The market is pricing in an 80% probability of a first rate hike occurring by February 2016 and a 30% probability by November 2015. If anything, the chances are higher, in our view. Composite PMIs are consistent with 2.5% GDP growth and wage growth is accelerating to 3.2%, even before the introduction of the living wage (which could add 0.5% to wage growth).
We think interest rates could rise more than expected in the medium term (1.6% is priced in for end 2017) due to the fact that the UK consumer is now less rate sensitive than in the past (half of mortgages are now fixed-rate, up
from 30%), and there is a high chance of fiscal policy slippage.
Sterling/Dollar has been driven by rate differentials: On a 2 year view, US rates should rise more than those in the UK (less floating rate debt, lower household leverage), but near term Sterling/Dollar should remain range-bound.
The dilemma for us is Euro/Sterling, where sterling appears to be more overvalued against PPP than at any time in the last 20 years (combined with a record trade deficit with Europe). Thus, we still want to buy the European
recovery plays (e.g., Kingfisher, Vodafone, SThree, Hays).
We downgrade UK equities to benchmark, and take our year-end FTSE 100 target down to 7,000 (from 7,450), due to sterling resilience (only 21% of profits come from the UK); GEM exposure (26% of market cap); our negative view on oil (the UK has a larger exposure to oil than even GEM); UK equities modestly underperform when UK rates initially rise; they are not clearly cheap excluding resources; and the UK market is overweight bond proxies.
We are overweight UK banks as they are very closely correlated to two-year note yields, underperformed European banks by 46% since 2013, cheap on P/B vs RoE or P/PPP, buy unfunded pension deficits (BT, GKN, BAE) and employment agencies (who tend to outperform when wages rise). We stick with the benchmark of UK life companies, which are expensive and have ceased to be rate sensitive (we downgraded them in April).