Last year, there were worries that the continued depreciation of the British pound was going to increase inflationary pressure in the UK economy and therefore force policymakers to start a hawkish tightening cycle. With uncertainty still significantly elevated, demand for Gilts would keep UK LT years at low levels and many analysts predicted a potential ‘yield curve inversion’ as one of the main outcomes for this year.
However, over the past few months, the fall in oil prices in addition to the 12M lagged currency ‘effect’ have been pressuring inflation expectations to the downside. Our model, which incorporates the annual change in currency and oil prices as two key inputs, has been predicting a correction in future inflation prints in the UK (figure 1, left frame). Therefore, with the short-term implied yield curves Dec19 Mar19 and Dec20 Dec19 trading at 19.5bps and 15bps, respectively, the market expects slightly less than two hikes by the end of 2020 (figure 1, right frame). This leaves policymakers more flexibility concerning their interest rate normalization policy after warning that Brexit uncertainty ‘intensified considerably’ in the end of last year.
Source: Eikon Reuters, RR
Mixed signs from leading indicators and surveys
As for many developed countries, industrial production has contracted significantly in the few couple of months of 2018, down 1.5% YoY in November. However, we can notice that our leading indicator recently ticked up and therefore is pricing a stabilization in the UK business activity (figure 2, left frame). It is still too early to switch our forecast to positive and therefore the next few data points will be important to watch in order to take a fundamental view on UK financial assets. On the other hand, the CFO survey from Deloitte is standing at 2016 critical levels, as CFOs expect uncertainty to impact business spending and lower hiring in the medium term.
Source: Eikon Reuters,
Uncertainty and firms’ investments
Empirical studies from the Bank of England found significant negative relationship between uncertainty and firm’s investments. For instance, Melolinna et al. (2018) found that the uncertainty, along with the cost of capital and macroeconomic fundamentals, has been an important driver of investment. The authors measure the uncertainty at a firm-specific level, which is the daily volatility in individual stock prices that cannot be explained by general market variation (CAPM model). Figure 3 (left frame) shows negative co-movement between uncertainty (HFM) and the UK business investment.
In another study, Smietanka et al. (2018) look at the macroeconomic uncertainty, which looks at the dispersion in surveys of professional forecasters. Figure 3 (right frame) also demonstrates a negative relationship between uncertainty (U) and the level of investment (dash line is a fitted line based on post-2008 sample).
Source: Melolinna et al. (2018), Smietanka et al. (2018)
Interesting risk premia for the long-run
Hence, the elevated uncertainty, combined with low consumption growth (consumption growth decreased from 0.9% annual prior the financial crisis to 0.3% post-Brexit) and a sluggish growth in the housing market are all going to weigh on the 3 to 6-month outlook, which may be reflected in asset prices. However, fundamentals in the UK have not deteriorated as in some of the European countries (i.e. France), and therefore we could expect an outperformance of UK assets relative to European ones. Figure 4 (left frame shows that the UK stock market appears cheap relative to the US and Europe.
Source: Bloomberg, Eikon Reuters, RR
What does it mean for the pound?
As we mentioned it in our latest FX Weekly, the British pound got strong support when it fell below the 1.25 level against the US dollar, therefore we think that buying Cable below that support could offer interesting returns for longer-term investors. As we expect the US dollar to weaken within the next 12 months (in our base scenario), currencies such as the euro and the pound could offset some of the USD weakness.
As we can see it in Figure 5, Cable is currently flirting with the 1.29 level, which corresponds to the 61.8% Fibo retracement of the 1.1975 – 1.4350 range and the 100-day SMA. A breakout of this area could lead us to the next retracement at 1.32. However, GBP may stabilize in the short term and therefore we think it could be interesting to play the crosses (long EURGBP and short GBPJPY). In addition, we can notice an interesting observation in figure 6, which shows the strong co-movement between GBPJPY and the world (ex-US) equities; we usually tend to look at AUDJPY as a proxy for risk-on / risk-off environment. Therefore, GBP could also be impacted by a small consolidation in the stock market.
Source: Eikon Reuters
Source: Eikon Reuters