The R-word loomed large in the financial news world once again Thursday. Whilst the Bank of England (BoE) raised its benchmark interest rate again to 1.0%, the main story in publications we follow was its 112-page quarterly Monetary Policy Report, which contains its updated economic forecasts.[i] Most coverage reported the BoE is forecasting a British recession (an extended, broad economic downturn) and 10% inflation (broadly rising prices across the economy), which we think is a rather oversimplified summary, as we will discuss. In our view, there are so many ifs in the report that, from an investing standpoint, it is likely of little practical use. It won’t surprise us if the forecast were to impact sentiment, and markets may pre-price, or pre-emptively incorporate, weakening economic expectations into share prices, but we don’t view these forecasts as reason to avoid UK or global stocks.
The BoE, to its credit, doesn’t release precise quarterly gross domestic product (GDP, a government-produced measure of economic output) forecasts as if they are a fait accompli—that is the trap too many supranational forecasts fall into, in our view, thinking they can pinpoint a growth rate down to the decimal point. The BoE does release headline forecasts like this, which is how its forecast for a -0.25% GDP contraction in 2023 came to dominate headlines, but that is just the central figure in a fan chart of various possible outcomes, with probabilities assigned by the BoE’s models.[ii] (A fan chart shows a range of potential outcomes, shaded according to their perceived probability. Since there is more uncertainty the farther out forecasters look, the range of potential outcomes becomes wider, forming a fan shape on a chart.) As a general rule, in our view, models are only as good as their inputs. The BoE’s inputs are:
From our experience researching global markets, those are all moving parts. Consider: In February’s forecasts, the BoE’s headline projection for 2023 GDP was 1.25% growth.[vii] That was based on its chosen market-based indicator projecting the Bank Rate would be at just 1.4% by mid-2023.[viii] It seems to us all it took to raise the probability of a slight full-year contraction, according to the BoE’s technique, was a shift in people’s viewpoints of future rates. In our experience, those viewpoints shift regularly. What if BoE guidance and global conditions—not to mention weak economic expectations—cause market-based interest rate projections to downshift again? If you are starting to suspect this is all a bit circular, you aren’t alone.
Then, too, as we mentioned, these fan charts show a wide range of outcomes. The chart showing projections for the level of quarterly real (inflation-adjusted) GDP, for instance (Chart 1.2 on page 14 here, if you would like to see), shows a broad distribution of potential GDP paths that could leave quarterly output anywhere from £520 billion (in constant 2019 GBP) to £630 billion by Q1 2025—the forecast’s high and low ends, with what the BoE thinks are higher-probability outcomes shaded in darker aqua colours.[ix] But, as the BoE explains:
“The distribution reflects uncertainty over the evolution of GDP growth (in Chart 1.1) and GDP (in Chart 1.2) in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that the mature estimate of GDP growth (in Chart 1.1) or GDP (in Chart 1.2) would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns are also expected to lie within each pair of the lighter aqua areas on 30 occasions. In any particular quarter of the forecast period, GDP growth or GDP is therefore expected to lie somewhere within the fan on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions GDP growth or GDP can fall anywhere outside the aqua area of the fan chart.”[x]
It seems to us this forecast is full of uncertainty. In our view, it is a monetary policy institution’s detailed examination of all the potential ways its monetary policy decisions might affect economic output—an accountability tool, in theory. In our experience, stocks pre-price expected economic trends, so we think keeping an eye on the economic outlook is useful for investors, but we are just very, very sceptical that there is anything actionable here on that front. We think stocks move most on probabilities, not possibilities.
Should the UK’s economic outlook worsen to the point where it presents a material negative for stocks, we think there will likely be other, better ways for investors to spot it. We think a deeply inverted yield curve (a graphical representation of one issuer’s interest rates across the spectrum of maturities, with inversion happening when short rates exceed long), for instance, would probably signal trouble. When markets closed Thursday, even with the BoE’s move, there was a 0.78 percentage point positive spread between benchmark 3-month and 10-year UK yields.[xi] That is flatter than the US yield curve, but it isn’t inverted—and we think it creates some wiggle room if the BoE decides to keep hiking.[xii] We think there is potential for the bank to overshoot—we are watching—but even then, our historical analysis shows the yield curve is a signal, not a timing tool. We think other indicators to watch include the new orders components of S&P Global’s manufacturing and services purchasing managers’ indexes (PMIs, monthly surveys that track the breadth of economic activity), which remained broadly expansionary in April.[xiii]
All of which the report suggests the BoE sees, by the way. The Monetary Policy Report cited today’s demand surplus as a near-term positive economic driver. According to the report, the bank merely forecasts that demand glut morphing to a supply glut by yearend as high living costs hit households harder and higher rates squeeze businesses and lending.[xiv] We think that is a possibility. We aren’t dismissing it. We are simply saying there isn’t a good way to ascribe actionable probabilities to this outcome for now, in our view. Not with energy prices in flux and, as yet, no hard data showing how April’s energy price cap increase and tax changes hit consumer demand.[xv]
In our experience, watching and waiting is one of the more frustrating tasks an investor can undertake, especially when sentiment is dour and stocks are in a correction (a sharp, sentiment-driven decline of around -10% to -20%). But at times like this, we think it is helpful to assess the situation from what we consider first principles. We don’t know precisely how the UK economy will evolve. But in our view, markets are efficient and forward-looking. We know the UK’s cost-of-living pains have dominated headlines for months. Rising energy price caps have been front-of-mind since last autumn, when a shortage of wind power first sent electricity prices spiking higher.[xvi] If markets are at all efficient—which we think they are—then stock prices logically reflect these headwinds to a great degree already, in our view. Note, too, that even with all the negatives hanging over the UK economy this year, UK stocks are outperforming global markets year to date.[xvii]
In our view, the question from here isn’t even necessarily whether UK GDP contracts later this year, but whether the outcome—positive or negative—is better or materially worse than what markets already priced in. If the BoE’s dismal forecast helps move sentiment even lower than it already is, then we think that creates positive surprise potential even if things just go less bad than financial commentators warn.
[i] Source: Bank of England, as of 6/5/2022.
[ii] “Monetary Policy Report,” Bank of England, May 2022.
[vii] Bank of England, as of 6/5/2022.
[viii] “Bank Rate Increased to 0.5% - February 2022,” Bank of England, 3/2/2022.
[ix] “Monetary Policy Report,” Bank of England, May 2022.
[xi] Source: FactSet, as of 5/5/2022.
[xii] Ibid. Statement based on benchmark 3-month and 10-year government interest rates in the US and UK.
[xiii] Source: S&P Global, as of 6/5/2022.
[xiv] Source: Office for National Statistics, as of 6/5/2022. Statement based on UK Consumer Price Index, year-over-year percent change, March 2022. A Consumer Price Index is a government-produced index tracking prices of commonly consumed goods and services.
[xv] Source: FactSet, as of 6/5/2022. Statement based on Brent Crude Oil spot prices, and “Price Cap to Increase by £693 from April,” Ofgem, 3/2/2022, and “Rishi Sunak Accused of Imposing £21bn ‘Stealth Tax’ on UK Workers,” Richard Partington, The Guardian, 16/3/2022.
[xvi] “Global Energy Crisis: How Key Countries Are Responding,” Jennifer Rankin, Oliver Milman and Vincent Ni, The Guardian, 21/10/2021.
[xvii] Source: FactSet, as of 6/5/2022. Statement based on MSCI UK IMI Index return with gross dividends and MSCI World Index return with net dividends in GBP, 31/12/2021 – 5/5/2022.
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