Upside risks of the election outweigh downside risks - Capital Economics
UK Markets

Upside risks of the election outweigh downside risks

UK Markets Outlook
Written by Paul Dales
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As the markets have not fully priced in the Conservatives winning the general election on 12th December and securing a Brexit deal, if that were to happen we suspect the pound would climb from $1.28 now to $1.35, 10-year gilt yields could rise from 0.76% now to 1.50% by the end of 2021 and domestically-focused equities would outperform the internationally-exposed FTSE 100. However, a surprise election victory for the Labour Party could result in the pound falling back to $1.25, gilt yields rising even further and equity prices declining. The common theme in both outcomes is that we think the markets are too complacent in expecting official interest rates to be no higher than 0.75% in a couple of years’ time.

  • As the markets have not fully priced in the Conservatives winning the general election on 12th December and securing a Brexit deal, if that were to happen we suspect the pound would climb from $1.28 now to $1.35, 10-year gilt yields could rise from 0.76% now to 1.50% by the end of 2021 and domestically-focused equities would outperform the internationally-exposed FTSE 100. However, a surprise election victory for the Labour Party could result in the pound falling back to $1.25, gilt yields rising even further and equity prices declining. The common theme in both outcomes is that we think the markets are too complacent in expecting official interest rates to be no higher than 0.75% in a couple of years’ time.
  • Global & UK Overview – We no longer expect UK markets to be buffeted by a rise in global bond yields and a sharp fall in global equity prices. But neither do we expect global influences to push UK equity prices much higher. (Page 2.)
  • Money Markets – We think that the markets are right to price in strong possibility of interest rates being cut from 0.75% to 0.50% in the coming months. But the markets would be caught out further ahead if a large fiscal stimulus results in interest rates rising above 0.75% by the end of 2021. (Page 3.)
  • Bonds – Gilt yields may surprise on the upside regardless of the election result. If the Conservative Party won, yields may rise to reflect the prospect of interest rate hikes. If Labour won, fears of the Party’s looser fiscal policies may result in yields rising by more than interest rate expectations. (Page 4.)
  • Equities – A Brexit deal would benefit domestically-focused equities, while the overseas revenues of the internationally-exposed FTSE 100 would be restrained by a stronger pound. All equity prices would probably fall if Labour implemented its policies that could squeeze profits. (Page 5.)
  • Sterling – The boost to the pound if a Labour government led to a softer Brexit deal or no Brexit at all would probably be offset by concerns that Labour’s other policies would make the UK a less attractive place to invest. Meanwhile, a Brexit deal could lead to the pound rising from $1.28 now to about $1.35. (Page 6.)
  • Commercial Property – We think that property returns will weaken regardless of what happens with the election and Brexit. But we think that returns would be even weaker if the Labour Party won the election and put in place policies that eroded commercial property rights. (Page 7.)
  • Historical Context & Valuations – These charts put current conditions into a historical context.
  • Key Forecasts – We have provided three sets of financial market forecasts based on three different Brexit outcomes; a deal on 31st January 2020, a no deal on 31st January 2020 and many more delays to Brexit.

Global & UK Overview

Markets complacent on rate hikes further ahead

  • Regardless of who wins the election and what happens with Brexit, we think the markets are too complacent in expecting UK interest rates to stay below 0.75% for many years.
  • We are no longer expecting UK assets to be hit by a global rise in bond yields and a fall in equity prices. As our view on US interest rates is no longer more hawkish than the markets’, there is less scope for the markets to be disappointed by the support provided by the Fed. (See Chart 1.) We have revised down our forecasts for 10-year US Treasury yields so that they now stay close to 2.0%. (See Chart 2.)
  • As a result, we no longer expect US equity prices to fall sharply this year. Even so, a further easing in US GDP growth and the lingering trade war mean that equity prices are unlikely to rise in 2020 or 2021. (See Chart 3.)
  • Instead, any big moves in UK markets would require an unexpected election result or a decisive Brexit outcome. As a Tory victory and a Brexit deal is not yet fully priced in, such an eventuality would probably lead to modestly higher interest rates, bond yields, domestically-focused equities and a slightly stronger pound.
  • The chances of a no deal Brexit fell sharply after the Prime Minister and the EU struck a Brexit deal in October. (See Chart 4.) Instead, the downside risk to the markets stems from the possibility of Labour winning the election. Although a Labour win could lead to a softer Brexit deal or no Brexit at all, Labour’s looser fiscal plans and policies to restrain profits could lead to higher interest rates, higher bond yields, a slightly lower pound and lower equity prices.
  • The common theme is that whoever wins the election, in a couple of years’ time interest rates will probably be higher than they are now.

Chart 1: Policy Rate & Markets’ Expectations (%)

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

Chart 3: Equity Price Indices

Chart 4: Betting Market Odds of Brexit Outcomes (%)

Sources: Refinitiv, Bloomberg, Betfair, Capital Economics


Money Markets

A clear election result could lead to rates surprising on the upside

  • While we think investors are right to price in a strong possibility of interest rates being cut in the coming months from 0.75% to 0.50%, we think they have gone too far by expecting rates to be lower than 0.75% in a few years’ time.
  • Part of the recent rise in rate expectations, which has resulted in the markets pricing in one 25bps rate cut rather than two, is due to the rise in rate expectations overseas. (See Chart 5.) But most of it is a result of the plunge in the odds of a no deal Brexit, which would almost certainly have been followed by swift rate cuts.
  • That said, the fact that the markets are still pricing in cuts suggests they are not expecting the election and Brexit to prompt the economy to improve significantly. Indeed, in five years’ time the markets still expect rates to be lower than 0.75%. (See Chart 6.)
  • Admittedly, if the election led to a hung Parliament or the Tories won and secured a Brexit deal but didn’t quickly extend the transition period beyond December 2020, uncertainty would remain high and the MPC would probably cut rates. A cut to 0.50% in May 2020 is built into our repeated delays Brexit scenario, but it could come sooner.
  • But if a deal removed the uncertainty and the Tories put in place a large fiscal stimulus, then the stronger outlook would probably trigger rate hikes. In our Brexit deal scenario, Bank Rate rises to 1.5% by the end of 2021. (See Chart 7.)
  • If Labour won the election, the uncertainty may push LIBOR spreads a bit wider. (See Chart 8.) And the combination of a softer Brexit (or no Brexit at all) and an even larger fiscal stimulus suggests that interest rates may rise further. So if there is a clear election outcome, eventually rates may rise by more than the markets expect.

Chart 5: Market Interest Rate Expectations (%)

Chart 6: Bank Rate Implied by OIS Rates (%)

Chart 7: Bank Rate (%)

Chart 8: LIBOR-OIS Spreads (bps)

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


Bonds

Gilt yields likely to rise further than the markets expect

  • If the economy is boosted by a Brexit deal on 31st January and a big fiscal stimulus, then gilt yields could rise by more than the markets expect. If there is a Labour government, there is a risk that yields could climb even further.
  • If the Conservatives win the election and a Brexit deal removes a lot of the uncertainty, we think the prospect of higher interest rates would push up gilt yields. In this scenario, we expect a rise in the 10-year gilt yield from 0.76% now to 1.50% by the end of 2021. That would reduce the unusual wedge that the Fed’s previous rate hikes have driven between US and UK yields. (See Chart 9.)
  • If Labour were to win the election and implement a large unfunded rise in government spending, as some fear, then gilt yields could rise over and above any increase prompted by higher interest rates. Doubts over the sustainability of the UK’s public finances have already fuelled concerns about the UK’s credit standing, prompting all of the big three credit rating agencies to put the UK’s AA rating on negative watch.
  • That said, the CDS premium on government debt – a measure of the cost of insuring against sovereign default – has barely budged. (See Chart 10.) What’s more, structural changes in the economy such as a flatter Philips curve and technological change will probably continue to restrain break-even inflation rates. So even if Labour were to win the election, gilt yields are unlikely to soar.
  • As a result, while we expect gilt yields to drift up after a Brexit deal, we think that they will do so at only a gradual pace. And if a hung Parliament leads to further Brexit delays, it’s conceivable that yields stay close to 0.76%. (See Chart 11.) Or if there is a no deal Brexit, yields could fall to 0.25%. (See Chart 12.)

Chart 9: US & UK 10-Year Bond Yields (%)

Chart 10: 10-Year Gilt Yield & 5-Year CDS Premium

Chart 11: 10-Year Gilt Yield & GDP Growth Forecasts

Chart 12: 10-Year Gilt Yield (%)

Sources: Refinitiv, Bloomberg, Capital Economics


Equities

Chance of a switch from underperformance to outperformance

  • A Brexit deal would be better for domestically focused stocks than the internationally-exposed FTSE 100. But all UK equity prices would probably fall if Labour won the election.
  • The reduction in the chances of a no deal Brexit has already provided a significant boost to the domestically-focused FTSE Local. It has climbed by 15% since August. (See Chart 13.) Over the same period, the internationally-exposed FTSE 100 has only risen by a little over 4%. That’s because the pound has also strengthened, which has weighed on the sterling value of overseas earnings.
  • Domestic stocks outperforming large multinational stocks when the pound rises has been a consistent theme since the referendum. (See Chart 14.) So if a Brexit deal is passed, domestically-focused equities would probably continue to rise relative to the FTSE 100.
  • That said, in a best-case scenario, the FTSE 100 might outperform other overseas equity indices despite the handbrake of a stronger exchange rate. After all, as UK mid- and large-cap equities have underperformed those in other major markets substantially since the EU referendum, valuations of UK equities are relatively modest. (See Chart 15.) If the Conservatives win a large majority at the election, a resolution to Brexit and a significant fiscal boost could give UK equities a leg up.
  • While a Labour victory would also lead to looser fiscal policy, Labour’s plans to nationalise rail, energy and water companies would mean utilities continue to underperform other equities. (See Chart 16.) In fact, as Labour’s policies to raise corporate tax and to redistribute shares to employees would squeeze profits, all UK equity prices would probably fall if Labour won the election.

Chart 13: FTSE Local & Chances of a No Deal Brexit Implied by Betting Odds

Chart 14: Trade-Weighted Sterling & the Performance of the FTSE Local Relative to the FTSE 100

Chart 15: Deviation of Current P/E Ratios of MSCI Indices From 10-Year Averages (%)

Chart 16: Popularity of the Labour Party and Performance of Utility Equity Prices

Sources: Refinitiv, Bloomberg, Capital Economics


Sterling

More risk to the upside than the downside

  • A Conservative win in the election followed by a Brexit deal could push the pound higher. But a Labour win could result in a small fall, despite the prospect of a softer Brexit or no Brexit at all.
  • The falling odds of a no deal have given the pound a boost, taking it to $1.28 and €1.17, a 5% rise since early October. The rise in net futures positions implies that investors are less fearful of a big fall. (See Chart 17.)
  • The pound is likely to rise further if the Tories win and the chances of a Brexit deal jump. Indeed, decent polling results for the Tories have supported the pound recently. (See Chart 18.) But there is a clear trade-off between the main parties’ stance on Brexit and their other policies. (See Chart 19.)
  • The best outcome for sterling would probably be a Liberal Democrat government. Their business-friendly policies and pledge to cancel Brexit could push the pound up to $1.40 (the top left box in Chart 19). However, their chances of winning are slim, so sterling is unlikely to enjoy the best of both worlds. Equally, the worst of both worlds – a no deal Brexit and a Labour government (the bottom right box) – is unlikely. In this scenario, the pound could fall to as low as $1.05.
  • So the markets are either going to have to cope with a hardish Brexit under a Conservative government with business-friendly policies (bottom left box and a rise in the pound to $1.35 if there is a deal) or a softish Brexit under a Labour government that could implement policies that will squeeze profits and may scare overseas investors (top right box and a fall back in the pound to around $1.25.) On balance, we think there is more upside risk for sterling than downside. (See Chart 20.)

Chart 17: $/£ & “Speculative” Positioning

Chart 18: Opinion Polls & $/£

Chart 19: Possible Election & Brexit Outcomes

Chart 20: $/£

Sources: Refinitiv, Bloomberg, Election polling, Capital Economics


Commercial Property

Property returns to be weak

  • The decline in bond yields this year has made property look favourably priced compared to bonds. (See Chart 21.) But we expect property yields to rise over the coming year, which will reduce property’s pricing advantage.
  • Property yields have edged up in recent months as investors responded to prolonged Brexit uncertainty. With the Brexit deadline delayed again, surveys suggest that commercial property investment will continue to be held back. (See Chart 22.)
  • The risk of a Labour government could cause investor sentiment to deteriorate further. For example, suggested policies, such as allowing local authorities to take over vacant retail properties, could damage investors’ perceptions of UK commercial property rights. And the expected rise in gilt yields would put further upward pressure on property yields.
  • Looking ahead, regardless of the outcome of the election and Brexit, we expect the weak outlook for rental values, driven by the retail sector, to cause property yields to rise.
  • However, the outcome of Brexit is likely to determine how quickly property yields rise. (See Chart 23.) If a deal is not secured, yields would rise faster in the near term, as investors respond to the weaker economic outlook. But even if a deal is agreed, with capital values already stretched in many sectors we expect that increases in Bank Rate will put gradual upward pressure on property yields.
  • We think that capital values could fall by a total of 5%, 7% or 9% after a deal, repeated delay or no deal respectively. (See Chart 24.) The upshot is that property returns are likely to remain weak over the next couple of years.

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

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

Chart 23: All-Property Equivalent Yield Scenarios (%)

Chart 24: Cumulative Change in All-Property Capital Values (%, 2019 to 2021)

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 Equity Price to Earnings 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 10 Yr Gilt Yield (ppts)

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


Forecast Table – Repeated Delays Brexit Scenario*

Table 1: Key Forecasts in Repeated Delays Brexit Scenario*

End period

Latest

(13th Nov)

Q4

2019f

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

0.50

0.50

0.50

0.50

0.50

0.50

0.50

3-month LIBOR

0.79

0.90

0.70

0.60

0.60

0.60

0.60

0.60

0.60

0.60

Bond yields (%)

2 year yields

0.56

0.50

0.50

0.50

0.50

0.50

0.50

0.50

0.50

0.50

5 year yields

0.55

0.55

0.55

0.55

0.55

0.55

0.55

0.55

0.55

0.55

10 year yields

0.76

0.75

0.75

0.75

0.75

0.75

0.75

0.75

0.75

0.75

20 year yields

1.20

1.10

1.10

1.10

1.10

1.10

1.10

1.10

1.10

1.10

30 year yields

1.31

1.15

1.15

1.15

1.15

1.15

1.15

1.15

1.15

1.15

Yield curve (30s –2s)

0.75

0.65

0.65

0.65

0.65

0.65

0.65

0.65

0.65

0.65

Exchange rates

$/£

1.28

1.25

1.25

1.25

1.25

1.25

1.25

1.25

1.25

1.25

Euro/£

1.17

1.14

1.14

1.14

1.14

1.14

1.14

1.14

1.14

1.14

BoE Trade-weighted index

79.1

77.7

77.8

77.9

78.0

78.1

78.0

77.9

77.8

77.7

Equity markets

FTSE 100

7365

7300

7300

7300

7300

7300

7300

7300

7300

7300

Commercial property market+

Rental value growth (% y/y)

-0.3

-0.4

-0.5

-0.6

-0.3

-0.1

0.2

0.4

0.8

0.9

End qtr equiv. yield (%)

5.5

5.7

5.8

5.9

5.9

6.0

6.0

6.0

6.0

6.0

Capital value growth (% y/y)

-2.5

-3.6

-3.8

-4.0

-4.2

-4.5

-3.2

-2.0

-0.7

0.6

Total return (% p.a)

2.0

1.2

1.0

0.9

0.7

0.6

1.8

3.1

4.3

5.6

Sources: Refinitiv, Capital Economics

* Based on a scenario in which Brexit is repeatedly delayed. For more see our UK Economics UpdateTwo small forecast tweaks”, 5th November 2019.

+ Latest is Q3 2019

Forecast Table – Deal on 31st January Brexit Scenario*

Table 2: Key Forecasts in Deal on 31st January Brexit Scenario*

End period

Latest

(13th Nov)

Q4

2019f

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

1.00

1.00

1.25

1.25

1.50

3-month LIBOR

0.79

0.80

0.80

0.80

1.00

1.10

1.30

1.30

1.50

1.70

Bond yields (%)

2 year yields

0.56

0.50

0.51

0.53

0.59

0.65

0.78

0.85

0.98

1.10

5 year yields

0.55

0.55

0.56

0.63

0.69

0.75

0.83

0.95

1.08

1.20

10 year yields

0.76

0.75

0.81

0.88

0.94

1.00

1.13

1.25

1.38

1.50

20 year yields

1.20

1.15

1.21

1.28

1.29

1.35

1.43

1.55

1.68

1.80

30 year yields

1.31

1.20

1.26

1.33

1.34

1.40

1.48

1.60

1.73

1.85

Yield curve (30s –2s)

0.75

0.70

0.75

0.80

0.75

0.75

0.70

0.75

0.75

0.75

Exchange rates

$/£

1.28

1.25

1.28

1.30

1.33

1.35

1.36

1.38

1.39

1.40

Euro/£

1.17

1.19

1.19

1.18

1.18

1.17

1.18

1.20

1.21

1.22

BoE Trade-weighted index

79.1

79.7

80.2

80.8

81.4

81.9

82.6

83.2

83.9

84.5

Equity markets

FTSE 100

7365

7300

7300

7300

7300

7300

7300

7300

7300

7300

Commercial property market+

Rental value growth (% y/y)

-0.3

-0.4

-0.2

-0.1

0.2

0.8

1.0

1.2

1.3

1.5

End qtr equiv. yield (%)

5.5

5.7

5.7

5.8

5.8

5.8

5.9

5.9

5.9

5.9

Capital value growth (% y/y)

-2.5

-3.6

-4.2

-4.6

-4.2

-1.8

-1.3

-0.9

-0.5

0.0

Total return (% p.a)

2.0

1.2

0.8

0.5

0.9

3.3

3.9

4.4

4.8

5.2

Sources: Refinitiv, Capital Economics

* Based on a “Deal on 31st January 2020” Brexit Scenario. For more see our UK Economics UpdateTwo small forecast tweaks”, 5th November 2019.

+ Latest is Q3 2019

Forecast Table – No Deal Brexit Scenario*

Table 3: Key Forecasts in No Deal on 31St January Brexit Scenario*

End period

Latest

(13th Nov)

Q4

2019f

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

0.50

0.25

0.25

0.25

0.25

0.25

0.25

0.50

3-month LIBOR

0.79

0.70

0.70

0.40

0.40

0.40

0.40

0.40

0.50

0.60

Bond yields (%)

2 year yields

0.56

0.55

0.05

0.05

0.05

0.05

0.18

0.30

0.43

0.50

5 year yields

0.55

0.60

0.10

0.10

0.10

0.15

0.28

0.40

0.53

0.60

10 year yields

0.76

0.75

0.25

0.25

0.25

0.25

0.38

0.50

0.63

0.75

20 year yields

1.20

1.15

0.70

0.65

0.60

0.55

0.68

0.80

0.93

1.05

30 year yields

1.31

1.20

0.70

0.70

0.65

0.60

0.73

0.85

0.98

1.10

Yield curve (30s –2s)

0.75

0.65

0.65

0.65

0.60

0.55

0.55

0.55

0.55

0.60

Exchange rates

$/£

1.28

1.25

1.15

1.15

1.15

1.15

1.18

1.20

1.23

1.25

Euro/£

1.17

1.19

1.07

1.05

1.02

1.00

1.02

1.04

1.07

1.09

BoE Trade-weighted index

79.1

80.0

72.6

71.7

70.9

70.0

71.5

72.9

74.3

75.8

Equity markets

FTSE 100

7365

7300

7300

7300

7300

7300

7300

7300

7300

7300

Commercial property market+

Rental value growth (% y/y)

-0.3

-0.4

-0.8

-1.1

-1.3

-1.7

-1.4

-1.2

-0.8

-0.6

End qtr equiv. yield (%)

5.5

5.7

6.0

6.0

5.9

5.9

5.9

5.9

5.9

5.9

Capital value growth (% y/y)

-2.5

-3.6

-7.9

-8.9

-7.8

-5.7

-0.3

0.0

0.0

0.1

Total return (% p.a)

2.0

1.2

-2.8

-3.8

-2.8

-0.6

4.8

5.1

5.1

5.1

Sources: Refinitiv, Capital Economics

* Based on a scenario in which the UK leaves the EU without a deal on 31st January 2020. For more see our UK Economics UpdateTwo small forecast tweaks”, 5th November 2019. + Latest is Q3 2019


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
Amy Wood, Property Economist, +44 20 7808 4994, amy.wood@capitaleconomics.com
William Ellis, Research Economist, +44 20 7808 4068, william.ellis@capitaleconomics.com