Return of risk appetite to buoy assets if virus contained - Capital Economics
UK Markets

Return of risk appetite to buoy assets if virus contained

UK Markets Chart Book
Written by Paul Dales

Market conditions have generally improved in recent months, with government bond yields remaining low, corporate bond spreads almost back to their pre-coronavirus levels and the FTSE 100 recovering almost half of its 33% slump in February and March. And we think that there is scope for the FTSE 100 and the pound to rise further this year due to a continued return of risk appetite as the economy recovers from the coronavirus crisis, and monetary policy remaining ultra-loose. However, the renewed sell-off in global equities highlights the downside risks. Indeed, a resurgence of the virus, a disappointing economic recovery, or the Brexit transition period ending without a trade deal would mean that equities and the pound make little progress, and perhaps suffer renewed falls.

  • Market conditions have generally improved in recent months, with government bond yields remaining low, corporate bond spreads almost back to their pre-coronavirus levels and the FTSE 100 recovering almost half of its 33% slump in February and March. (See Chart 1.) And we think that there is scope for the FTSE 100 and the pound to rise further this year due to a continued return of risk appetite as the economy recovers from the coronavirus crisis, and monetary policy remaining ultra-loose. (See here.) However, the renewed sell-off in global equities highlights the downside risks. Indeed, a resurgence of the virus, a disappointing economic recovery, or the Brexit transition period ending without a trade deal would mean that equities and the pound make little progress, and perhaps suffer renewed falls.
  • Investors expect interest rates to be cut into negative territory within two years.
  • Government bond yields have remained low despite the announced reduction in the pace of QE.
  • Corporate bond yields are now back around their pre-coronavirus levels, although spreads remain higher.
  • UK equities have given up some of their gains due to worries about second waves of the coronavirus.
  • Sterling has suffered against the euro on the back of the government’s pledge not to extend the Brexit transition period.
  • Markets forecasts.

Chart 1: FTSE 100 & Corporate Bond Spreads

Sources: Refinitiv, Capital Economics


Interest Rates

  • We think the Bank of England will need to loosen monetary policy further and keep it looser for longer than many forecasters and investors expect. Indeed, the Bank kept interest rates on hold at 0.10% its last meeting on 18th June (2) and like investors, we don’t expect rates to rise above their current rate for the foreseeable future (3).
  • In a sign of a further easing of stresses in the financial markets, LIBOR rates have fallen across all but the shortest durations (4). As a result, LIBOR-OIS spreads have declined in most developed markets (5). However, as inflation is likely to remain well below the Bank’s 2.0% target over the next few years, it seems likely that more policy stimulus will be needed. Indeed, at its last meeting the Bank shifted from providing liquidity to supporting demand.
  • However, unlike the market we don’t think that this additional policy loosening will come in the form of negative interest rates (6). Admittedly, we wouldn’t rule it out. But the potential damage to the financial sector means that the Bank may be very cautious about using them. Instead, the Bank’s tool of choice is likely to be substantially more QE over the next few years (7).

Chart 2: Bank Rate & Gilt Yield

Chart 3: Market-Implied Path for Interest Rates in Two Years’ Time Based on OIS Rates* (%)

Chart 4: LIBOR Rates (%)

Chart 5: 3-Month LIBOR-OIS Spreads (ppts)

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

Chart 7: Forecasts for the Stock of QE Purchases (£bn)

Sources: Refinitiv, Capital Economics


Government Bonds

  • The gilt market has shrugged off the reduction in the pace of QE announced at the June MPC meeting. And if we are right that monetary policy will remain ultra-loose, there is little prospect of a significant rise in gilt yields anytime soon. Better-than-expected US payrolls data on the 5th June led to a rise in government bond yields as it raised the possibility of the economy recovering quickly and monetary stimulus being withdrawn (8). But this soon subsided, in line with our view that interest rates will remain very low for the foreseeable future.
  • In contrast to a large reduction in market inflation expectations elsewhere, UK inflation expectations have been less affected by the coronavirus crisis, perhaps for fear that Brexit or the current account deficit may yet trigger another fall in the pound (9). As a result, while nominal yields have fallen by much less in the UK than the US this year, the gap between real yields has not narrowed much (10).
  • Finally, the big reduction in the pace of QE, from around £14bn a week since March to £4bn a week from now until “the turn of the year” had little market impact (11). There was only a small steepening in the yield curve as investors grew a little more wary of holding long-dated gilts (12), and demand for primary gilt issuance has remained solid (13).

Chart 8: 10-Year Government Bond Yields (%)

Chart 9: 10-Year Inflation Swap Rate (%)

Chart 10: UK & US 10-Year Real Yield (%)

Chart 11: QE Purchases per Week (£bn)

Chart 12: Spread between Benchmark Gilt Yields (bps)

Chart 13: Bid-Cover Ratio on Primary Gilt Auctions

Sources: Refinitiv, BoE, DMO, Capital Economics


Corporate Bonds

  • The yields of investment-grade corporate bonds have fallen sharply since the end of May (14) aided by a recovery in risky assets and the Bank of England’s corporate bond buying programme (15 & 16). Note that the Bank of England has purchased around £5.7bn of corporate bond purchases so far since the start of April, bringing the total stock of its corporate bond holdings to £15.5bn (17).
  • As a result, yields on UK corporate bonds are now back around their pre-coronavirus levels, although credit spreads remain higher (18). Spreads are only slightly wider in the UK than abroad, despite the more depressed level of activity and the more cautious lifting of the lockdown relative to elsewhere (19).
  • While we think spreads will fall further as the UK economy continues to re-open, rising insolvencies may mean that it is some time before they return to their pre-crisis levels. We expect the corporate insolvency rate to double from 0.4% at the end of 2019 to 0.9% by the end of 2020 and to remain high for some time.

Chart 14: Yields of ICE BofA ML IG Corporate Bond Index & 10-Year Gov’t Bonds (%)

Chart 15: FTSE 100 & ICE BofA ML IG AA Corporate Bond Spread

Chart 16: Yields of ICE BofA ML IG Corporate Bond Indices (%)

Chart 17: Weekly Corporate Bond Purchases & Total Holdings (£bn)

Chart 18: Option-Adjusted Spreads of ICE BofA ML IG Corporate Bond Indices (bp)

Chart 19: Option-Adjusted Spreads of ICE BofA ML IG Corporate Bond Indices (bp)

Sources: Refinitiv, BoE, DMO, Capital Economics


Equities

  • The recovery in equities stalled in June in response to fears about a second wave of the virus, demonstrating the main risk to our forecast that equities will rise over the remainder of this year and in 2021 (20). Nonetheless, having dropped by 33% from the peak on 19th February to the trough on 23rd March, the FTSE 100 has recovered almost half of the fall, leaving it 18% below its pre-coronavirus peak.
  • The sectoral composition of UK equity indices and Brexit has caused UK equities to underperform other developed market indices. The oil, gas and financial sectors have a large weighting in the FTSE indices and have been laggards in the recovery (21 & 22). Meanwhile, the risk that the UK and the EU fail to agree a trade deal by 31st December is weighing on the share price of domestically-focused companies (23).
  • Indeed, the gap between the valuation of UK and developed market stocks since the referendum in 2016 suggests Brexit is still causing UK stocks to trade at a discount (24). As a result of that and the continued fall in real interest rates, the return on UK equities is attractive relative to bonds (25). Therefore, if we are right to assume that a slim trade deal is agreed by the end of the year and that risk appetite continues to recover, there is scope for UK equities to outperform over the next few years.

Chart 20: Equity Indices (19th Feb 2020 = 100)

Chart 21: FTSE All-Share Sectors (% Change)

Chart 22: Oil Price & FTSE 100/S&P 500

Chart 23: Probability of an EU-UK Trade Deal & the FTSE Local

Chart 24: Price to 12 Month Forward Earnings Ratio

Chart 25: Equity Earnings Yield & Real Gilt Yield

Sources: Refinitiv, smarkets.com, Capital Economics


Sterling

  • There should be some upside for the pound if the UK and the EU agree a slim Brexit trade deal by the end of the year as we expect. The pound has risen against the US dollar but weakened against the euro over the past month (26). This is partly due to the recent weakness in the dollar as demand for risky assets returned and investors moved out of safe-haven assets (27). But the weakness against the euro is primarily due to Brexit.
  • According to betting markets, the probability that the transition period will be extended beyond the 31st December 2020 has fallen from about 40% at the start of June to just 20% now (28), and we don’t think that’s because investors are betting on a deal being done! Indeed, the UK government has formally said it will not extend the transition period and measures of investor sentiment, such as investor positioning and six-month risk reversal are likely to stay depressed until there is better news on Brexit (29 & 30).
  • However, we still expect there to be a slim trade deal which prevents step change in the trading relationship by the end of the year. In this case, the pound could rise back to $1.35 and €1.13, in line with our forecasts for UK & US government bond yields (31).

Chart 26: Sterling Exchange Rates

Chart 27: US Dollar Index & $/£

Chart 28: Prob. of Transition Period Extension & €/£

Chart 29: Sterling Futures Net Position & €/£ Rate

Chart 30: Six-Month Risk Reversal on $/£ Exchange Rate

Chart 31: Relative Bond Yields & $/£

Sources: Refinitiv, Capital Economics


UK Markets Forecasts

Table 1: Key Market Forecasts*

End period

Latest

25th Jun

Q1 20

Q2 20

Q3 20

Q4 20

Q1 21

Q2 21

Q3 21

Q4 21

2020

2021

2022

Bank Rate (%)

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

0.10

3 month LIBOR (%)

0.16

0.55

0.15

0.20

0.20

0.20

0.20

0.20

0.20

0.20

0.20

0.20

6 month LIBOR (%)

0.30

0.70

0.30

0.30

0.25

0.25

0.25

0.25

0.25

0.25

0.25

0.25

12 month LIBOR (%)

0.48

0.85

0.50

0.40

0.35

0.35

0.35

0.35

0.35

0.35

0.35

0.35

10 Year Gilt Yield (%)

0.15

0.25

0.15

0.20

0.25

0.25

0.25

0.25

0.25

0.25

0.25

0.25

$/£

1.24

1.24

1.24

1.30

1.35

1.35

1.35

1.35

1.35

1.35

1.35

1.35

€/£

1.11

1.14

1.11

1.12

1.13

1.13

1.13

1.13

1.13

1.13

1.13

1.13

Sterling TWI

76.5

78.1

76.5

78.9

80.8

80.7

80.6

80.5

80.4

80.8

80.4

80.4

Real GDP (%q/q)1

0.0

-2.0

-23.0

15.1

4.5

3.3

2.6

1.5

1.0

-12.0

10.0

3.7

Real GDP (%y/y)1

1.1

-1.6

-24.1

-13.2

-9.2

-4.4

27.5

12.4

8.6

CPI Inflation (%y/y)2

0.5

1.7

0.6

0.4

0.5

0.4

0.9

1.0

1.1

0.8

1.0

1.0

RPI Inflation (%y/y)2

1.0

2.6

1.3

1.2

1.1

0.8

1.4

1.7

2.0

1.5

1.5

2.0

RPIX Inflation (%y/y)2

1.3

2.7

1.4

1.2

1.0

0.7

1.3

1.6

1.9

1.6

1.4

2.0

Sources: Refinitiv, Capital Economics. 1Latest value data from Q1 2020. 2Quarterly period average. Latest values data from May 2020.

*Assumes that the restrictions on activity created by the coronavirus lockdown last for three months from late March to late June. Assumes the UK and the EU agree a slim trade in goods deal by the end of the year, with the status quo for services and financial services 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
Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com
Thomas Pugh, UK Economist, +44 7568 378 042, thomas.pugh@capitaleconomics.com
James Yeatman, Research Economist, +44 7485 138 556, james.yeatman@capitaleconomics.com