How long will the UK equity market hold?

With an expected annual real growth of 1.5% in 2018 according to the general consensus, the UK economy switched from the top DM performer in 2014 to bottom 2 in 2018, the second lowest growing country after Japan (1.2%).  Uncertainty around Brexit is still weighing on the economic outlook, which is pushing the Bank of England to keep a loose monetary policy and use different tools to counter a potential downturn. As a result of the referendum, policymakers announced in August 2016 a GBP 70bn expansion of the central bank’s balance sheet, purchasing GBP 60bn of government bonds (Gilts) and GBP 10bn of corporate bonds. In addition, the BoE also provided GBP 127bn of cheap loans (TFS drawings) to banks through the Term Funding Scheme (TFS), a 4-year funding at the BoE Base Rate plus a fee to the banks requiring them to lend into the real economy (an equivalent to the LTROs in the Euro area). Therefore, if we combine the three outstanding amounts together (figure 1, left frame), the BoE balance sheet’s total assets currently stand at GBP 572bn, or roughly 28% of UK’s GDP. In addition, UK policymakers kept the Official Bank rate at low levels and have slowly started a tightening cycle (figure 1, right frame)The base rate currently stands at 0.75%, and market participants are pricing in 1 to 2 hikes by the end of 2019, with the Short-Sterling Dec19 futures contract trading at 98.85 (1.15% implied rate).

Figure 1

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Source: Bank of England, Eikon Reuters

Even though the headline inflation in the UK is running at 2.5%, significantly helped by Sterling weakness following the referendum and the recovery in energy prices, policymakers are in a difficult position as the economic activity seems to be slowing down according to the fundamentals. Our leading economic indicator, which is built using a combination of survey and price data as inputs, is pricing a slowdown in industrial production within the next 6 months. Therefore, using the industrial production as a proxy of the UK’s economy activity, the real GDP annual growth could be actually be lower than the 1.5% expected for 2018.

Inflation should remain high according to our 6-month forecasting model, averaging an annual growth (CPI) of 2.5%/3% for the rest of the year, therefore nominal GDP in the UK should average 4% (which is far significantly higher than the 1.5% 10Y yield). Overall, political uncertainty around Brexit and the Trade war in addition to slowing fundamentals should limit growth expectations to the upside in the medium term and therefore should be reflected in the real and financial economy.

Figure 2

Fig2

Source: Eikon Reuters, RR

Another interesting observation is the dramatic decrease in excess liquidity, computed as the difference between the annual growth of real M1 (CPI adjusted) and annual growth in industrial production. According to many empirical studies, an increase in excess liquidity should benefit to the risky assets such as the stock market. As you can see it in figure 3 (left frame), excess liquidity has significantly decreased from 10.15% in August 2016 to 0.51% in June 2018 and therefore could weigh on UK equities in the medium term. In figure 3 (right frame), we use excess liquidity as a 6M leading indicator that we overlay with the annual performance of UK financials (using Eikon Reuters Total Return Index), a sector which is usually considered to act as a barometer of the country’s economy. We can clearly notice that financials tend to perform badly in periods of decelerating excess liquidity.

Figure 3

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Source: Eikon Reuters, RR

With the 10-year on Gilts trading slightly below 1.5% and an equity market up 1,500 points since Brexit (trading at 7,630 and 230pts away from the all-time high reached on May 21st), the British pound was the main asset that suffered from the Brexit vote. Cable plummeted from 1.4750 in early May 2016 to hit a low of 1.20 in October 2016 (its lowest level since 1985) before starting its recovery to 1.44 on the back of a US Dollar weakness in 2017. This year, Sterling is once again under pressure since the start of the Dollar rally in April, down 16 figures and currently trading below 1.29. Market sentiment is extremely bearish, with speculative investors net short -72.3K contracts according to the CFTC (August 21st CoT report). In figure 4 (left frame), we can notice that the 33K increase in longs was offset by the massive increase in shorts from -82.4K to -140.4K (-58K) over the past month. We think there is still room for GBP weakness in the next three months to come ahead of Brexit negotiations, but the premium and the convexity on shorting the pound at these levels are not that interesting in our opinion.

However, it seems that the equity market has not been reacting neither to Brexit uncertainty and the recent slowdown in UK fundamentals. Figure 4 (right frame) shows that over the past two years, to the exception of the early 2018 (global) equity sell-off, the Footsie 100 index has been significantly sensitive to a move in Sterling (see more here). For instance, Cable’s weakness starting in mid-April has helped pushed UK equities to hit new all-time highs, with the index soaring from 6,890 On March 26th to 7,860 on May 21st. Even though we may see some further GBP weakness in the months to come that could push UK equities to new highs, we think that current low levels of implied volatility (FTSE 100 VIX is currently trading at 11) offer a good opportunity for investors to hedge against a sudden sell-off within the next 6 months.

Figure 4

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Source: Eikon Reuters, CFTC

Great Chart: US ST Yield Curve vs. Cyclical-Defensive Stocks

Lately, the sharp revision of the US annual saving rate (up 1.6% on average since 2010) shifted growth expectations to the upside and lowered the bottom of the unemployment rate for the next few quarters. For instance, Goldman revised its GDP growth to 3% in Q4 (from 2.5% previously) and to 2% for 2019 (vs. 1.75%) and expects the unemployment rate to bottom at 3% in 2020. As a result, some investors are starting to consider that we may see more rate hikes by the Fed than currently expected. With two more hikes priced in for this year and another two to three for 2019, market participants expect the Fed Funds rate to hit [at most] 3.25% by the end of next year, which is more or less in line with the  Fed’s dot plot released at the June meeting (median projection at 3.125% for 2019).

However, we saw that the market is not expecting any more hikes post-2019, which could be interpreted as the end of the tightening cycle by US policymakers. According to the Eurodollar futures market, the December 2019 and December 2020 implied rates are trading equally at 3.06%, which suggests that the US economic outlook is expected to slow down at the end of next year. Hence, an interesting analysis is look at which sectors should perform well within the next 12 to 24 months if we stick with the scenario that economic uncertainty will increase at the end of 2019. A classic strategy looks at the Cyclical vs. the Defensive stocks. The main difference between Cyclical and Defensive stocks is their correlation to the economic cycle; Cyclical stocks tend to do well in periods of economic expansion (relative to Defensive stocks) but tend to experience more losses during recessions. According to empirical research, one of the main aspects that drive Cyclical and Defensive stocks’ performance is the beta of these stocks (also called the market risk premium). As the Defensive stocks are more resilient to an economic downturn, their beta is lower than 1 (resp. higher than 1 for Cyclical stocks).

Therefore, if we take the EuroDollar (ED) Dec19-Dec20 implied rate yield curve as our leading indicator of the business cycle, a flattening yield curve should benefit to the Defensive stocks (vs. Cyclical stocks). However, the chart below tells us a different story (Original Source: Nomura). We looked at the relationship between Cyclical-versus-Defensive sectors and the Dec19-Dec20 ED yield curve since the summer of 2008, and noticed that the two times series have been diverging for the past two years. The yield curve has constantly been flattening during that period, however Cyclical stocks have outperformed Defensive Stocks. We chose Materials, IT and Industrials sectors for the Cyclicals and HealthCare, Telecom and Utilities sectors for the Defensives (Source: Thomson Reuters Total Return Indices), and compute the ratio of the Cyclicals and Defensives new indices (find attached the file).

If you expect the two series to convergence back together, this would imply either a sudden steepening of the yield curve or Cyclicals to underperform Defensives.

Chart: ED Dec19-Dec20 yield curve vs. Cyclical-Defensive stocks (Source: Eikon Retuers)

Sectors vs. YC.PNG

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