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

Fig1.PNG

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

Fig3.PNG

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

Fig4.PNG

Source: Eikon Reuters, CFTC

Update on UK and Cable…

The storm on the Euro also impacted the value of the British pound after Draghi’s speech in Brussels last month. Cable is now approaching its strong psychological support level at 1.6700 where there could potentially be some ‘buyers on dip’.

On the UK side, the BoE MPC met on Thursday but as expected nothing new concerning its monetary policy was released. The BoE is still seen as the first major bank to start raising rates in early 2015 (probably Q2); therefore investors are still interested in playing the monetary policies divergence between the major central banks (short EUR/GBP is a popular medium term position to hold at the moment). In addition, the National Institute of Economic and Social Research (NIESR) estimated today that the UK economy have eventually surpassed the pre-recession peak it reached in January 2008 after more than 6 years. NIESR are forecasting a 0.9% growth in the March-May period (tight slowdown compared to the 1.1% estimated between February and April), which would mean that the level of UK GDP stands 0.2% above where it was in January 2008. With an economy that almost faced a triple-dip recession in 2013, Britain has taken much longer time to recover compare to other ‘strong’ economies such as Germany or the US (both returned to pre-cisis level in 2010).

If we have a quick look at the economic indicators, we saw last week that Manufacturing, Construction and Services PMIs all stood well above the 50 (expansion / contraction) level at 57.0, 60.0 and 58.6 respectively. Moreover, industrial and manufacturing output both came in higher-than-expected at 3.0% YoY (vs 2.8% expected) and 4.4% YoY (vs 4.0% consensus) in April.

The rebound we have since in the US yields since the lows reached in the end of May helped the greenback recover against the major currencies this week. The graph below shows you one of Cable’s main drivers, the 2-year UK-US spread (in red). As you can see it, the spread narrowed by 10 bps since the end of May and now sits at 0.291%, which pushed Cable (in Yellow) down by 120 pips to 1.6750.

Cable-Spread

(Source: Reuters)

Based on this analysis, we will try to buy Cable at around 1.6720/30 for a test back towards 1.6800 (at first) with a stop loss at 1.6680 (below its 100-day MA at 1.6688).

Euro: Correction or Bear momentum?

After Yellen announced that the Fed will taper QE by another 10 billion dollars to $45bn monthly pace (largely priced in by the market, no effect on the dollar and US yields), it was Draghi’s comments last Thursday that triggered a reversal of the US dollar against the major currencies. During his press conference in Brussels, he said that the ECB officials were comfortable with acting in June if needed (in response to WSJ Brian Blackstone). The Euro, which surged to 1.3992 against the greenback after Governing Council of the ECB decided to keep interest rates steady (refi rate at 0.25%, deposit rate at 0.00% and marginal lending facility rate at 0.75%), fell dramatically after Draghi’s words. As you can see it on the chart below, it broke its 10-month uptrend on Friday (closing below it), its two supports at 1.3775 (April 30 low) and 1.3739 (100-day SMA) and seems on its way to test 1.3671 (April 4 low).

EURUSD-May-8

(Source: Reuters)

The single currency is now trading at 1.3710, down 60 pips from this morning’s high after Bundesbank comments ‘willing to cut rates if needed’ combined with disappointing German ZEW survey (economic sentiment printed at 33.1, well below expectations of 41.0). We believe that the bearish trend is ON now on the Euro, and our next target stands at 1.3670. Another good strategy would be to short EURGBP ahead of UK employment reports and the UK Quarterly inflation report this week. Economists expect the unemployment rate to decrease by another 0.1% to 6.8% in March (with a claimant counts change of -30K in April). Moreover, the divergence of monetary policy between a ‘hawkish’ BoE that is considering so start raising rates early next year and a ‘dovish’ ECB should act in favour of the British pound. The next resistance on the downside stands at 0.8100 (Jan 4th 2013 low), followed by 0.8030.

EURGBP-May-8

(Source: Reuters)

We would play that short EURGBP with long USDCHF and USDJPY positions as we believe that US yields will continue to strength. In our last article What could wake up the Dollar (from its coma), we said that the US Dollar would need ‘some action after all these policymakers’ talks’ in order to start strengthening against most of the currencies. The next move we are waiting is from Kuroda and BoJ officials after Japanese data continues to disappoint. Yesterday, the Ministry of Finance reported that the current account surplus was smaller than expected at JPY 116.4bn in March (vs JPY 305bn expected). Our target on USDCHF would be at 0.9000; and our first target on USDJPY is at 102.80.

FOMC meeting: the impacts

As expected, the Fed reduced the asset purchase programme by another $10bn in April to $55bn, adding $25bn of agency MBS and $30bn of LT Treasuries to its holdings every month. The surprise though came from the upward revision to the Fed funds rate, which is expected to increase to 1% or more by the end of 2015 (up from 0.75%) and to 2.25% by the end of 2016 (up from 1.75%). US interest rates increased sharply after the statement, pushing the value of the US Dollar higher (US Dollar index was up 60 pts to 80.10).

In addition, US policymakers lowered the 2014 GDP growth range to 2.8% – 3.0% (from 2.8% – 3.2% in December) and are targeting a 6.1% – 6.3% jobless rate by the end of this year (see the details below). With the unemployment rate standing close to the 6.5-pecent threshold (6.7% in February), Janet Yellen announced during her first conference as a Fed chair that the central bank would shift to a more qualitative approach and will consider a ‘wide range’ of variables instead of relying mainly on the unemployment rate.

(Source: Federal Reserve website)

Now let’s review the impacts of the Fed funds rate forecast change. Firstly, as you can see it on the chart below, the 10-year US yield increase by 10 bps to 2.77%, sending Gold to end-of-February lows (trading at 1,328 after the statement).

(Source: Reuters)

The FOMC meeting also put the Euro under pressure, a currency that has remained resilient in the middle of this Risk-ON / Risk-OFF market driven by Russian-Ukrainian tensions and the weakening Chinese Yuan episode. EURUSD, which had been traded around the 1.3900 level (1.3850 – 1.3960 range) for the past couple of weeks, was pushed back towards 1.3800 (1.3810 after the statement), frustrating the bulls (who were expecting 1.4000) and easing ECB concerns about a ‘strong exchange rate’.

EURUSD-FOMC

(Source: Reuters)

Eventually, Cable broke its 1.6545 support and found support slightly above the 1.6500 level. As you can see it on the chart below, the plunge in the 2-year UK-US spread (purple line) from 31.5 bps to 22.5 bps pushed the pair (orange) to mid-Feb levels. The 2-year spread has been one of the major drivers of Cable since Carney adopted the forward guidance in August last year. As unemployment rate has decreased faster than expected and is now standing close to the 7-percent threshold (7.2% in the three months to January), traders have been speculating on a rate hike in the first quarter of 2015. However, some MPC members put the British pound under pressure stating that a ‘strong exchange rate’ could weigh on the BoE’s decision to start tightening. With policymakers’ recent comments and an annual inflation at its lowest level since 2009 (1.9% YoY in January), the market is now pricing in a BoE action in the second quarter of 2015.

GBPUSD - Sp

(Source: Reuters) 

UK Budget: In the early afternoon, the Chancellor of the Exchequer Osborne presented the new budget and as expected, it contained a few surprises in the aggregate numbers of the deficit path (real news was the incentives for savers, which we are not going to cover in this article). As the UK economy is expected to accelerate this year (2.7% according to the Office for Budget Responsibility – OBR), the deficit is expected to decrease gradually in the following years and switch to a small surplus of 0.2% in 2018/19 according to the OBR.

Time to go Long GBPAUD

For the past couple of weeks, GBPAUD has been recovering from its January losses as traders and investors are starting to price in a BoE rate hike in early 2015 (some observers target Q4 2014). Firstly, the UK unemployment rate fell sharply over the past few months since Carney introduced the forward guidance back in August 2013 and now stands at 7.2% (edged up 0.1% today in the quarter to December, but claimant count change down 27,600 In January vs. expectations of 20K), closed to the 7-percent threshold for considering a rate rise. Secondly, fundamentals remain pretty strong in the UK, with PMIs well above the 50-recession level (Mfg PMI printed at 56.7 in January) and the BoE raising its growth forecast (again) for 2014 from 2.8% to 3.4%.

Therefore, even if the annual inflation rate undershot the Bank of England’s 2-percent target for the first since 2009 (1.9% YoY in January), boosting the central bank’s case that there is no immediate need to raise the Official Bank rate, the British pound should continue to be supported against most of the currencies as the market is starting to believe in an early ‘BoE tightening’ scenario.

On the Aussie side, the $A dollar has recovered quite a bit since its low reached in late January (0.8660 on January 24 against the USD) supported by the demand for carry trades (AUDJPY is trading at 92.20, up four figures in two weeks) and driving other RISK-ON assets such as equities (S&P500 back to its December highs at 1,838). However, higher levels on the Aussie brought back traders’ interest to short the currency again as they consider that the recovery won’t last for long. Fundamentals remain weak in Australia as we saw last week with official employment data that showed a 3,700 fall in January versus a 15,000 rise expected by economists (Unemployment rate stands now at a 10-year high at 6.0%). Moreover, the Australian Bureau of Statistics reported overnight that the wage price index slowed to 2.6% YoY in Q4 last year (slowest annual increase since the series began in 1979), confirming RBA Governor Glenn Stevens’s commentary ‘the Aussie is uncomfortably high’.

Therefore, we maintain a bullish view on GBPAUD in the medium term; 1.8400 seems to be a good support to start buying on dips for a test back towards 1.8650 at first (1.8800 is our MT target).

(Source: Reuters)