Word on the Street
Word on the Street is a news and financial markets podcast where leading investment experts discuss events that have been making the headlines. See the latest edition here, or access our podcast archive by subscribing below.
A summer of discontent?
In this week’s podcast, Mike Haslam, Head of Funds Distribution, talks to Jean-Paul Jaegers, Head of Asset Allocation, about the latest market developments and what they may mean for investors.
Despite UK wage growth rising at its fastest pace for 11 years and employment reaching a record high, uncertainty over the future path of interest rates and concerns over a looming recession continue to weigh on investor sentiment.
Mike Haslam: Welcome to Word on the Street, my name is Mike Haslam and this is my opportunity to look at the stories that are making the headlines over the last week or so. And to help you understand and trawl through this mess I am joined by John-Paul Jaegers, Head of Asset Allocation. Thanks for joining me today JP. So today I wanted to talk about, and focus on, fears of a recession, and really two parts: about week ago the headlines were talking about the UK economy slowing down and leading to a recession, and then this week we have more headlines, this time focusing on something called the ‘yield curve inversion’. So let's start with last week's news about the UK shrinking. Just picking out some of the headlines I read last week – the FT led with “Recession threat hangs over the UK”, Spectator had “Is Britain heading for a recession?”, the Guardian: “Britain on the cusp of recession” and we even had the Daily Star leading with “Brexit turmoil drives UK towards recession”. Blimey JP, these are pretty awful headlines but, these came out a few days ago, what's really going on?
Jean-Paul Jaegers: Well the latest GDP print for the second quarter was negative for the UK, and the definition of a recession is that you have two consecutive quarters of negative economic growth.
MH: So ‘GDP print’ - could you just explain a little bit about GDP, what GDP is?
JP: GDP stands for Gross Domestic Product, and it's essentially a measure of how the economy is doing. It's a measure of the size and the health of the of a country's economy over a period of time. So usually measured in a quarter or a year. There are three ways you can measure this economic health: it's either by summing up the total value of goods and services produced; or you could sum up everyone's income; or what everyone in the country has spent.
MH: OK so the news last week was that GDP had fallen in the UK – what does that mean?
JP: Well, when GDP falls it means the economy is contracting, so people are spending less and businesses are not expanding.
MH: And that's important?
JP: Well, yes and no. Yes, it is important if this means it’s the start of a period where the economy continues to contract because of the reasons just mentioned, so people spend less and businesses are not expanding and investing. On the other hand, we can also say “No” if it's something more transitory, for example, I've seen in UK that corporations have been stockpiling as a result of the Brexit uncertainty.
MH: You mentioned stockpiling JP – what is it, what does that mean?
JP: All companies can run up their inventories of produced goods when they are concerned about supply chain disruptions and produce the goods to be put in inventory – this will be recorded as GDP: essentially economic activity; when in the next period the company sells the products and runs down its inventory a bit, there is less production and therefore GDP will be less. It is the activity of production that is measured for economic growth, thus inventory swings due to concerns can actually impact the sequential recording of GDP at times.
MH: Right, I get it. OK so fast-forward to this week then and the headlines coming out this week are all about yield curves and the fact that bond markets are predicting a looming recession. How does that work?
JP: Well in the past we've seen that either yield curve inverts (and that actually means that long-term interest rates go below current cash interest rates) and typically in the US this has been followed by a recession, therefore a lot of people interpret the yield curve as a recession indicator. In UK we now see that the interest rate on a 10-year Gilt is now lower than the overnight cash rate of the Bank of England, and this actually means that there are expectations that the Bank of England will need to lower their interest rates in order to support the economy.
MH: But it seems strange to me to predict a recession coming in the UK when the underlying economy actually looks pretty good. We've got unemployment at an all-time low, wage growth is picking up pretty strongly, and interest rates are at virtually all-time lows which is good for borrowing and reinvesting.
JP: In terms of the labour market it indeed looks in very good shape. We see wages start to accelerate, and typically when you look back in history it's at times when you have low unemployment rate, when you have wage growth accelerating, it usually has been a time where the economic environment has been quite strong.
MH: This all looks pretty puzzling to me though JP. So if you forget the numbers though and tell it to me straight: what's going on, what's actually behind all this?
JP: Well in the UK there is a lot of uncertainty around Brexit. We see that corporations are holding back investments and expansion plans, and on top of that we also see there is an ongoing trade dispute between the US and China. So you have a situation where uncertainty starts to impact confidence about the future, which in some way could become a little bit more self-fulfilling.
MH: Wow, I didn't really appreciate it was having that much of an impact on the UK economy. But talking of recessions, now I remember when a recession meant recession, so you had massive unemployment, slowdown and you know it really was a pretty awful environment to be in. But when I look around at other countries, you know it actually looks a bit weird… let's take Spain for example: 14% of the entire workforce is unemployed but they're not in a recession; you look at Greece as well: 17% of the of their population is unemployed - that's one in every six people – yet they're not in recession. So is this term ‘recession’ just some kind of old-school doomsayers’ term that is pretty redundant today?
JP: It's a technical term to describe that an economy is contracting. They have chosen it to be two consecutive quarters, but you could have one quarter where you have a sharp slowdown in the economy that's NOT recorded as a recession, and you could have two consecutive quarters where you have a mild slowdown that IS recorded as a recession. So in essence it's just one of the possible definitions. We look at a number of economic indicators to understand whether a country or economy is going through a period of a downturn, and not just GDP, as GDP is something like an afterthought. What most investors care about is what will happen next, so we need to have more up-to-date data points on how the economy and economic activity is evolving.
MH: Got it, OK that sounds more important. So surely though, when a country enters a recession the stock market falls?
JP: When an economy is in recession typically you see that corporate earnings fall and as a result stock prices drop. However, recessions come in many shapes and forms. It's incredibly hard to pinpoint exactly when an economy will sufficiently roll over for it to be a downturn, and this is just exemplified by large institutions with vast resources out there like economists and analysts still being unable to point to when a turning point will be happening in time. In addition, stock markets can anticipate very fast so you have to ask yourself whether a slowdown at some moment is not already being priced in. Stock markets tend to drop on recession fears much more often than recessions actually do occur, especially when an economy has been expanding for quite some years. Also, if anything, often in the midst of a recession is the moment to buy as by that time stock prices have adjusted and the recovery is likely to enter on the horizon.
MH: Blimey, JP this is all pretty confusing to me. So the UK is slowing down, maybe potentially entering a recession, but there actually looks a pretty strong economy. So as an investor what do I do? Do I buy now, or do I wait?
JP: Well there are a couple of points to make: first of all, don't read too much into the headlines -they're there to sell newspapers; second, as investors we have to balance the mix of the transitory effects and really the fears of an economy slowing down, and we also know that if you look at the labour markets, these often lag economic activity which essentially means corporations let staff go after activity has dropped. And third, don't time your long term investments.
MH: Really? Just get invested?
JP: Well our work shows that by waiting for the dip you actually forego a lot of returns. Investing for the long term is all about harvesting the returns of those assets over time. Even if you invest in the run-up to a recession it's all about the time being in the market. So be diversified – that means spread your risk because we know that events will come and go, and also let the power of compounding do the work – that's essentially the snowball effect of having returns on returns on returns over time.
MH: So the conclusion here: headlines can be sensational – read beyond the headlines to try and understand exactly what's going on. JP you've helped me do that today – as always you make it sound so simple, and I guess the long-term story is get invested and stay invested. Thanks again JP.
All investments can fall as well as rise in value and their past performance is not a reliable indicator of future performance. This podcast is not a personal investment recommendation.
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