25

3-month LIBOR

0.76

0.80

0.80

0.80

0.80

1.00

1.10

1.50

Bond yields (%)

2 year yields

0.45

0.63

0.75

0.81

0.88

0.94

1.05

1.50

5 year yields

0.34

0.68

0.85

0.91

0.98

1.04

1.15

1.60

10 year yields

0.49

0.87

1.00

1.06

1.13

1.19

1.25

1.75

20 year yields

1.01

1.31

1.40

1.51

1.53

1.54

1.55

2.05

30 year yields

1.17

1.41

1.45

1.51

1.58

1.59

1.60

2.10

Yield curve (30s –2s, bps)

0.72

0.78

0.70

0.70

0.70

0.65

0.55

0.60

Exchange rates

$/£

1.21

1.25

1.25

1.26

1.28

1.29

1.30

1.35

Euro/£

1.08

1.12

1.19

1.17

1.16

1.14

1.13

1.17

BoE Trade-weighted index

74.5

76.7

79.4

79.3

79.3

79.2

79.2

81.8

Equity markets

FTSE 100

7215

7125

6800

6850

6900

6950

7000

7200

Commercial property market+

Rental value growth, % y/y

5.5

-0.5

-0.7

-0.5

-0.3

-0.1

0.1

1.2

End qtr equiv. yield, %

-1.4

5.6

5.7

5.8

5.8

5.9

5.9

6.0

Capital value growth, % y/y

-0.1

-2.9

-4.4

-4.1

-3.8

-3.5

-3.2

-1.0

Total return, % p.a

3.1

1.7

0.4

0.7

1.1

1.4

1.8

4.1

Sources: Refinitiv, Capital Economics

* Based on a scenario in which Brexit is repeatedly delayed. For more see our UK Economics Update “Pick your own Brexit forecast”, 1st July 2019.

+ Latest is Q2 2019

Forecast Table – Brexit Deal on 31st October Scenario*

Table 2: Key Forecasts in Brexit Deal on 31st October Scenario*

End period

Latest

(12th Aug)

Q3 2019f

Q4 2019f

Q1 2020f

Q2 2020f

Q3 2020f

Q4 2020f

Q4 2021f

Short interest rates (%)

Bank Rate

0.75

0.75

0.75

0.75

0.75

1.00

1.00

1.50

3-month LIBOR

0.76

0.80

0.80

0.80

1.00

1.10

1.10

1.60

Bond yields (%)

2 year yields

0.45

0.66

0.70

0.78

0.90

1.03

1.15

1.60

5 year yields

0.34

0.72

0.80

0.88

1.00

1.13

1.25

1.70

10 year yields

0.49

0.92

1.00

1.13

1.25

1.38

1.50

2.00

20 year yields

1.01

1.37

1.40

1.58

1.65

1.73

1.80

2.30

30 year yields

1.17

1.45

1.45

1.58

1.70

1.78

1.85

2.35

Yield curve (30s –2s, bps)

0.72

0.80

0.75

0.80

0.80

0.75

0.70

0.75

Exchange rates

$/£

1.21

1.25

1.25

1.28

1.30

1.33

1.35

1.40

Euro/£

1.08

1.12

1.19

1.19

1.18

1.18

1.17

1.22

BoE Trade-weighted index

74.5

76.72

79.8

80.2

80.5

80.9

81.2

84.3

Equity markets

FTSE 100

7215

7125

6800

6850

6900

6950

7000

7200

Commercial property market+

Rental value growth, % y/y

5.5

-0.5

-0.7

-0.3

0.2

0.6

1.0

1.6

End qtr equiv. yield, %

-1.4

5.6

5.6

5.6

5.7

5.8

5.9

6.0

Capital value growth, % y/y

-0.1

-2.9

-2.5

-2.7

-3.4

-3.1

-4.2

-0.8

Total return, % p.a

3.1

1.7

2.3

1.9

1.6

1.2

0.9

4.4

Sources: Refinitiv, Capital Economics

* Based on a “Deal on 31st October” Brexit Scenario. For more see our UK Economics Update “Pick your own Brexit forecast”, 1st July 2019.

+ Latest is Q2 2019

Forecast Table – Brexit No Deal Scenario*

Table 2: Key Forecasts in Brexit No Deal Scenario*

End period

Latest

(12th Aug)

Q3 2019f

Q4 2019f

Q1 2020f

Q2 2020f

Q3 2020f

Q4 2020f

Q4 2021f

Short interest rates (%)

Bank Rate

0.75

0.75

0.50

0.25

0.25

0.25

0.25

0.50

3-month LIBOR

0.76

0.60

0.40

0.40

0.40

0.40

0.40

0.60

Bond yields (%)

2 year yields

0.45

0.25

0.05

0.10

0.15

0.20

0.25

0.85

5 year yields

0.34

0.22

0.10

0.15

0.20

0.25

0.35

0.95

10 year yields

0.49

0.37

0.25

0.30

0.35

0.40

0.50

1.25

20 year yields

1.01

0.85

0.70

0.75

0.80

0.85

0.95

1.70

30 year yields

1.17

1.00

0.85

0.90

0.95

1.00

1.10

1.80

Yield curve (30s –2s, bps)

0.72

0.75

0.80

0.80

0.80

0.80

0.85

0.95

Exchange rates

$/£

1.21

1.20

1.15

1.16

1.18

1.19

1.20

1.25

Euro/£

1.08

1.08

1.05

1.04

1.04

1.04

1.04

1.09

BoE Trade-weighted index

74.5

74.0

71.4

71.6

71.8

72.0

72.2

75.2

Equity markets

FTSE 100

7215

7125

6800

6850

6900

6950

7000

7200

Commercial property market+

Rental value growth, % y/y

5.5

-0.5

-0.7

-0.8

-1.0

-1.3

-1.2

-0.5

End qtr equiv. yield, %

-1.4

5.6

5.9

5.9

5.9

6.0

6.0

6.0

Capital value growth, % y/y

-0.1

-2.5

-7.5

-7.9

-8.1

-7.9

-3.7

-0.2

Total return, % p.a

3.1

1.7

-2.4

-1.4

-0.4

0.6

1.5

5.0

Sources: Refinitiv, Capital Economics

* Based on a scenario in which the UK leaves the EU without a deal on 31st October. For more see our UK Economics Update “Pick your own Brexit forecast”, 1st July 2019.

+ Latest is Q2 2019


Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 20 7808 4693, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com
Gabriella Dickens, Assistant Economist, +44 20 3974 7421, gabriella.dickens@capitaleconomics.com
William Ellis, Research Economist, +44 20 7808 4068, william.ellis@capitaleconomics.com

Written by
Ruth Gregory Senior UK Economist
ruth.gregory@capitaleconomics.com +44 (0)20 7811 3913
Thomas Pugh UK Economist
thomas.pugh@capitaleconomics.com +44 (0)20 7808 4693
Andrew Wishart UK Economist
andrew.wishart@capitaleconomics.com +44 (0)20 7808 4062
Gabriella Dickens Assistant Economist
gabriella.dickens@capitaleconomics.com +44 (0)20 3974 7421
Capital Economics Economist Research Assistant
William.Ellis@capitaleconomics.com +44 (0)20 7808 4068