Policy to anchor gilt yields and to buoy equities - Capital Economics
UK Markets

Policy to anchor gilt yields and to buoy equities

UK Markets Outlook
Written by Paul Dales
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As a protracted economic recovery from the coronavirus crisis will force the Bank of England to keep interest rates close to zero and further expand its quantitative easing programme, gilt yields will probably stay very low for many years. And although UK equity prices are unlikely to return to their previous highs soon, the prospect of economic recovery and exceptional policy support should allow them to continue to reverse their previous declines. UK equities may even outperform those in the US. The big threat to risky assets, though, is a second wave of the virus. And something like a no deal Brexit at the end of this year could hold back the recoveries in UK equities and the pound.

  • As a protracted economic recovery from the coronavirus crisis will force the Bank of England to keep interest rates close to zero and further expand its quantitative easing programme (QE), gilt yields will probably stay very low for many years. And although UK equity prices are unlikely to return to their previous highs soon, the prospect of economic recovery and exceptional policy support should allow them to continue to reverse their previous declines. UK equities may even outperform those in the US. The big threat to risky assets, though, is a second wave of the virus. And something like a no deal Brexit at the end of this year could hold back the recoveries in UK equities and the pound.
  • Global & UK Overview – With April probably marking the low point for the economy, there is scope for most risky assets to continue their gradual recoveries from their previous precipitous declines.
  • Money Markets – The Bank of England’s liquidity facilities mean LIBOR spreads will continue to reverse the prior spike. Bank Rate is unlikely to be cut below 0%, but it will stay at 0.1% for a few years.
  • Bonds – Despite a surge in the supply of government debt and some fears of inflation, low official interest rates and further expansions of the Bank’s QE programme will anchor gilt yields for some years.
  • Equities – The economic recovery should help the financial, energy and materials sectors of the FTSE 100 to start performing better, thereby allowing UK equity prices to narrow the gap with US prices.
  • Sterling – The pound is likely to benefit from a further recovery in all risky assets, although the possibility of something like a no deal Brexit at the end of the year poses a downside risk.
  • Commercial Property – A big fall in rents and capital values is underway. And structural changes in demand caused by the coronavirus crisis will weigh on property returns in some sectors further ahead.
  • Historical Context & Valuations – These charts put current conditions into a historical context.
  • Key Forecasts Table – Our forecasts are based on the assumption that most of the restrictions put in place to contain the coronavirus will last until the end of June, that there is not a significant second wave of the virus and that the Brexit transition period is extended by a year from 31st December 2020.

Global & UK Overview

Risky assets to regain their shine

  • The combination of a protracted economic recovery from the coronavirus crisis and continued policy support should allow bond yields to stay close to their recent lows and equities to continue to claw back their losses.
  • Our forecasts that the global and UK economies have been hit very hard by the lockdowns imposed to contain the virus and that the recoveries will be sluggish assume that the lockdowns will be eased gradually and that there is not a second wave of the virus. We estimate that UK GDP fell by 25% from its peak to its trough and that by the end of 2022 it will still be 5% lower than otherwise. (See Chart 1.)
  • The gradual recovery will force central banks to keep interest rates close to zero for many years. The ECB and Bank of England will probably expand quantitative easing (QE) further too. Although government bond yields may edge up as the recovery gets going, loose policy and low inflation will hold them down. (See Chart 2.)
  • Policy support and further signs of economic recovery should enable equity prices and other risky assets to continue to reverse their previous declines. Equity indices are unlikely to return to their previous highs soon and the big rebound seen in the US reduces the scope for further gains there. There is more upside for equities in Europe and the UK. (See Chart 3.)
  • In contrast, a big fall in UK commercial property rents and capital values is still underway in response to the immediate drop in demand for property and the shifts that will permanently reduce demand in some sectors.
  • A second wave of the virus is a big threat to all risky assets. And the possibility of a no deal Brexit in December poses an extra downside for UK equities and the pound. (See Chart 4.)

Chart 1: Level of UK GDP (Q4 2019 = 100)

Chart 2: Government Bond Yields (%)

Chart 3: Equity Price Indices (1st January 2020 = 100)

Chart 4: Sterling Exchange Rates

Sources: Refinitiv, Bloomberg, Capital Economics


Money Markets

Looser for longer than the markets expect

  • We think that the Bank of England will need to loosen monetary policy further and keep it looser for longer than many forecasters and the financial markets expect.
  • The Bank of England’s liquidity provisions have prevented a further blow out in the money markets. Spreads of interbank interest rates over overnight interest rate swaps have narrowed, although they remain wider than a year ago and wider than in the euro-zone. (See Chart 5.) Even so, further policy action is not out of the question to ensure that there is ample liquidity and to help spreads to narrow further.
  • The MPC may be forced to further utilise its other policy levers too. Just like in the US, the markets are mulling over the possibility of UK rates falling into negative territory. (See Chart 6.) But given the resistance among MPC members towards cutting rates below zero, we doubt the Bank will go further than the cuts from 0.75% to 0.10% put in place in March. That said, in contrast to the financial markets, we think that the protracted nature of the recovery will mean that rates won’t rise above 0.10% for the foreseeable future. (See Chart 7.)
  • Instead, we think that any further monetary policy support will most likely take the form of more quantitative easing (QE). As such, we suspect that the MPC will soon start putting less emphasis on providing liquidity and more on using its asset purchase programme to try to prevent inflation from undershooting its target.
  • Our forecast is that the Bank will conduct more QE than many other forecasters expect, starting with a further £100bn of gilt purchases in June on top of the £200bn already announced. (See Chart 8.) And if anything, over the coming months and years, the MPC will probably end up doing far more.

Chart 5: Spread of 3-month LIBOR over OIS Rates (bps)

Chart 6: Market-Implied Path for Interest Rates in One Year’s Time Based on OIS Rates (%)

Chart 7: Expectations for Bank Rate (%)

Chart 8: Stock of QE (£bn)

Sources: Refinitiv, Bloomberg, HMT, Capital Economics


Bonds

Gilt yields going nowhere fast

  • Although government bond yields may rebound slightly over the next few years, they are likely to stay extremely low by historical standards as the Bank Rate remains at 0.10% and the Bank of England purchases large amounts of gilts.
  • Central Banks around the world were quick to use asset purchases to stamp out signs of financial stress in the market in mid-March. As a result, 10-year government bond yields are only fractionally above their record lows. (See Chart 9.) Admittedly, corporate bond yields remain elevated. (See Chart 10.) But this makes sense given the heightened risk of defaults. Indeed, we expect the number of corporate insolvencies to double in 2020 compared to 2019. What’s more, insolvencies remain high for a long time after a crisis, which may keep corporate bond yields elevated for a while.
  • In contrast, gilt yields are likely to remain low for three key reasons. First, the Bank Rate is likely to remain at 0.10% for the next few years. Second, the Bank has implied that it will use QE to stamp just as hard on any future spike in yields as it did in March. Third, it is likely that there will be additional rounds of QE, focused on buying gilts, to support the economy.
  • In addition, there are few fears about the ability of the government to repay its debts. The CDS premium on gilts is the same level it was a year ago. And the fall in the breakeven inflation rate means the market agrees with us that the unprecedented levels of policy support are unlikely to translate into a surge in inflation. (See Chart 11.)
  • As the economy starts to recover, government bond yields should start to rise as investors move into riskier assets. That said, gilt yields aren’t going to rise quickly. We do not expect 10-year yields to reach 0.50% again until the end of 2022. (See Chart 12.)

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

Chart 10: 10-Year Bond Yields (%)

Chart 11: Real Yields & Inflation Expectations (%)

Chart 12: Policy Rate & 10-Year Gilt Yield (%)

Sources: Refinitiv, Bloomberg, Capital Economics


Equities

Equity prices will continue to rise unless economic recovery is even weaker

  • Our forecast that the economy will recover in the second half of this year and that the MPC will extend quantitative easing means equities should continue to recover. That said, a more protracted recovery then we anticipate would limit any further increase in equity prices.
  • While the economic data is only just starting to reveal the scale of the fall in activity due to the virus lockdown, we do not think equities will suffer renewed declines. In previous recessions, equities have turned the corner before the economy. (See Chart 13.) This recession, although very large in GDP terms, should also be very short. In that context, it makes sense that the FTSE 100 has already reversed about a third of the 34% peak to trough fall that began in mid-February. And we expect it to regain a bit more ground by the end of the year.
  • What’s more, exceptional monetary policy support, including at least a further £100bn of quantitative easing, should provide extra support, just like previous bouts of gilt purchases have done. (See Chart 14.)
  • On top of that, we doubt that the underperformance of financials, energy and materials stocks that has held back the FTSE 100 compared to the S&P 500 will continue as economies recover. So there is scope for the recent widening in the gap between valuations of UK and US equities to reverse. (See Chart 15.) We expect the FTSE 100 to rise by 6% to 6,300 by year-end and to 6,900 in 2021, further catching up with the S&P 500. (See Chart 16.)
  • However, the risk is that equities don’t do that well and may even fall further if the economic recovery is weaker than we anticipate, perhaps due to another flare up in the virus or a hard Brexit at the end of 2020.

Chart 13: FTSE 100 (100 = Start of Recession)

Chart 14: FTSE 100 & Quantatitive Easing

Chart 15: Price to Earnings Ratio of UK & US Refinitiv Equity Indices

Chart 16: Equity Price Indices (Jan. 2020 = 100)

Sources: Refinitiv, Capital Economics


Sterling

Recent recovery likely to continue, but risks lie to the downside

  • We expect sterling’s recent appreciation to continue as the economic recovery begins later this year and an extension of the Brexit transition period is followed by a deal. However, we suspect that there is more downside risk for sterling than upside.
  • The pound was initially hit hard, falling by 12% against the US dollar to a low of $1.15, as investors shed risky assets. Indeed, given the UK’s reliance on external funding to finance its current account deficit, sterling is more vulnerable to negative investor sentiment than other currencies. But the pound has recovered to $1.22 as market sentiment has improved. And barring a flare-up in the pandemic, we think that this is likely to continue.
  • Admittedly, sterling has some history of remaining low after crises. But having already fallen sharply on the decision to leave the EU, the pound does not appear to have been overvalued going into this crisis, as it had been ahead of the 2008/09 Global Financial Crisis. (See Chart 17.) And the larger cut to US interest rates than UK interest rates may eventually provide some support to the pound relative to the dollar. (See Chart 18.)
  • At the same time, our assumption of an extension of the Brexit transition period for a year from 31st December 2020 and an eventual deal of some sort in late 2021, should give the pound a boost.
  • That’s why we expect sterling to rally to $1.30 and to €1.24 by the end of next year. (See Chart 19.) However, in the near-term the risks lie on the downside. Indeed, investors are once again placing more bets on sterling falling than rising. (See Chart 20.) That makes sense when the pound would be hit if there was another flare-up of the virus and/or if the UK left the EU without a trade deal at the end of 2020.

Chart 17: Sterling TWI (January 2005 = 100)

Chart 18: UK Less US 1-Year OIS Rate & $/£ FX Rate

Chart 19: Sterling Exchange Rate

Chart 20: Sterling Futures Net Position & $/£ Rate

Sources: Refinitiv, Bloomberg, Capital Economics


Commercial Property

Returns to slump this year

  • We forecast that commercial property returns will be negative this year as a result of a slump in rents and rising yields. But in line with the economic outlook, we expect a recovery to begin this year and run into 2021.
  • A sharp rise in equity yields means property looked more expensive relative to shares in Q1. (See Chart 21.) By contrast, a fall in gilt yields has widened the spread against property. In the near term, with investors highly risk averse, this premium versus gilts is unlikely to narrow.
  • Economic uncertainty and disruption from the lockdown will result in plummeting occupier demand. (See Chart 22.) With non-essential retailers still closed and the sector already in structural decline, retail will suffer the most.
  • As such, we think that all-property rents will fall this year. The worst of the drop will be concentrated in H1, with rents rebounding later in the year. (See Chart 23.) Indeed, retail closures are already accelerating rental declines. And while industrial and office rents have held up so far and are less exposed, we also expect them to decline in 2020 as a whole.
  • Despite low interest rates, we expect investor concern will push up all-property yields. Indeed, retail yields have already risen sharply in Q1. And we think that the other sectors will follow suit in Q2, though yields will peak mid-year and then start to inch lower as the economy gradually recovers. (See Chart 24.)
  • Overall, we expect all-property capital values to fall by 10% in 2020 as a whole. And despite a quick bounce back, values will remain below their pre-crisis peak for several years. In turn, we expect all-property returns to fall by 6% this year, before increasing by 11% in 2021.

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

Chart 22: RICS Surveyors Reporting a Rise in Commercial Property Occupier Demand (% Net Bal.)

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

Chart 24: All-Property Equivalent Yield (%)

Sources: MSCI, Refinitiv, RICS, 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

(14th May)

Q2 2020f

Q3 2020f

Q4 2020f

Q1 2021f

Q2 2021f

Q3 2021f

Q4 2021f

Q4 2022f

Short interest rates (%)

Bank Rate

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

3-month LIBOR

0.34

0.40

0.25

0.20

0.20

0.20

0.20

0.20

0.30

Bond yields (%)

2 year yields

-0.05

0.05

0.10

0.10

0.10

0.15

0.15

0.15

0.35

5 year yields

0.04

0.10

0.15

0.15

0.15

0.20

0.20

0.20

0.50

10 year yields

0.21

0.20

0.25

0.25

0.25

0.25

0.25

0.25

0.50

20 year yields

0.54

0.55

0.55

0.60

0.60

0.60

0.60

0.60

0.90

30 year yields

0.58

0.60

0.65

0.65

0.65

0.65

0.65

0.65

1.00

Yield curve (30s –2s, bps)

63

55

55

55

55

50

50

50

65

Exchange rates

$/£

1.22

1.24

1.24

1.25

1.27

1.28

1.29

1.30

1.30

Euro/£

1.13

1.13

1.13

1.14

1.17

1.19

1.21

1.24

1.24

BoE Trade-weighted index

77.6

78.1

78.3

78.9

80.6

81.7

82.5

84.1

84.1

Equity markets

FTSE 100

5904

6000

6150

6300

6450

6600

6750

6900

7650

Commercial property market

Rental value growth (% y/y)

-0.9+

-15.0

-7.0

-4.5

-3.2

13.6

4.2

2.2

1.6

End qtr equiv. yield (%)

5.7+

6.1

6.1

6.0

6.0

5.9

5.9

5.8

5.8

Capital value growth (% y/y)

-5.1+

-26.0

-16.3

-10.6

-6.9

22.0

10.3

5.9

2.1

Total return (% p.a)

-0.6+

-20.7

-11.0

-5.5

-1.7

27.1

15.3

10.7

7.0

Sources: Refinitiv, Capital Economics +Latest is Q4 2019

* Assumes that the restrictions on activity created by the coronavirus lockdown last for three months from late March to late June. Assumes the UK and the EU agree to extend the Brexit transition period for a year from 31st December 2020 and strike some sort of trade deal thereafter perhaps in a step-by-step approach. (See here.)


Paul Dales, Chief UK Economist, +44 7939 609 818, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 7568 378 042, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com
Prohad Khan, Property Economist, prohad.khan@capitaleconomics.com
James Yeatman, Research Economist, james.yeatman@capitaleconomics.com