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Is the UK heading for recession?

15 February 2019

5 minute read

Brexit uncertainty continues to weigh on the UK economy, as sluggish economic data pays testament to. This week, we discuss if the UK economy is heading for recession and whether this matters for investors.

Who's this for? Confident investors

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • How Brexit has impacted the UK economy.
  • The signs that the UK may be heading towards a recession.
  • How this could impact investors.

Amidst the coughs and snivels in the office, there were clear signs this week that the UK economy has been feeling below par. Whether it’s just Brexit related or there are broader factors at play remains a matter of some debate. Nonetheless, the latest output data confirmed the picture of gathering economic malaise painted by a broad range of UK focused data points. This obviously matters for those of us who live and work in the UK. Here, we consider what it means for investors.

Not alone

While the continuing uncertainty over how the UK will exit the EU is clearly weighing on private sector decision-making (consumers reluctant to spend and businesses to invest), there are external factors also having an impact.

The world economy has clearly slowed relative to 2017 and early 2018. The surge in investment and global trade enjoyed by pretty much every corner of the world, except perhaps the UK, has waned. Some of this is a function of the mostly benign ebb and flow of the business cycle, as we’ve explored previously. However, there are also some deliberate, self-inflicted and more idiosyncratic elements at play.

Rising trade tensions have not helped, neither have Italy’s political problems. We can probably also assume that higher US interest rates have played an important role, as have the deliberate attempts by Chinese policy makers to curb domestic financial stability risks. Meanwhile, the German economic powerhouse has been hobbled by a necessary retooling of its auto manufacturing sector and the abnormally low levels of the Rhine. Yellow vested popular discontent has had a similar effect on the French economy.

All of this has created a less friendly external backdrop for the UK and others to contend with. Some, like Italy, are already in recession, others such as the UK may flirt with it in coming quarters if current trends persist.

Sell everything?

One interesting aspect of investing through the last decade in particular, is that a relatively clean living economic cycle has been juxtaposed by an understandably paranoid global investor community. The desire to get out of the way of a repeat of the Great Financial Crisis has often led to the risks being misrepresented or simply exaggerated. Those trigger fingers are getting visibly itchier the older this cycle gets, as our experience in December and January amply illustrated.

The most important context point here is that the US economy remains far and away the dominant economy for the world’s capital markets, even those such as the UK’s FTSE. A UK recession would have some effect on Sterling, its bond market and perhaps some of the mid cap and consumer focused areas of the equity market. However, it is a US recession that would play a more definitive role in overall portfolio returns.

Causes of US recessions

The good news is that the US economy has been getting significantly less prone to recessions and significantly less volatile outside of them. If one looks at the share of the preceding 20 years spent in recession, US citizens around at the beginning of the 20th century could expect to have spent well over half of that time enduring a recession. That figure plunges after the Second World War and has continued to moderate ever since, now sitting at around 10%.

One of the reasons for this can be attributed to improved technology and supply chain management techniques. This has enabled companies to hold a lower volume of inventory thanks to more accurate forecasts of final demand. In turn, inventories aren’t as likely to upset the wider economic apple cart as was the case historically1.

Less dependence on overseas oil has also helped amidst rising domestic production and less hunger for oil per capita. More credible central banks and better anchored inflation expectations have no doubt played a vital role too. Of course, that still leaves credit crises and asset bubbles as a key source of recessions to look out for.

Some reassurance

The financial crisis has justifiably, and reassuringly, resulted in a far greater degree of caution on the part of the world’s households, firms and, indeed regulators. This changed regulatory backdrop has helped to make banks, for example, significantly less complex and more focused. They tend to lend more to the real economy and less to each other.

Trading assets have been cut in half, and interbank lending is down by one third2. Alongside this, in most jurisdictions, the sector’s resilience has been transformed thanks to step changes in the quantity of high quality liquid assets needing to be held on balance sheets.

This more chaste setting may have important implications for the length of this cycle. We shall see. As usual, we would caution that most recessions have historically been caused by factors that were not necessarily predictable in advance. However, for long term investors, this wariness may have more important implications beyond how it affects the length of the economic cycle.

Although asset prices have risen substantially since 2009, it is a recovery in corporate earnings that has been primarily responsible. There is a notable absence of exuberance across asset classes, leaving valuations at far from daunting levels. This, allied to a belief in the continuing progress of humankind, is all the investor needs to enter that long term bet on a diversified portfolio.

The travails of the UK economy will continue to compete for headline space alongside the increasingly fraught political process of Brexit. However, investors are maybe best off looking elsewhere.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances. Smart Investor doesn’t offer personal financial advice. If you’re not sure about investing, seek independent advice.

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