UK equities are unlikely to make further gains as the drivers behind the post-referendum rally begin to run out of steam, according to consultancy Capital Economics.
Since last June’s EU referendum, the FTSE 100 has risen by around a fifth, the consultancy noted, while UK equities have outperformed global peers in local currency terms.
Performance of FTSE 100 vs S&P 500 over 1yr
Source: FE Analytics
The UK blue-chip index has been boosted by the drop-off in sterling since the Brexit vote with many of the multi-nationals seeing their overseas earnings boosted.
Furthermore, the domestically focused firms have also started to recover post-referendum losses after investors sought safety in large-caps.
However, despite the strong run of performance over the past year, the consultancy expects the rally to come to an end as the market begins to adapt to the new conditions.
“We don’t see grounds for UK equities to continue their recent rally,” noted Capital Economics analysts.
“Indeed, we expect the FTSE 100 to finish this year around its current level of 7,500. And while there may be some scope for further gains as the economy beats expectations next year, stretched valuations will start to bite as global interest rates rise further ahead.”
Capital Economics said that it expects sterling to consolidate recent gains. While strong PMI (purchasing managers index) numbers suggest the UK economy is continuing to grow robustly, “the most recent rally in the FTSE 100 outstrips what the past relationship would suggest”.
The boost to UK equity indices from a relatively high concentration to industrials with exposure to a global commodity price recovery “now looks overdone”.
It added: “In particular, oil & gas firms’ equity valuations have outrun what the recent recovery in the oil price would, on past form, suggest.”
However, while the rally is likely to end, a correction for UK equities looks unlikely in the near term although valuations look expensive.
“On a historical basis, the current price-to-earnings [P/E] ratio is consistent with negative annual average returns over the next decade,” it noted.
“Indeed, as global interest rates start to rise, the hunt for yield will subside reducing the upward pressure on equity valuations.
“As a result, following a rise in the FTSE 100 to 7,750 in 2018, we have pencilled in a global correction in equities in 2019 and expect the FTSE to finish that year at 6,750.”
Following the referendum, sterling fell dramatically as investor concerns over the outlook for the UK economy undermined confidence in the currency.
Performance of sterling vs US dollar and euro over 1yr
Source: FE Analytics
However, the pound should benefit from economic growth in 2018, which the consultancy expects to surprise on the upside, and from a greater degree of monetary tightening than expected in 2019.
However, uncertainties about the future trading relationship with the EU means that the sterling is unlikely to recover all of its post-referendum decline, warns Capital Economics.
“The pound has reversed some of its depreciation in recent months, supported by a rebound in forecasts for GDP growth in 2017 and an assumption that pushing the next election back to 2022 and a larger Conservative majority in Parliament would make the Brexit process smoother,” it noted.
“However, expectations for growth next year have remained depressed.”
The consultancy said if the economy outperforms the 1.3 per cent growth forecast, then there could be scope for a growth-supported rise in sterling.
“Admittedly, relative interest rate expectations point to a weakening in sterling against the dollar. But the relationship has broken down over recent months.”
Elsewhere, Capital Economics said that gilt yields should rise from current lows “as the US tightening cycle progresses and the continued resilience of the UK economy wrong-foots investors”.
Performance of indices over 1yr
Source: FE Analytics
Yields have fallen on the back of expectations of a Brexit slowdown, the consultancy said, with markets expecting interest rates to remain lower for longer.
It added: “Yields have also been supported by a fall in expected gilt issuance on the back of a better-than-expected year for the public finances in 2016/17.”
Yet, these factors are expected to unwind with issuance expected to pick up as the government’s quantitative easing programme concludes and funding requirements change.
“Much of the improvement in the public finances last year was due to timing effects and as such the government’s financing requirement will increase again next year,” it said.
“Combined with the absence of demand from the Bank of England following the conclusion of its asset purchases, competition for gilts will be reduced.”
Coupled with further increases in the Fed Funds Rate that the US central bank has already announced should also lift yields and make the UK government bonds more attractive.