Return of risk appetite to benefit UK assets - Capital Economics
UK Economics

Return of risk appetite to benefit UK assets

UK Economics Update
Written by Andrew Wishart

A continued return of risk appetite as the economy slowly recovers from the coronavirus crisis will boost equities and the pound so long as there is a compromise on Brexit. But with the Bank of England likely to keep interest rates close to zero and do much more QE, we expect gilt yields to stay low for many years.

  • A continued return of risk appetite as the economy slowly recovers from the coronavirus crisis will boost equities and the pound so long as there is a compromise on Brexit. But with the Bank of England likely to keep interest rates close to zero and do much more QE, we expect gilt yields to stay low for many years.
  • Notwithstanding a couple of days of losses recently, global equities have recovered a significant portion of their February and March sell-off. The gradual reopening of global economies suggests that earnings will recover. And ultra-loose monetary policy will support valuations. So we think that global equities will rise over the remainder of this year and in 2021. (See here.)
  • A further return of risk appetite will probably reduce safe haven flows, causing the US dollar to weaken. And signs that EU policymakers are getting their act together has reduced the risk of a debt crisis, boosting the euro. (See here.) As a result, we now think that the dollar will continue to weaken this year and the euro will strengthen, resulting in a $/€ rate of $1.20 (previous forecast $1.10). (See here and Table 1.)
  • The implication for UK markets is that the FTSE 100 will rise alongside global equities. And it could outperform. Whereas the S&P 500 is now 11% below its pre-coronavirus peak, the FTSE 100 is still down by 21%. That’s due to the high weighting of the financial, energy and materials sectors in the UK index, which fared the worst during the bear market. But in the past few weeks, these sectors have outperformed. We expect this recent trend to continue.
  • Moreover, since 2016 the valuation of UK equities has fallen relative to that of other stock markets, seemingly for fear of the UK leaving the EU without a trade deal. If there is some sort of last-minute Brexit compromise as we assume (see here), the FTSE 100 may close this valuations gap. Our forecast is that the index will rise by 13% from 6,274 now to 7,100 by year-end and to 7,900 in 2021. (See Chart 1.)
  • A continued recovery in risk appetite would also benefit the pound. Because of Brexit and the UK’s current account deficit, the pound is seen as a risky currency and tends to appreciate when risk appetite rises. Admittedly, we think the Bank of England will loosen monetary policy further and have nudged down our 2022 10-year gilt yield forecast from 0.50% to 0.25%, close to the current level. (See here.) So monetary policy will not support the pound. But very loose policy elsewhere means it won’t weigh on sterling either.
  • The biggest driver of the pound will be Brexit. Over the next six months the pound will be pushed up and down by progress in the negotiations. We always thought some sort of compromise would boost the pound, previously to $1.30 and €1.24 at end-2020. Now that we expect the dollar to be weaker and the euro to be stronger, we think the pound will rise from $1.26 now to $1.35 and from €1.12 to €1.13. Of course, our Brexit assumption is critical. We think there is about a 30% probability of the transition period ending without a trade deal, in which case we suspect that the pound would slump to $1.15.
  • These equity and currency forecasts are based on a continued return of risk appetite, which hangs on the economy recovering from the coronavirus crisis, and an orderly resolution to Brexit. A resurgence of the virus, a disappointing economic recovery, or the Brexit transition period ending without a trade deal being struck would mean equities and the pound make less progress, and perhaps suffer renewed falls.

Chart 1: FTSE 100 & $/£

Sources: Refinitiv, Capital Economics

Table 1: CE UK Markets Forecasts (Previous in Brackets)

Latest

2020*

2021*

2022*

Bank Rate %

0.10

0.10 (0.10)

0.10 (0.10)

0.10 (0.10)

10y Gilt Yield %

0.23

0.25 (0.25)

0.25 (0.25)

0.25 (0.50)

$/£

1.26

1.35 (1.25)

1.35 (1.30)

1.35 (1.30)

€/£

1.12

1.13 (1.14)

1.13 (1.24)

1.13 (1.24)

$/€

1.13

1.20 (1.10)

1.20 (1.05)

1.20 (1.05)

FTSE 100

6,274

7,100 (6,250)

7,900 (6,900)

8,900(7,650)

Sources: Refinitiv, Capital Economics *End-period


Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com