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Pancakes are flat – and so is UK growth

The UK’s average quarterly GDP growth rate for the eight quarters ending in the final three months of 2023 was zero – quite an appropriate comment in a week that saw families celebrate Pancake Day. The UK economy is enduring its weakest period in recent times - outside of the pandemic in 2020 and the recession caused by the banking crisis in 2008-2009. Between 1995 and the end of 2007, the average quarterly growth rate was 0.7% and between 2010 and the end of 2019 it was 0.5%. This week, the Office for National Statistics reported December GDP came in at -0.1% and it was then widely reported that the UK was in technical recession after reporting negative growth in both the third and fourth quarters of last year.

At the same time, core inflation is running above 5% and the unemployment rate was 3.8% in the three months ending in December. Is it stagflation? Is it a super-low productivity trap – more workers employed but output falling? It is not a macro picture that points to a high conviction investment strategy? Yes, I like gilts here because one could take the view that the growth backdrop suggests the Bank of England (BoE) will cut rates aggressively at some point. The market currently has fewer BoE rate cuts priced in than European Central Bank rate cuts in 2024. While Eurozone growth is soft, the UK has stagnated in terms of growth for over two years. Given the comparison with the US – which I will discuss later – it is amazing that sterling is trading at $1.25. A re-test of the lows of 2022 at $1.07 would not look out of place.

2020 double shock

The pandemic hit the UK just after its exit from the European Union was finalised on 31 January 2020. Since then, what strikes me is that real export growth has only averaged 0.25% per quarter compared to 1.1% between 1995 and 2019. Import growth has remained at about the same pace, as has consumer spending. Government spending has risen at about twice the quarterly pace since 2020, reflecting the political pressures on the government to deal with the aftermath of the pandemic as well as public sector pay issues. One could conclude Brexit has harmed UK PLC’s ability to export, which has dragged down overall growth. According to comparable OECD data, the UK economy is only 2.3% larger in real terms compared to Q1 2016 while the US is 10% bigger and France, Italy, Spain and Canada have all grown by more.

Hard to sell an investment story

It is a messy picture. The UK could be heading for a change in government at the next election, especially if inflation and interest rates remain elevated against a backdrop of no growth. The picture does nothing to excite foreign investors about UK equities or bonds. Not only is the macro and political picture unclear – we have not yet got a lot of details on Labour’s economic plans - but there is also currency risk. So far this year, UK equities are down between 2.0% and 2.5%, and have underperformed (in local currency terms) most other global equity markets except China and related Asian markets. 

Equities are cheap but is the UK a value trap? 

The FTSE 350 index, capturing about 90% of UK listed equity market capitalisation, is currently trading with a price to 12-months forward earnings per share of around 10.8 times. On a normalised basis, this is around 0.74 standard deviations lower than its average price-to-earnings ratio from 2008. Only China is cheaper. The US, on the same measure, is at 1.46 standard deviations above its 15-year average. So, the UK market is cheap with an implied earnings yield of above 9% - more than double the yield on 10-year UK government bonds. The question is whether the UK equity market is in a value trap or not. The market has been de-rating since 2015 and total returns from UK equities have lagged: 5% annualised return over the last 10 years compared to 12% for the S&P 500, 9.2% for the MSCI World and 7.1% for the Euro600 index.

Or a cheap buy? 

Now for the good news. UK equities have consistently delivered better returns than UK corporate bonds. Over five, 10 and 20 years the FTSE 350 total return has been around 3.5% higher than UK corporate bond returns. For UK investors, stocks are a viable investment. There are good companies, with exposure to global markets, and to dynamic sectors such as information technology and life sciences, as well as large banking groups and global players in consumer staples, fashion brands and commodities. Moreover, earnings expectations are moving higher. For the index, earnings per share fell to an estimated 9% in 2023. For 2024, growth of 5% is the current consensus, accelerating to 8% in 2025. With a dividend yield of 4%, the potential for high single/low double-digit returns over the next couple of years is clear.

I like bonds, you should know that by now, but in an economy which is flatlining there could be some triggers to help equities perform better – BoE rate cuts, a weaker pound and the prospect of a change of government all have the potential to have a positive impact on investor confidence. While these statistics themselves say little for the relative attractiveness of different equity markets, it is fair to say that the UK listed sector is less encumbered by debt – according to Bloomberg data the UK 350 index has a net debt to corporate profitability (EBITDA) ratio of 0.42 compared to 1.39 for the S&P 500 and 3.76 for the Euro Stoxx index.

And the US keeps on powering on 

Still, the UK is a niche in global equities and only mostly interesting to UK investors and private equity money looking for turnaround stories. The real action in global equities remains in the US where growth is stronger than anywhere else and the large-cap information technology (IT) stocks continue to take the lion’s share of total return and earnings growth. While the commentariat have displayed some schadenfreude this week at the very short-term performance of Apple and Tesla, the rest of the so-called magnificent seven tech stocks and the broader sector continue to deliver strong performance. The IT sector has driven about 50% of the S&P 500’s total return over the last year and is responsible, on a market cap-weighted basis, for about 50% of the market’s earnings per share. I remain positive on the sector as long as the roll-out of generative artificial intelligence and related technologies continues.

Yields stable

 In 2022, higher long-term rates hit the performance of US tech stocks as they were classified as long duration, so higher interest rates reduced the present value of future earnings. Long-term rates have stabilised, and earnings growth has been even better. The macro backdrop remains positive. There has been more talk about the US economy going through a ‘no landing’ scenario, where growth remains positive and inflation above target, and as such the Federal Reserve (Fed) does not need to cut rates at all. The slight upside surprise to January’s inflation data has fuelled such talk, particularly as service sector inflation continues to be sticky. 

Watch the Fed’s forecasts

The reality though is that goods price inflation in the US has been running at a negative year-on-year pace since the end of 2022, and service sector inflation peaked at 7.6% in January 2023. It has been easing since then. It remains above its average of 4% since 1990, but it is likely to move lower as the computation of housing costs catches up with the reality of what is happening in the housing market. Also, a crucial point to make here is that it is not unusual for traded goods price inflation to be incredibly low or negative and for service sector inflation - less open to globally competitive forces - to be higher. That was the case for the US between 1997 and 2021. Average inflation was close to the Fed’s target. The Fed tolerated the wedge, knowing that trying to get service sector inflation down further risked recession and massive credit problems. Indeed, tighter monetary policy from around 2005 in response to a blip higher in goods and services prices triggered the housing crisis.

A period of the Fed keeping rates close to where they are today, making only small but more frequent changes in response to macro signals, might be a scenario with a growing probability. However, for now, the soft landing scenario is the most likely. If China’s own low inflation rates of late herald a period of global goods price disinflation and the next few months see US service sector inflation continue to roll over, then rate cuts from June remain the base case for investors. Watch out at the next Federal Open Market Committee meeting to see what the Fed does with its ‘dot plots’.  If it does not change its forecasts, then US bonds are likely to experience another period of robust performance in the months ahead. The Fed will likely validate that it thinks long-term neutral rates are still around 2.5% and thus that today, monetary policy is too tight.

Sport unites and divides 

To conclude on the theme, the last week was also memorable for a lot of US and UK sporting events including the climax to the American football season and the second round of games in rugby’s Six Nations Championship. I tried to stay up for Super Bowl 58 but only made the first quarter (I was bored as well as tired). The winning headed goal by Scott McTominay for Manchester United against Aston Villa a few hours earlier was far more exciting. American and British sport is great and while my equity allocation is more than likely always going to be more US than UK, my heart is with the Premier League over the NFL, and the FA Cup Final over the Super Bowl. 

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 15 February 2024). Past performance should not be seen as a guide to future returns.