Markets may be caught out on interest rates - Capital Economics
UK Markets

Markets may be caught out on interest rates

UK Markets Outlook
Written by Paul Dales
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We think the financial markets will be caught out this year by a decent acceleration in the quarterly rate of GDP growth preventing interest rates from being cut below 0.75%. And if we are right to assume that the UK and the EU will reach a fudge or compromise to prevent a major change in their relationship at the end of the year, then interest rates may even be raised to 1.00% next year. That’s why we think gilt yields will rise from 0.60% now to 1.25% by the end of next year, the pound will climb from $1.30 to $1.40 and UK equity prices will outperform their international peers.

  • We think the financial markets will be caught out this year by a decent acceleration in the quarterly rate of GDP growth preventing interest rates from being cut below 0.75%. And if we are right to assume that the UK and the EU will reach a fudge or compromise to prevent a major change in their relationship at the end of the year, then interest rates may even be raised to 1.00% next year. That’s why we think gilt yields will rise from 0.60% now to 1.25% by the end of next year, the pound will climb from $1.30 to $1.40 and UK equity prices will outperform their international peers.
  • Global & UK Overview – A subdued global economic recovery means that asset returns in the major overseas markets will probably be fairly modest both this year and next.
  • Money Markets – There is scope for market interest rate expectations to rise as we don’t think the MPC will deliver the cut in rates from 0.75% to 0.50% that the financial markets are expecting.
  • Bonds – An improving economic outlook and rising interest rate expectations will probably result in gilt yields rising by more than global bond yields over the next couple of years.
  • Equities – Some sort of fudge or compromise on the UK and the EU’s future relationship may allow valuations of UK equities to catch up with valuations of overseas equities.
  • Sterling – As the negotiations between the UK and the EU will probably be tough and long, the pound will have a bumpy year. But it could surprise on the upside late this year and next year.
  • Commercial Property – We expect commercial property values to decline again this year, largely as a result of weakness in the retail sector
  • Historical Context & Valuations – These charts put current conditions into a historical context.
  • Key Forecasts Table– While we wouldn’t rule out the UK and the EU failing to reach any agreement before the status-quo transition period ends on 31st December 2020, our forecasts are based on the more likely outcome that some kind of compromise prevents a major change in trading arrangements.

Global & UK Overview

Subdued global economy leads to modest global asset returns

  • While we expect that the falls in global equity prices and bond yields triggered by the coronavirus will continue to be reversed (see Chart 1), subdued and uneven global economic growth will restrain returns in overseas markets this year. In contrast, we believe that the UK economy will perform better than most expect.
  • We suspect that the effects of coronavirus will delay rather than derail the global economic recovery. But that recovery will be modest as the boost from stronger growth in the US economy is tempered by weaker growth in China and hardly any improvement at all in the euro-zone. (See Chart 2.)
  • Central banks in the euro-zone and China will probably loosen monetary policy by more than the markets expect. But with the Fed unlikely to cut interest rates again, global bond yields are more likely to edge up than fall further. (See Chart 3.) Without a boost from much lower expected interest rates, equity prices in most markets will rise only modestly. (See Chart 4.)
  • There is scope for UK markets to stand out from the crowd. The negotiations over the UK’s new relationship with the EU will be tough, bumpy and long. And the risk that nothing is agreed should not be ignored. But the most likely scenario is that a fudge or compromise prevents a big change in trading arrangements.
  • In any case, a further loosening of fiscal policy in March’s Budget is the main reason why we suspect GDP growth will surpass the consensus forecast by accelerating from 1.0% this year to 1.8% in 2021. That’s why we think the next move in UK interest rates will be up, 10-year yields will climb to 1.25% next year, the pound will rebound to $1.40 in 2021 and UK equities will outperform their international peers.

Chart 1: US Equity Prices & 10-Year Bond Yield (%)

Chart 2: GDP (%y/y)

Chart 3: 10-Year Government Bond Yields (%)

Chart 4: Equity Prices (1st January 2015=100)

Sources: Refinitiv, Bloomberg, Capital Economics


Money Markets

Interest rates will surprise investors on the upside

  • Whereas investors expect interest rates to be cut this year, we think the economy will improve enough for the MPC to leave rates at 0.75%. And investors may get a further surprise in 2021 when we think the MPC will raise rates to 1.00%.
  • Most of the fall in short-term interbank rates before the January MPC meeting has been reversed as anticipation of a cut in interest rates from 0.75% to 0.50% proved misplaced, as we had forecast. (See Chart 5.) Nonetheless, interbank rates are still below their levels at the start of the year. That’s partly because fears over the coronavirus have pulled down rate expectations everywhere. (See Chart 6.)
  • Mainly, though, it is because investors think that a sluggish economic performance in the UK will cause the MPC to cut rates to 0.50% later this year. The MPC noted that “policy might need to reinforce the expected recovery in UK GDP growth” in the January minutes, but we think that will be unnecessary. The rise in the all-sector PMI in January suggests that the economy has moved out of the territory associated with interest rate cuts. (See Chart 7.)
  • Moreover, if we are right in expecting there to be no major step change in the UK-EU relationship at the end of this year, fiscal policy to provide a decent boost to the economy, and the global economy to improve then the MPC would need to raise interest rates to 1.00% in 2021. That would be a major surprise to the markets, which are pricing in a cut in interest rates to 0.50% this year and interest rates staying there in 2021. (See Chart 8.)

Chart 5: LIBOR (%)

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

Chart 7: All-Sector PMI & Changes in Bank Rate

Chart 8: Expectations for Bank Rate (%)

Sources: Refinitiv, IHS Markit, Bloomberg, Capital Economics


Bonds

Strengthening UK economy will push up gilt yields

  • Our forecast for an acceleration in GDP growth, a rise in interest rates, and an improvement in the global backdrop suggests that gilt yields will rise over the next two years.
  • Assuming the spread of coronavirus is curbed and global growth starts to recover, as we expect, the downward pressure on gilt yields from lower global bond yields should ease this year. We think that the US Treasury yield will rise from 1.6% now to 2.0% by the end of the year.
  • Domestic factors will also push up gilt yields. Admittedly, our forecast of 1.0% GDP growth in 2020 is in line with the consensus. But we expect GDP growth to increase to 1.8% in 2021 (consensus 1.5%), which would put further upward pressure on gilt yields. (See Chart 9.)
  • The rise in interest rates from 0.75% to 1.00% in 2021 that we think will result from stronger UK growth, while rates in the US remain unchanged, suggests that the gap between gilt yields and US Treasury yields will narrow a bit further. (See Chart 10.)
  • But we don’t think a fiscal stimulus and inflation fears will put extra upward pressure on gilt yields. Debt servicing costs are very low, so there is no question that government debt is sustainable. And while investors initially revised up their inflation expectations in the US in anticipation of the Trump fiscal stimulus, in the event inflation didn’t rise and the move was reversed. (See Chart 11.) If anything, investors’ inflation expectations for the UK already look a bit too high.
  • All told, we think that the 10-year gilt yield will rise from around 0.60% now to around 1.00% by the end of this year and to around 1.25% in 2021. (See Chart 12.)

Chart 9: GDP Forecasts & 10-Year Gilt Yield

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

Chart 11: 10-Year Break-Even Inflation Rates (%)

Chart 12: 10-Year Government Bond Yields (%)

Sources: Refinitiv, Bloomberg, Capital Economics


Equities

Equities to outperform international rivals as Brexit fears fade

  • The short-term outlook for UK equities depends heavily on the impact of the coronavirus on the global economy. However, there are plenty of reasons to think that UK equities will outperform international equities over the next few years.
  • The outbreak of the coronavirus has taken some of the shine off UK equities since the 5% jump after December’s election. Indeed, at its most recent nadir the FTSE 100 was almost back at its pre-election level. (See Chart 13.) As the virus has triggered a $10 per barrel (16%) fall in the price of oil since mid-January, it is mainly the share prices of commodity and transportation firms that have been hardest hit. (See Chart 14.)
  • But looking past the short-term impact of the coronavirus, UK equities are likely to outperform their international counterparts over the next few years for two reasons.
  • First, the valuation of UK equities is still much lower than before the EU referendum, whereas valuations in other developed markets are the same or higher. (See Chart 15.) As the uncertainty around Brexit fades, this valuation gap should close. 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%. Second, an acceleration in UK GDP growth from 1.0% this year to 1.8% next year should boost UK equity prices.
  • Overall, we forecast the FTSE 100 to rise from around 7,500 now to about 8,000 by year-end, and to around 8,700 by the end of 2021. That is a much larger rise in percentage terms (15%) than we expect from most other developed market equity indices. (See Chart 16.)

Chart 13: UK Equity Indices (1st Jan. 2018 = 100)

Chart 14: Change in FTSE All Share Sector Since 20th January (%)

Chart 15: Forward Price/Expected Earnings Ratios of MSCI Indices

Chart 16: Change in MSCI Indices by End-2021, CE Forecast (%)

Sources: Refinitiv, Bloomberg, Capital Economics


Sterling

Another bumpy year, but sterling could still surprise on the upside

  • As the negotiations between the UK and the EU will probably be tough and long, 2020 is likely to prove to be another bumpy year for the pound. But sterling could still surprise on the upside later this year and in 2021.
  • While the election result has led to a revival in economic activity and reduced uncertainty about sterling (see Chart 17), we doubt the pound will rise much as long as there remains the possibility of the UK trading with the EU on WTO terms at the end of the year. Indeed, in that scenario, sterling could drop significantly, possibly to $1.15 (€1.05) or a bit below.
  • Meanwhile, judging by the net-long positions now held in sterling, investors have already become much more positive about the pound. (See Chart 18.) So sterling is unlikely to receive another big lift from this source.
  • Nonetheless, we still think that sterling will end the year at $1.35, up from $1.30 at present as the UK and the EU agrees some sort of fudge that avoids a step change in the UK’s relationship with the EU in 2021. If Brexit uncertainty fades and the Bank of England raises interest rates in 2021, as we expect, then we think there is scope for sterling to rise further next year. Indeed, the shrinking interest rate differential between the UK and the US in 2021 suggests that sterling could jump to $1.40 by the end of that year. (See Chart 19.)
  • Meanwhile, since we expect the US dollar to appreciate against most currencies over the next couple of years as the US economy performs better than elsewhere, sterling will probably rise by more against other currencies. Against the euro we expect it to reach €1.29 by the end of 2020 and €1.33 by the end of 2021. (See Chart 20.)

Chart 17: Sterling Volatility & Business Investment

Chart 18: $/£ & “Speculative” Positioning

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

Chart 20: Sterling Exchange Rate

Sources: Refinitiv, Bloomberg, Capital Economics


Commercial Property

Capital values to fall again this year

  • We expect that commercial property values will decline again this year, largely as a result of continued weakness in the retail sector.
  • Commercial property is likely to remain good value compared to other assets. Admittedly, there were mixed movements in valuation measures during Q4. The dividend yield for equities fell slightly improving the spread against property. By contrast, there was a rise in bond yields relative to property yields. (See Chart 21.)
  • As we expect uncertainty surrounding trade negotiations to linger for most of the year, property investment is unlikely to recover this year. Despite a pick-up in transactions in the second half of last year, investment values fell to £49.6bn in 2019 from £64.6bn in 2018. (See Chart 22.) This drop was largely due to a decline in office purchases.
  • Looking ahead, we expect all-property rental values to decline this year. This is largely the result of further declines in retail as demand continues to move online, as well as slowing rental growth in the industrial sector as supply increases. (See Chart 23.)
  • A continued fall in capital values in the retail sector this year will put upward pressure on all-property yields in 2020. A rise in interest rates is likely to bring a more broad based, but smaller, increase in yields across all sectors during 2021. (See Chart 24.)
  • Overall, we expect all-property capital values to start falling at a slower pace, by around 2% this year and not at all in 2021. In turn, we think that will mean all-property total returns will recover this year and next. But at around 3% and 5% respectively, returns will be modest by historical standards.

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

Chart 22: Value of Deals Completed (£bn per quarter)

Chart 23: Sector Rental Values (% y/y)

Chart 24: All-Property Equivalent Yield (%)

Sources: MSCI, Refinitiv, Property Archive, 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


Key Forecast Table

Table 1: Key Forecasts*

End period

Latest

(11th Feb.)

Q1 2020f

Q2 2020f

Q3 2020f

Q4 2020f

Q1 2021f

Q2 2021f

Q3 2021f

Q4 2021f

Short interest rates (%)

Bank Rate

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.00

1.00

3-month LIBOR

0.75

0.80

0.80

0.90

0.90

1.00

1.10

1.10

1.20

Bond yields (%)

2 year yields

0.51

0.60

0.65

0.70

0.75

0.80

0.90

0.95

1.00

5 year yields

0.43

0.65

0.70

0.75

0.80

0.85

0.95

1.00

1.05

10 year yields

0.60

0.85

0.90

0.95

1.00

1.05

1.15

1.20

1.25

20 year yields

0.97

1.25

1.30

1.35

1.40

1.40

1.45

1.50

1.55

30 year yields

1.05

1.30

1.35

1.40

1.45

1.45

1.50

1.55

1.60

Yield curve (30s –2s, bps)

0.54

70.0

70.0

70.0

70.0

65.0

60.0

60.0

60.0

Exchange rates

$/£

1.30

1.30

1.31

1.33

1.35

1.36

1.38

1.39

1.40

Euro/£

1.19

1.19

1.22

1.24

1.29

1.30

1.31

1.32

1.33

BoE Trade-weighted index

80.4

80.4

82.0

83.5

86.0

86.7

87.4

88.1

88.9

Equity markets

FTSE 100

7499

7550

7700

7850

8000

8150

8350

8500

8700

Commercial property market+

Rental value growth (% y/y)

-0.6

-0.5

-0.6

-0.3

-0.3

0.1

0.4

0.8

1.2

End qtr equiv. yield (%)

5.6

5.8

5.9

6.0

5.7

5.7

5.8

5.8

5.8

Capital value growth (% y/y)

-3.3

-2.9

-2.5

-2.2

-1.8

-1.3

-0.7

-0.2

0.3

Total return (% p.a)

3.1

1.7

2.1

2.6

3.1

3.6

4.2

4.7

5.3

Sources: Refinitiv, Capital Economics

+ Latest is Q4 2019

* Assumes the UK and the EU agree some kind of fudge that means there is not a big step change in their relationship on 31st December 2020. See our UK Economic Outlook, “Turning the corner”, 28th January 2020.


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
James Yeatman, Research Economist, +44 20 7808 4694, james.yeatman@capitaleconomics.com