Markets underestimate euro-zone threat

Despite further large falls in gilt yields and little overall change in equity prices over the last quarter, we doubt that markets have fully appreciated the likely impact of the euro-zone debt crisis on the UK economy. Indeed, if the recession that we now expect in the UK comes to pass, equity prices seem set to fall again, given that the market currently expects only a modest fall in corporate profits next year. What’s more, although renewed recession would cause the outlook for the public finances to deteriorate further, the Government’s commitment to fiscal austerity, reaffirmed in the recent Autumn Statement, should enable gilts to benefit from further safe-haven demand. More QE and a sharp drop in inflation should also help gilt yields to grind lower.