Vaccines allow UK assets to catch up - Capital Economics
UK Markets

Vaccines allow UK assets to catch up

UK Markets Outlook
Written by Paul Dales
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After having been hit particularly hard during the COVID-19 crisis, UK assets are well placed to perform much better now that COVID-19 vaccines are brightening the economic outlook. Indeed, the combination of a decent economic recovery and continued ultra-loose monetary and fiscal policy should be a potent mix for both the FTSE 100 and the pound. We think the FTSE 100 could climb by about 18% from now to 7,500 by the end of next year despite the pound appreciating from $1.34 now to around $1.40. The stronger economic outlook may well push up 10-year gilt yields from 0.30% now. But as we think the Bank of England won’t raise Bank Rate above 0.10% for five years or so, 10-year yields may not rise above 0.50%.

 

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  • After having been hit particularly hard during the COVID-19 crisis, UK assets are well placed to perform much better now that COVID-19 vaccines are brightening the economic outlook. Indeed, the combination of a decent economic recovery and continued ultra-loose monetary and fiscal policy should be a potent mix for both the FTSE 100 and the pound. We think the FTSE 100 could climb by about 18% from now to 7,500 by the end of next year despite the pound appreciating from $1.34 now to around $1.40. The stronger economic outlook may well push up 10-year gilt yields from 0.30% now. But as we think the Bank of England won’t raise Bank Rate above 0.10% for five years or so, 10-year yields may not rise above 0.50%.
  • Global & UK Overview – COVID-19 vaccines have the capacity to dramatically improve the outlook for economic activity. And despite this, policy will probably remain very loose for many years yet. (Page 2.)
  • Money Markets – A further reduction in the chances of negative interest rates may push up LIBOR rates in the coming months. But they won’t rise much given Bank Rate probably won’t rise for years. (Page 3.)
  • Bonds – A growing risk of higher inflation further ahead may continue to push break-even inflation rates higher. But with the Bank of England anchoring real yields, nominal gilt yields will stay very low. (Page 4.)
  • Equities – A decent economic recovery will continue to benefit most those sectors that make up a large chunk of the FTSE 100, such as consumer stables and financials. (Page 5.)
  • Sterling – Our forecast that the pound will strengthen is driven mostly by the stronger global outlook rather than Brexit, as a Brexit deal is now mostly priced in. But a no deal Brexit is a big downside risk. (Page 6.)
  • Commercial Property – A structural decline in the demand for retail and office space will probably mean that capital values in those sectors continue to fall even as vaccines boost the economy. (Page 7.)
  • Historical Context & Valuations – These charts put current conditions into a historical context. (Page 8.)
  • Key Forecast Table – Our forecasts assume a growing likelihood of COVID-19 vaccines allowing the economy to recovery more rapidly in 2021. They also assume that the UK and the EU agree a Brexit deal by 31st December 2020. (Page 9.)

Global & UK Overview

Potent mix of economic recovery and loose policy

  • The mix of a stronger economic recovery and ultra-loose monetary and fiscal policy should mean that risky assets continue to perform well. After having been vulnerable during the COVID-19 crisis, the FTSE 100 and the pound are now particularly well placed to benefit.
  • Renewed COVID-19 restrictions and lockdowns mean that over the next few months the risks to activity in most economies lie on the downside. We suspect GDP in the UK will fall by around 8% m/m in November. However, the prospect of effective vaccines means that the risks shift to the upside next year when GDP may be able to recover faster. (See Chart 1.)
  • Even then, most economies are unlikely to return to their pre-crisis trends for some years, so inflation will probably stay low. As such, the Fed, the ECB and the Bank of England are all unlikely to raise interest rates. And the Fed has indicated it won’t tighten policy even when inflation rises above 2%. So although we have revised up our forecasts for gilt yields, the key point is that yields will probably remain very low. 10-year gilt yields may not rise above 0.50% for a few years. (See Chart 2.)
  • This combination of a brighter economic outlook and loose policy will probably mean global equity prices continue to rise. With the FTSE 100 packed with firms that were hit hard during the COVID-19 crisis, there is now scope for a decent increase. We suspect it will rise back to its pre-virus peak of about 7,500 by the end of 2021. (See Chart 3.)
  • The pound may also benefit from a general improvement in risk sentiment and the growing prospect of a Brexit deal. We think it will appreciate from $1.34 now to around $1.40 in 2021 and to about $1.45 in 2022. (See Chart 4.)

Chart 1: UK Real GDP (Q4 2019 = 100)

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

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

Chart 4: Exchange Rates

Sources: Refinitiv, Capital Economics


Money Markets

Only limited upside to LIBOR rates

  • The potential improvement in the economic outlook triggered by COVID-19 vaccines reduces the need for the Bank of England to expand Quantitative Easing (QE) further or resort to negative interest rates. But any resulting rise in LIBOR rates won’t be large as Bank Rate will probably remain at rock bottom levels for many years yet.
  • We think the rises in interest rate expectations in the US, the euro-zone and the UK in recent weeks is justified by the better prospects for the economy beyond the next few months. (See Chart 5.) In fact, given that the markets are still pricing in the possibility of the Bank of England cutting Bank Rate from 0.10% now to below zero within the next two years, we think there is room for near-term rate expectations to rise a bit further. (See Chart 6.) And while the Bank will complete the £150bn of QE scheduled to take place throughout next year, it’s becoming more likely that it won’t expand QE further.
  • That said, we disagree with the markets’ expectations that Bank Rate will rise above 0.10% in three years’ time. Over the next few years, we doubt that inflation will spend much time above the 2% target. And even if it did, the Bank has said it would need to be convinced it will stay above 2% before it tightens policy. As such, Bank Rate may not rise above 0.10% for around five years. (See Chart 6 again.)
  • With the Bank continuing to give financial institutions access to plenty of funds, we are not expecting LIBOR spreads to widen much from their current lows. (See Chart 7.)
  • Overall, while diminishing expectations of negative interest rates may push up LIBOR rates a bit, they are likely to stay very low until Bank Rate rises above 0.10%. (See Chart 8.)

Chart 5: Market Expectations for Policy Rate in Two Years’ Time Implied by OIS Rates (%)

Chart 6: Bank Rate Expectations (%)

Chart 7: Spread of 3m LIBOR Over OIS Rates (bps)

Chart 8: LIBOR Rates (%)

Sources: Refinitiv, Capital Economics


Bonds

Gilt yields to stay very low for a long time yet

  • Even though COVID-19 vaccines will accelerate the economic recovery and boost inflation, the era of low bond yields is far from over.
  • The prospect of effective vaccines being rolled out in the coming months has caused spreads on investment-grade corporate bonds to continue to decline. (See Chart 9.) These spreads are now only marginally higher than pre-pandemic levels. And with the appetite for risk set to continue to rise, they may fall further.
  • Meanwhile, the news of effective vaccines has boosted the gilt markets’ expectations of inflation. (See Chart 10.) And our view that vaccines will accelerate the economic recovery could be consistent with yet higher break-even inflation rates. Indeed, with lots of policy stimulus sloshing about in the system, the risks to inflation will shift to the upside once the economy has recovered in full. So there is a risk that gilt yields rise, especially at the long end of the curve.
  • But central banks seem intent on anchoring real yields. Indeed, the Bank of England is going to complete its asset purchases over the coming year. And while it may be less inclined than the Fed to let inflation rise above the 2% target, the Bank has said it won’t react to rising inflation straight away. This suggests that it wouldn’t be happy to see real yields rise much and would probably expand QE if they did rise.
  • This means there may be a combination of rising inflation expectations, but still low real yields. The net effect is that we have revised up our 10-year nominal gilt yield forecast from 0.15% to 0.50%. But we still think that the era of low bond yields has many years to run yet. (See Chart 11.) And low rate expectations should keep the yield curve flat for some time to come. (See Chart 12.)

Chart 9: ICE BofA ML Investment-Grade Corporate Bond Spreads (bps)

Chart 10: Breakdown of 10-Year Gilt Yield (%)

Chart 11: Bank Rate & Gilt Yields (%)

Chart 12: Gilt Yield Curve (bp)

Sources: Refinitiv, Bloomberg, Capital Economics


Equities

FTSE to benefit from rotation out of tech stocks

  • The rotation away from the tech stocks which have benefited from COVID-19 lockdowns and towards more traditional consumer-facing and financial stocks should boost UK equity prices over the next few years. But a stronger pound will keep any market exuberance in check.
  • UK equities have underperformed other developed markets by a wide margin during the recovery from the COVID-19 crisis 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 them to catch up if vaccines are rolled out early next year.
  • The FTSE 100 is tilted towards sectors like consumer staples, energy, materials and financials, which we think will fare best as economic activity normalises once a vaccine becomes available. (See Chart 14.)
  • What’s more, the continuation of exceptional monetary policy support should provide an extra boost. Previous bouts of QE have certainly helped equities. (See Chart 15.)
  • The slim Brexit deal that we are expecting should also help to close the valuation gap between UK and US equities and help the FTSE Local in particular. (See Chart 16.) But a rise in the pound after a Brexit deal will limit the upside to the FTSE 100 by reducing the value of its overseas earnings in pounds.
  • As a result, we expect the FTSE 100 to rise by 18% from now to 7,500 by end-2021. That’s a very similar rise to the one we expect in the S&P 500. Of course, the risk is that a no deal Brexit hammers investor sentiment and leads to a drop in UK equity prices. But even then, a lower pound would cushion the blow for the FTSE 100.

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

Chart 14: Sector Weights in Equity Price Index (%)

Chart 15: FTSE 100 Equity Index & BoE QE

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

Sources: Refinitiv, Capital Economics


Sterling

Brexit deal priced in, risks to the downside

  • A slim Brexit deal by the end of the year and a continued recovery in all risky assets should be enough to push the pound a little higher against the dollar. But the near-term risks are skewed to the downside.
  • The UK’s reliance on external funding to finance its current account deficit explains why the pound was hit harder than most other developed market currencies by the COVID-19 crisis, just like in previous crises. (See Chart 17.) But the promising news on vaccines has caused appetite for risky assets, including the pound, to rise. Indeed, a large part of the recent rise in the pound has been due to a decrease in safe haven demand for the dollar. This is the main reason why we expect the pound to rise from $1.34 now to $1.40 by the end of 2021 and to $1.45 by end-2022.
  • Brexit could either solidify this upward move or reverse it. The progress in the negotiations has caused the chances of a Brexit deal to rise sharply in recent weeks. (See Chart 18.) But even if there is a deal by end-2020, there is now little upside for the pound. Indeed, we think the pound could rise to $1.35 and to €1.13 by year-end. (See Chart 19.)
  • However, Brexit does pose a significant downside risk for the pound. If the Brexit transition period ends without a trade deal (we put the chances of this at close to 40%), we think the pound would slump by about 14% to $1.15 in a “cooperative” no deal (where side agreements remain in place) and to $1.10 in an “uncooperative” no deal (where existing agreements are unravelled). Perhaps it is not too surprising, then, that investors are still hedging themselves against these downside risks. (See Chart 20.)
  • Overall, a Brexit deal plus COVID-19 vaccines could mean the pound rises from $1.34 now to around $1.45 by the end of 2022.

Chart 17: Current Account Balance & $/£

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

Chart 19: Sterling Exchange Rates

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

Sources: Refinitiv, Capital Economics


Commercial Property

Capital values unlikely to recover until 2022

  • Our valuation estimates suggest that UK commercial property remains good value compared with gilts and equities. But with economic uncertainty continuing to undermine rents, we don’t think decent valuations will be enough to entice buyers back yet and further yield increases are likely.
  • The stability of our composite measure of all-property valuations relative to equities and gilts in Q3 was due to all-property yields remaining flat. (See Chart 21.) This was driven by a drop in industrial yields, as office and retail yields continued to rise, albeit by less than in Q2. We still expect all-property yields to rise further in the coming months on the back of continued economic weakness and further rental falls. Indeed, on a year-on-year basis, we think yields will increase by around 10bps in 2020 and 2021, with the largest increases in the retail sector. (See Chart 22.)
  • Meanwhile, surveyors’ expectations for rents over the next 12 months in the office and retail sectors remain negative. (See Chart 23.) This supports our view that a weak economic outlook and structural shifts in office and retail demand will prevent any recovery in rents over the next 12 months. By contrast, we think industrial property will benefit from sustained high online spending and we forecast rental growth of around 1.5% y/y in 2020 and 2021.
  • Overall, a weaker outlook for rents and a rise in yields will result in all-property capital values falling. Better than expected Q3 data mean that we have revised up this year’s estimate slightly to -8.6% y/y from -10.3% y/y. Next year, although the economy is set to recover, we think capital values will fall again and only begin to recover in 2022. (See Chart 24.)

Chart 21: Capital Economics All-Property Valuation Score (Composite of Relative to Equities & Gilts, % pts)

Chart 22: Property Yields by Sector (%)

Chart 23: RICS Surveyors Rental Expectations (% Net Balance)

Chart 24: 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 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, Bank of England, Capital Economics

Key Forecast Table

Table 1: Key Forecasts*

End period

Latest

(23rd Nov.)

Q4 2020

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

0.10

3-month LIBOR

0.05

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

Bond yields (%)

2 year yields

-0.02

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

5 year yields

0.01

0.15

0.15

0.15

0.15

0.15

0.15

0.15

0.15

0.15

10 year yields

0.35

0.50

0.50

0.50

0.50

0.50

0.50

0.50

0.50

0.50

20 year yields

0.76

0.90

0.90

0.90

0.90

0.90

0.90

0.90

0.90

0.90

30 year yields

0.90

1.05

1.05

1.05

1.05

1.05

1.05

1.05

1.05

1.05

Yield curve (30s –2s, bps)

92

95

95

95

95

95

95

95

95

95

Exchange rates

$/£

1.33

1.35

1.37

1.38

1.39

1.40

1.42

1.43

1.44

1.45

Euro/£

1.12

1.13

1.12

1.12

1.12

1.12

1.12

1.12

1.12

1.12

BoE trade-weighted index

78.5

79.2

79.3

79.3

79.4

79.5

79.7

79.9

80.0

80.2

Equity markets

FTSE 100

6334

6500

6750

7000

7250

7500

7690

7880

8060

8250

Commercial property market+

Rental value growth (% y/y)

-2.8

-3.5

-3.1

-2.6

-2.2

-1.7

-1.2

-0.8

-0.2

0.3

End qtr equiv. yield (%)

5.8

5.9

6.0

6.0

6.0

6.0

5.9

5.9

5.9

5.9

Capital value growth (% y/y)

-7.4

-8.6

-6.9

-5.2

-3.5

-1.8

-1.1

-0.4

0.3

1.0

Total return (% p.a)

-3.2

-3.8

-2.0

-0.2

1.6

3.3

4.0

4.8

5.5

6.2

Sources: Refinitiv, Capital Economics +Latest is Q3 2020

*Our forecasts assume that severe COVID-19 restrictions are in place during November, December and January and that lighter, diminishing, restrictions are in place in February, March and April. (See here.) Thereafter, vaccines significantly reduce the need for COVID-19 restrictions and social distancing measures. Our forecast also assume that the UK and the EU agree a slim trade in goods deal by the end of the year. (See here.)

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