Time to shine - Capital Economics
UK Markets

Time to shine

UK Markets Outlook
Written by Paul Dales
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UK assets may outperform overseas assets over the next year or two even though the UK’s economic recovery from the coronavirus crisis may take longer. We think that a larger expansion in the Bank of England’s quantitative easing (QE) programme than the markets expect will contribute to 10-year gilt yields declining from 0.22% now to 0.15% by the end of the year. And as we doubt the Bank will raise interest rates above 0.10% for five years, gilt yields will stay at record lows for many years. Meanwhile, the sectoral make-up of the FTSE 100 and the sensitivity of the pound to global risk sentiment suggests that both will outperform as the global economy continues to recover. And if some sort of Brexit deal is agreed by the end of the year, then UK equities will get an extra boost and the pound may climb from $1.31 to $1.35. Of course, if there is a major second wave of the virus or a no deal Brexit then UK assets will underperform.

  • UK assets may outperform overseas assets over the next year or two even though the UK’s economic recovery from the coronavirus crisis may take longer. We think that a larger expansion in the Bank of England’s quantitative easing (QE) programme than the markets expect will contribute to 10-year gilt yields declining from 0.22% now to 0.15% by the end of the year. And as we doubt the Bank will raise interest rates above 0.10% for five years, gilt yields will stay at record lows for many years. Meanwhile, the sectoral make-up of the FTSE 100 and the sensitivity of the pound to global risk sentiment suggests that both will outperform as the global economy continues to recover. And if some sort of Brexit deal is agreed by the end of the year, then UK equities will get an extra boost and the pound may climb from $1.31 to $1.35. Of course, if there is a major second wave of the virus or a no deal Brexit then UK assets will underperform.
  • Global & UK Overview – Global influences will support UK equities, boost the pound and help anchor gilt yields. UK-specific influences will provide an extra kick too. (Page 2.)
  • Money Markets – The upward influence of the fading chances of negative interest rates will be offset by the downward influence from more QE than is priced in to leave LIBOR rates at very low levels. (Page 3.)
  • Bonds – We have revised down our forecasts for 10-year gilt yields from 0.25% to 0.15% for the next few years based on our view that the Bank of England will use much more QE to keep policy loose. (Page 4.)
  • Equities – After underperforming while the global economy was collapsing, we think UK equities will catch up as it continues to recover. A Brexit deal would give UK equity valuations an extra lift. (Page 5.)
  • Sterling – A further recovery in global risk appetite and a Brexit deal would boost the pound relative to other developed market currencies. But a no deal Brexit would hit it hard. (Page 6.)
  • Commercial Property – The sharp downturn in the retail sector will contribute to all-property total returns falling by almost 4.5% in the year to Q4 2020. (Page 7.)
  • Historical Context & Valuations – These charts put current conditions into a historical context. (Page 8.)
  • Key Forecasts Table – Our forecasts assume that there are some renewed lockdowns to contain localised outbreaks of the virus, but that there is not a second wave that leads to another nationwide lockdown. They also assume that later this year the UK and the EU agree a slim trade in goods Brexit deal, with the status quo for services and financial services being maintained until a later date. (Page 9.)

Global & UK Overview

UK-specific influences add to support from overseas

  • Despite the prospect of the UK’s recovery from the crisis being slower than in the US and the euro-zone (see Chart 1), there is scope for UK equities and the pound to outperform.
  • Our forecasts that global economic activity will continue to recover and that both fiscal and monetary policy will remain ultra-loose around the world are consistent with investors’ risk appetite continuing to grow.
  • That should allow global equity prices to continue to recoup the heavy losses endured earlier in the year and result in the US dollar weakening a bit further, from €1.18 now to €1.20 by the end of the year. (See Chart 2.)
  • And although we don’t expect the ECB or the Fed to cut interest rates, both central banks will probably expand their balance sheets by even more than they have already done by announcing more asset purchases. (See Chart 3.) As such, global government bond yields probably won’t rise from their current record lows for a number of years. (See Chart 4.)
  • Our forecasts that the UK’s economic recovery will be slower than elsewhere and that the Bank of England will yet expand quantitative easing by a further £250bn suggests that 10-year gilt yields may fall back from 0.22% to 0.15%.
  • Global factors will support UK equities and the pound. But both would get an extra boost if we are right in expecting some form of Brexit deal to be agreed by the end of the year. UK equities would then catch up with those overseas and the pound may climb from $1.31 now to $1.35.
  • The risk is that a second wave of the virus and/or a no deal Brexit holds back UK equity prices and sends the pound plunging again.

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

Chart 2: S&P 500 Equity Price Index $/€ Exchange Rate

Chart 3: Total Assets (January 2020 = 100)

Chart 4: 10-Year Government Bond Yields (%)

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


Money Markets

Interest rates going nowhere fast

  • Both official interest rates and money market rates are likely to remain extremely low for at least the next five years as the Bank of England loosens monetary policy further.
  • The Bank of England has largely done its job as far as providing liquidity to the market is concerned. LIBOR spreads have now fallen back to their pre-crisis levels or below in the case of shorter maturities. (See Chart 5.) And given the ample supply of liquidity in the market and little concern about commercial banks’ ability to absorb losses, we doubt spreads will widen anytime soon.
  • But we still expect the MPC to loosen policy further to support demand. Unlike the market, though, we do not expect the MPC to cut rates from +0.10% to below zero. (See Chart 6.) Rate expectations have already risen since the MPC said at its meeting on 5th August it was not planning to use negative rates soon. A further rise may lift them relative to those in the US and euro-zone, and put some upward pressure on UK LIBOR. (See Chart 7.)
  • That said, part of the markets’ expectations for negative interest rates could be explained by traders betting on more QE. If so, our forecast that the MPC will announce more QE than the market expects (we think it will announce another £250bn in total) will be a downward influence on LIBOR rates. (See Chart 8.)
  • Overall, we think that the upward pressure on LIBOR rates caused by the declining probability of negative interest rates will be offset by the Bank of England committing to much more QE than the market currently expects. As a result, LIBOR rates could remain close to their record low levels for another five years or so.

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

Chart 6: Bank Rate Expectations (%)

Chart 7: Interest Rate Expectations (%)

Chart 8: Forecasts for the Stock of QE Purchases (£bn)

Sources: Refintiv, Bank of England, Capital Economics


Bonds

Gilt yields to stay close to zero

  • Extremely low interest rates, further quantitative easing and subdued inflation will keep gilt yields close to zero for many years.
  • As investors price in a slow recovery and further policy support, we expect 10-year gilt yields to fall back from 0.22%. The MPC’s message that it won’t tighten policy until it is clear that inflation will reach the 2% target supports our forecast that Bank Rate won’t rise above +0.10% for the next five years. That should anchor 10-year gilt yield close to 0.15% for a number of years. (See Chart 9.)
  • The Fed’s signal that it too will only tighten policy once inflation has picked up limits the risk of rising US yields dragging up gilt yields.
  • We don’t think inflation or default risk will raise gilt yields either. The Bank already owns 38% of the gilt market, and we expect its stock of QE to rise to £995bn over the next couple of years. (See Chart 10.) That will support demand for gilts and diminish the risk of the government being unable to roll over its debt.
  • If anything, investors may revise down their inflation expectations, which have been steady so far despite the recession. But we think weak demand will cause inflation to undershoot the Bank’s 2% target for a few years, despite the surge in the money supply. (See Chart 11.)
  • Meanwhile, low interest rates, the economic recovery and a further rise in risky asset prices should allow corporate bond spreads to narrow back to pre-virus levels. (See Chart 12.)
  • A second wave of the virus or a no deal Brexit could yet undermine the recovery and cause gilt yields to fall even further, as that may be enough to prompt the Bank to use negative interest rates after all.

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

Chart 10: Gilt Issuance & BoE Purchases (£bn)

Chart 11: 10-Year Gilt Yield (%)

Chart 12: FTSE 100 & Corporate Bond Spread (%)

Sources: Refinitiv, Bloomberg, Capital Economics


Equities

Equity prices to shrug off the weak recovery

  • Despite the UK economic recovery lagging behind the recovery in other developed countries, UK equities could still outperform over the next few years. However, a breakdown in the Brexit negotiations or a second surge in virus cases could scupper this recovery.
  • UK equities have underperformed other developed markets by a wide margin during the recovery so far. (See Chart 13.) However, some of the factors which have held back UK equities over the past 12 months could be the same ones which enable it to catch up over the next few years.
  • Admittedly, the UK’s long and slow economic recovery will not help equities bounce back. But exceptional monetary policy support, including a further £250bn of QE, should provide an extra boost. Previous bouts of QE have certainly helped equities. (See Chart 14.)
  • And the FTSE 100 is tilted towards sectors like consumer discretionary, energy, materials and financials, which we think will fare best as economic activity slowly normalises. What’s more, the slim Brexit deal that we are expecting should help to close the valuation gap between UK and US equities and help the FTSE Local in particular. (See Charts 15 & 16.) As a result, we expect the FTSE 100 to rise by 13% to 7,100 by year-end and to 7,900 in 2021. That’s a lot better than the 4% rise we expect in the S&P 500 over the next two years.
  • However, there are two major downside risks. First, a flare up in virus cases could cause further lockdowns and harm corporate earnings. Second, a no deal Brexit at the end of 2020 could hammer investor sentiment, just as firms are already grappling with the unwinding of the coronavirus government support.

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

Chart 14: FTSE 100 Equity Index

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

Chart 16: Probability of an EU-UK No Deal & FTSE Local

Sources: Refinitiv, Capital Economics


Sterling

Scope for the pound to rise further, but risks skewed to the downside

  • A slim Brexit deal by the end of the year and a continued recovery in all risky assets suggests that sterling has further to climb. But the near-term risks are skewed heavily to the downside.
  • We suspect that the growing appetite for risky assets, which has caused the dollar to weaken and the pound to strengthen from $1.25 at the end of June to $1.31, has a bit further to run. Indeed, the political risks associated with Brexit and the UK’s reliance on external funding to finance its current account deficit explains why the pound has behaved more like a “risky” currency. As a result, it has been more sensitive to changes in global equity prices. (See Chart 17.) Our forecast for a 3% rise in global equity prices by end-2020 is consistent with sterling rising by a further 1% or so, to $1.32.
  • But the biggest driver of the pound over the rest of the year will be Brexit. Some of sterling’s decline from €1.15 at the start of May to €1.11 has been driven by the strengthening in the euro triggered by the EU’s €750bn recovery fund. But part of it is due to the fall in the chances of an extension to the transition period beyond 31st December. (See Chart 18.) If there is a slim trade deal by end-2020, as we expect, then we think there is scope for the pound to rise to $1.35 and to €1.13 by year-end and stay there in 2021 and 2022. (See Chart 19.)
  • These forecasts are based on a continued economic recovery and an orderly resolution to Brexit. So if there is a second wave of the virus, sterling would probably fall, albeit by less than the 10% fall in March. And if the Brexit transition period ends without a trade deal (we put the chances of this at about 30%), we think the pound would slump by about 12% to $1.15. Perhaps it is not too surprising then that in response to the growing downside risks, investors have begun to place more bets on sterling falling rather than rising. (See Chart 20.)

Chart 17: Sensitivity of Currencies to Changes in Global Equity Prices in 2020

Chart 18: Prob. of Transition Period Extension & €/£

Chart 19: Sterling Exchange Rates

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

Sources: Refinitiv, Bloomberg, Capital Economics


Commercial Property

No respite for rents

  • We think that the sharp downturn in the retail sector will continue to weigh heavily on all-property capital values, which we expect to fall further in the second half of the year.
  • With investors still highly risk averse, commercial valuations seem high. The decline in dividend yields has reduced the spread between equity and property yields. (See Chart 21.) In contrast, thanks to record low policy rates, property looks cheap compared with gilts.
  • Surveyors’ expectations for rents have fallen dramatically this year. (See Chart 22.) But this has yet to be reflected in the rental data. Even though GDP is now recovering, output and employment will remain well below their pre-virus levels for 12-18 months yet. This means occupiers will continue to struggle and we think this will lead to further falls in rents in the coming quarters.
  • As the shift to online shopping accelerates, retail will be the main driver of the decline in rents. In contrast, strong online sales will support industrial demand and we expect rents in this sector to hold up this year. A weak outlook for employment is set to drive a drop in office rents this year, albeit by less than in previous economic downturns.
  • Given the weak rental outlook and the rise in risk premia, we expect all-property yields to be 50bps higher than pre-virus by the end of the year. (See Chart 23.)
  • Overall, we think that capital values will decline by 9.5% in the year to Q4 2020, leaving total returns down by 4.4%. (See Chart 24.) Despite values starting to recover next year, we think they will remain below their pre-crisis peak until the end of 2022.

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

Chart 22: RICS Surveyors’ Rental Expectations (% Net Balance)

Chart 23: All-Property Equivalent Yield (%)

Chart 24: CE Forecasts for Total Returns (% p.a.)

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 A-Rated Corporate 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 10 Yr Gilt Yield (ppts)

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


Key Forecast Table

Table 1: Key Forecasts*

End period

Latest

(12th Aug.)

Q3 2020

Q4 2020

Q1 2021

Q2 2021

Q3 2021

Q4 2021

Q4 2022

Short interest rates (%)

Bank Rate

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

3-month LIBOR

0.07

0.10

0.10

0.10

0.10

0.10

0.10

0.10

Bond yields (%)

2 year yields

0.01

0.00

0.00

0.00

0.00

0.00

0.00

0.00

5 year yields

-0.01

0.00

0.05

0.05

0.05

0.05

0.05

0.10

10 year yields

0.20

0.20

0.15

0.15

0.15

0.15

0.15

0.15

20 year yields

0.65

0.60

0.50

0.50

0.50

0.50

0.50

0.50

30 year yields

0.77

0.60

0.55

0.55

0.55

0.55

0.55

0.55

Yield curve (30s –2s, bps)

75

60

55

55

55

55

55

55

Exchange rates

$/£

1.30

1.30

1.35

1.35

1.35

1.35

1.35

1.35

Euro/£

1.11

1.12

1.13

1.13

1.13

1.13

1.13

1.13

BoE Trade-weighted index

78.2

78.5

80.4

80.3

80.2

80.2

80.1

80.1

Equity markets

FTSE 100

6280

6460

7100

7300

7500

7700

7900

8900

Commercial property market+

Rental value growth (% y/y)

-2.0

-3.1

-3.4

-2.5

-1.5

-1.0

0.7

1.3

End qtr equiv. yield (%)

5.8

5.9

6.0

6.0

6.0

5.9

5.9

5.9

Capital value growth (% y/y)

-7.2

-8.2

-9.5

-4.6

-2.4

0.5

2.4

2.6

Total return (% p.a)

-2.9

-3.7

-4.4

-2.3

1.2

3.1

7.5

7.6

Sources: Refinitiv, Capital Economics +Latest is Q2 2020

*Our forecasts assume that there are some renewed lockdowns to contain localised outbreaks of the virus, but that there is not another nationwide lockdown. They also assume that later this year the UK and the EU agree a slim trade in goods Brexit deal, with the status quo for services and financial services being maintained until a later date. (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
Bradley Saunders, Research Economist, bradley.saunders@capitaleconomics.com