Shaking off the underperformance - Capital Economics
UK Markets

Shaking off the underperformance

UK Markets Outlook
Written by Paul Dales
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UK assets are well placed to shake off their underperformance since the 2016 Brexit vote by outperforming global assets over the next couple of years. All risky assets will continue to be buoyed by the combination of a rapid global economic recovery from the COVID-19 crisis and global central banks running ultra-loose policy for many more years. But the UK’s more favourable valuations and its greater exposure to the sectors that are likely to benefit most from the recovery, such as consumer-facing, energy and financial, suggests that equities in the UK will rebound more rapidly than elsewhere. And a further improvement in global risk sentiment and a relative rise in UK interest rate expectations may mean the pound continues to strengthen, perhaps from $1.39 (€1.15) now to $1.45 (€1.16) this year. That would take the dollar/pound rate back to within a whisker of the level seen before the 2016 Brexit vote.

  • UK assets are well placed to shake off their underperformance since the 2016 Brexit vote by outperforming global assets over the next couple of years. All risky assets will continue to be buoyed by the combination of a rapid global economic recovery from the COVID-19 crisis and global central banks running ultra-loose policy for many more years. But the UK’s more favourable valuations and its greater exposure to the sectors that are likely to benefit most from the recovery, such as consumer-facing, energy and financial, suggests that equities in the UK will rebound more rapidly than elsewhere. And a further improvement in global risk sentiment and a relative rise in UK interest rate expectations may mean the pound continues to strengthen, perhaps from $1.39 (€1.15) now to $1.45 (€1.16) this year. That would take the dollar/pound rate back to within a whisker of the level seen before the 2016 Brexit vote.
  • Global & UK Overview – A growing tolerance for inflation means that central banks are unlikely to raise interest rates or unwind QE for many years even if the economic recovery is fast and full.
  • Money Markets – A further fading in expectations of more rate cuts from the Bank of England may lift LIBOR rates. But our view that the Bank won’t raise rates until 2026 implies they won’t rise much.
  • Bonds – Rising inflation expectations and real yields will probably push up 10-year gilt yields. But the Bank of England’s loose policies will probably prevent nominal yields from rising much above 1.00%.
  • Equities – Favourable UK valuations mean we are even less concerned about the recent speculative behaviour in some areas and that there is scope for UK equities to outperform their global rivals.
  • Sterling – The pound will benefit from any further improvement in risk appetite. It may also get an extra boost from a rise in UK interest rate expectations relative to those in the US and the euro-zone.
  • Commercial Property – Further declines in rents, especially in the retail sector, will limit the rebound in total returns this year. But in a low-yield world, property will look relatively attractive.
  • Historical Context & Valuations – These charts put current conditions into a historical context.
  • Key Forecast Table – Our financial market forecasts are underpinned by our economic forecasts, which assume that vaccines mean few COVID-19 restrictions are required beyond June. (See here.)

Global & UK Overview

Rapid recovery and loose policy a recipe for rising risky assets

  • Our forecast that monetary policy will stay ultra-loose for many years even as the economy enjoys a quick and full recovery from the COVID-19 crisis suggests that gilt yields will stay unusually low, UK equities will rise rapidly and the pound will continue to strengthen.
  • Our assumption that vaccines mean that few COVID-19 restrictions will be required beyond June largely explains why we think the recovery in UK GDP will be faster and fuller than most expect. Its fiscal stimulus means America’s recovery will be faster, while the slower vaccine rollout may hold back the recovery in the euro-zone. (See Chart 1.)
  • An increasing tolerance for inflation means that global central banks will keep policy loose for many years. Admittedly, fading expectations of further QE or rate cuts from the Bank of England may mean that 10-year gilt yields follow US yields higher by climbing from 0.58% to 1.00% by end-2022. (See Chart 2.) But we doubt the Bank will raise rates or unwind QE until 2026.
  • This combination of a rapid economic recovery and ultra-loose policy should be a boon for global equities. And its favourable valuations and bigger exposure to consumer-facing, energy and financial firms suggest the FTSE 100 will benefit more than other global indices. By the end of 2022, the FTSE 100 may have risen from 6,680 now to 8,250. (See Chart 3.)
  • With a no-deal Brexit no longer hanging over it, we suspect the pound will continue to be boosted by a further improvement in global risk sentiment and a rise in UK rate expectations relative to those in the US and the euro-zone. We are forecasting rises from €1.15 to €1.16 and from $1.39 to $1.45 by the end of this year. The latter would be the highest rate since the UK voted for Brexit in 2016. (See Chart 4.)

Chart 1: Real GDP (Q4 2019 = 100)

Chart 2: 10-Year Government Bond Yields (%)

Chart 3: Equity Price Indices

Chart 4: Pound Exchange Rates

Sources: Refinitiv, Capital Economics


Money Markets

Some upside to LIBOR rates, but super low rates are here to stay

  • A further fading in expectations of a cut in Bank Rate will probably lift LIBOR rates over the next 6-12 months. But our view that monetary policy will be looser for longer than the consensus and the markets expect means they won’t rise far.
  • Given the ample supply of liquidity in the market and few concerns about commercial banks’ ability to absorb losses, we are not expecting LIBOR spreads to widen from their current lows in 2021 and 2022. (See Chart 5.)
  • But we still think there is scope for market interest rate expectations to rise further this year relative to those in the US and euro-zone, which will put some upward pressure on LIBOR rates. (See Chart 6.) Admittedly, expectations for rate cuts have already faded since the MPC at its meeting on 4th February ruled out using negative rates in the next six months. (See Chart 7.) But if market rate expectations move towards our forecast that the MPC won’t need to cut interest rates or announce more QE either this year or next, then 12-year LIBOR rates may nudge up from 0.12% now to about 0.20%.
  • Even so, our view that Bank Rate won’t rise above +0.10% until 2026, rather than in 2023 as the markets expect (see Chart 7 again) implies that LIBOR rates won’t rise much further. And while the Bank is pondering whether to unwind QE or raise Bank Rate first when it comes round to tightening policy, the Bank’s signal that it will be more tolerant of inflation than before the crisis means that neither is likely for many years.
  • Overall, while we expect fading expectations of looser monetary policy to push up LIBOR rates, they are likely to stay close to their record lows until QE is unwound or Bank Rate rises in 2026. (See Chart 8.)

Chart 5: Spread of LIBOR Over OIS Rates (bps)

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

Chart 7: Bank Rate Expectations (%)

Chart 8: LIBOR Rates (%)

Sources: Refinitiv, Capital Economics


Bonds

Loose policy to keep a lid on gilt yields despite rapid rebound in UK economy

  • We have revised up our end-2022 10-year gilt yield forecast from 0.50% to 1.00% due to both rising inflation expectations and real yields. But extremely accommodative monetary policy will continue to anchor yields at very low levels. (See Chart 9.)
  • The UK looks less exposed to high inflation than the US, where break-even inflation rates have been boosted by expectations of a large fiscal stimulus.
  • However, our two-year ahead forecast for RPI inflation understates the scope for gilt yields to rise for two reasons. (See Chart 10.) First, the inflation compensation component also includes other factors, including term premia, which are likely to rise as the economy recovers and uncertainty fades. Second, a rise in actual inflation further out will creep into higher gilt yields at the long end and result in a steepening in the yield curve. (See Chart 11.)
  • At the same time, real yields are likely to rise if the markets swing round to our view that rather than being reduced to zero this year, Bank Rate will remain at 0.10%. We doubt the Bank of England will extend QE again either.
  • But our forecast that the Bank won’t raise interest rates or unwind QE until 2026 will anchor bond yields at very low levels by historical standards.
  • So despite a rapid rebound in the economy and a further rally in risky asset prices, accommodative monetary policy will prevent gilt yields from rising too much between now and the end of 2022. 10-year yields may rise to just 0.75% by the end of this year and to 1.00% by the end of 2022. (See Chart 12.)

Chart 9: UK & US 10-Year Government Bonds

Chart 10: UK 10-Yr Govt Break-even Rate & RPI Inflation

Chart 11: Gilt Yield Curve (bps)

Chart 12: Gilt Yields & Bank Rate (%)

Sources: Refinitiv, Bloomberg, Capital Economics


Equities

Equities to pick up their game in the second half of the year

  • A rapid economic recovery in the second half of this year should help UK equities outperform those in the US.
  • We are not concerned about the recent speculative behaviour in GameStop filtering through into a large fall in global equity prices as valuations are being supported by low interest rates. And in the UK, valuations look even more reasonable. (See Charts 13 & 14.) Indeed, one reason UK equities look so cheap is because they have significantly underperformed since the Brexit referendum in 2016. But there are now three key reasons to think that UK equities will start to outperform.
  • First, we expect oil prices to continue to rise to $70pb by the end of the year, which should benefit the energy-heavy FTSE 100 by more than the US S&P 500. (See Chart 15.)
  • Second, while lower interest rates are generally good for equity prices, there were concerns that negative interest rates could damage the profitability of banks, which have an especially high weighting in the FTSE 100. As the market is no longer pricing in negative rates and as the yield curve steepens, the prices of financial equities may start to recover faster.
  • Third, the rapid vaccine rollout in the UK has increased the chances that COVID-19 restrictions will start to be eased soon, which should help consumer-facing firms recover from the pandemic and boost their earnings. Indeed, the FTSE local index has outperformed the more international FTSE 100 recently. (See Chart 16.)
  • The upshot is that we expect the FTSE to rise from around 6,680 now to 7,500 by the end of the year, a 12% rise, compared to a 7% rise in the S&P 500.

Chart 13: Equity Indicies (19th Feb. 2020 = 100)

Chart 14: Equity Price/Earnings Ratios

Chart 15: Oil Price & FTSE 100

Chart 16: Equity Indices (1st Jan. 2020 = 100)

Sources: Refinitiv, Capital Economics


Sterling

Pound to get close to its pre-Brexit level in 2021

  • The pound may strengthen this year as riskier assets come back into fashion, the UK economy stages a rapid rebound and interest rate expectations in the UK rise.
  • Most of the recent strength in the pound was due to the signing of the Brexit deal between the UK and EU before Christmas and the weakness of the US dollar. (See Chart 17.) But even as these factors start to fade, there are at least three reasons to expect the pound to continue to appreciate.
  • First, the pound has been behaving more like a risky asset than a safe haven one since the start of the pandemic. Indeed, the correlation between the FTSE 100 and the pound has risen sharply since the start of 2020. (See Chart 18.) So even a small further rise in investor sentiment should benefit the pound.
  • Second, the rapid vaccine rollout in the UK has improved the economic outlook relative to its peers, especially in the EU. As a result, investors may start to favour UK assets over those elsewhere, putting upward pressure on the pound. (See Chart 19.)
  • Third, the Bank of England has recently backed away from using negative interest rates and, based on our forecasts at least, won’t expand its QE purchases. At the same time, the Fed and the ECB are likely to continue with their QE programmes for another year at least. This may push up UK rate expectations relative to those in the US and the euro-zone, driving up the pound. (See Chart 20.)
  • Overall, we have raised our forecast so that we now expect the pound to rise from $1.39 (€1.15) now to $1.45 (€1.16) by the end of 2021. That’s a little stronger than our previous forecast of $1.40 (€1.12) and it would be the highest level since the 2016 Brexit referendum.

Chart 17: US Dollar Index & $/£

Chart 18: Rolling 1-year Correlation between FTSE 100 & Sterling

Chart 19: GDP & Euro/£

Chart 20: Relative Rate Expectations & $/£

Sources: Refinitiv, Bloomberg, Capital Economics


Commercial Property

Capital values to fall again this year

  • Our forecasts that all-property total returns will improve from -2.3% last year to +4% and +6% in 2021 and 2022 respectively may mean that the average annual return from now until 2025 will be 5.5%. But while that would be weaker than the 7% average in the five years before the pandemic, in a low interest rate world it looks relatively attractive. (See Chart 21)
  • All-property rents fell by 3.1% in 2020 and despite the prospect of a strong economic recovery in the second half of this year, rents are unlikely to recover much. We have pencilled in a 1.6% fall in rents in 2021. This will be driven by further big falls in retail rents, as the legacy of lockdowns and online competition continue to bite. As part of these factors are structural, we think rents will continue to fall in 2022 albeit at a slower rate. (See Chart 22.)
  • All-property yields fell slightly in Q4 with a drop in industrial yields offsetting rises in office and retail. While there is likely to be upward pressure on property yields in the coming months, particularly in the shuttered retail and leisure sectors, we think all-property yields will end the year close to where they are now. With valuations favourable and the economy likely to be much healthier in 2022, yields may then edge lower. (See Chart 23.)
  • Capital values fell by 6.6% in 2020, which was a modest drop given the dire economic backdrop. The weak rental outlook points to a further 1% decline in 2021. What’s more, as a lot of the factors that are undermining rents in the retail and office sectors since the start of the pandemic are here to stay (i.e. the shift to spending online and to working from home), we don’t expect capital values to return to pre-pandemic levels before 2025. (See Chart 24.)

Chart 21: All-Property Total Returns (% Per Annum)

Chart 22: Property Rental Values (% y/y)

Chart 23: Property Yields by Sector (%)

Chart 24: All-Property Capital Values (% y/y)

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 Price to Earnings Ratio

Chart 28: UK A-Rated Corporate Bond Spread (bps)

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

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

Chart 31: Equity Earnings Yield Less Commercial Property Yield (ppts)

Chart 32: 10-Year Gilt Yield Less Commercial Property Yield (ppts)

Sources: Refinitiv, Bank of England, Capital Economics


Key Forecast Table

Table 1: Key Forecasts*

End period

Latest

(12th Feb.)

Q1 2021

Q2 2021

Q3 2021

Q4 2021

Q1 2022

Q2 2022

Q3 2022

Q4 2022

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

0.05

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

Bond yields (%)

2 year yields

0.02

0.05

0.05

0.05

0.05

0.10

0.20

0.25

0.30

5 year yields

0.15

0.20

0.25

0.35

0.40

0.45

0.55

0.60

0.65

10 year yields

0.54

0.55

0.60

0.70

0.75

0.80

0.90

0.95

1.00

20 year yields

0.99

1.00

1.05

1.15

1.20

1.30

1.45

1.55

1.65

30 year yields

1.11

1.10

1.20

1.25

1.30

1.40

1.55

1.65

1.75

Yield curve (30s –2s, bps)

109

105

115

120

125

130

135

140

145

Exchange rates

1.38

$/£

1.39

1.40

1.43

1.45

1.45

1.45

1.45

1.45

Euro/£

1.14

1.14

1.15

1.15

1.16

1.16

1.16

1.16

1.16

BoE trade-weighted index

80.4

80.4

80.9

81.4

81.9

81.9

81.9

81.9

81.9

Equity markets

FTSE 100

6590

6680

6950

7230

7500

7690

7880

8060

8250

Commercial property market+

Rental value growth (% y/y)

-3.1

-3.1

-2.2

-1.5

-1.2

-0.6

-0.3

-0.1

0.5

End qtr equiv. yield (%)

5.8

5.8

5.8

5.8

5.8

5.8

5.8

5.8

5.8

Capital value growth (% y/y)

-6.6

-4.4

-1.6

-0.7

-0.7

0.0

0.3

0.7

1.3

Total return (% p.a)

-2.3

0.4

3.0

3.6

4.0

4.7

5.0

5.4

6.0

Sources: Refinitiv, Capital Economics +Latest is Q4 2020


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
Thomas Pugh, UK Economist, +44 (0)7568 378 042, thomas.pugh@capitaleconomics.com
Prohad Khan, Property Economist, prohad.khan@capitaleconomics.com
Jack France, Research Economist, jack.france@capitaleconomics.com