Why Markets Seem to See Through Britain’s Blues

UK GDP (gross domestic product, a government-produced measure of economic output) for October hit the wires Monday, and in what we saw as a rather telling sign of sentiment, not many commentators we follow spent much time on it. In our experience, headlines would have typically bent over backward to explain that the 0.5% m/m rise stemmed primarily from the Queen’s funeral knocking September’s output, pushing it into October—as the Office for National Statistics stressed in its data release.^[i] This caveat likely means October’s growth doesn’t much reflect the broader economy’s state, in our view. But this year, our research suggests economic trends aren’t the primary item weighing on sentiment. We think that honour goes to inflation (broadly rising prices across the economy), so we don’t find it shocking that the UK Consumer Price Index (CPI, a government-produced measure of goods and services prices across the broad economy) report for November stole centre stage. Whilst inflation slowed, commentators we follow warned much more pain is in store even if the inflation rate has passed its peak—with more Bank of England (BoE) rate hikes likely to come.^[ii] In other words, the same forecasts we have seen all year. Yet against that sentiment backdrop, the UK is one of just four MSCI World Index constituent countries with positive year-to-date returns in local currency.^[iii] In our view, this speaks volumes about how markets work.

We think it is fair to say things aren’t exactly going terrifically for the UK economy. GDP contracted in Q3, putting the nation back on recession-watch.^[iv] BoE forecasts presume one is underway.^[v] It was just one of four developed nations to contract in Q3.^[vi] But unlike Japan, the Netherlands and Luxembourg—all of which grew at least 1.0% q/q in Q2—its slide followed meagre Q2 growth.^[vii] Its year-to-date high inflation rate, 11.1% y/y, trails only Belgium, the Netherlands and Italy amongst developed nations.^[viii] Inflation’s modest slowdown from that to 10.7% y/y in November hardly seems anything to celebrate, in our view.^[ix] Yes, there was some relief on petrol and transit prices, but without seasonally adjusted monthly data, there are no granular trends to investigate, making it difficult for us to pin down where prices are slowing. So if you are looking at the data alone, we think it is easy to see why some are making a case for the UK as the latest proverbial sick man of Europe, a label given to a European country supposedly experiencing economic hardship. 

But in our view, markets tend not to think in these terms. For one, our research suggests they are forward-looking. This means they pre-price widely expected events, opinions and forecasts well in advance. We have seen recession forecasts dotting UK financial headlines for over half a year now, which we think likely limits the power for actual GDP declines to surprise anyone. From our vantage point, high energy costs have similarly dominated the national conversation, seemingly rendering relatively faster inflation a foregone conclusion. In our view, the energy price caps that reset at higher levels in April and October likely make it easier to pencil in high costs, compared to other nations where the prices fluctuate more. When the data confirmed these bad expectations, markets seemed mostly to sigh and moved on, looking more toward the future—a future where even the biggest pessimists see growth resuming in 2024, which is now well within the 3 – 30 month range that stocks focus on, in our view.^[x]

Two, we don’t think markets hinge on whether things are objectively good or bad. In our experience, not many people are arguing things are good in Britain right now. High home heating costs are reportedly forcing many households to cut back. Stealth tax hikes are cutting into workers’ take-home pay at a time when wages aren’t keeping pace with inflation.^[xi] But in our view, what matters more for markets is how reality—whatever it looks like—squares with what investors broadly thought likely to happen. We imagine it is cold comfort for many of our readers, but it does seem that in the realms our research shows stocks focus on, things are shaping up modestly better than many commentators we follow warned was likely to happen. Steep energy shortages haven’t materialised. Even at this weekend’s cold snap, the National Grid didn’t have to resort to rationing and rolling blackouts, and natural gas was abundant enough that power providers were able to avoid restarting mothballed coal plants.^[xii] Factories en masse haven’t had to sit idle due to prohibitive operating costs.^[xiii] Leisure and hospitality has reaped some benefits from the end of COVID lockdowns even with prices up and the World Cup happening on the cusp of winter rather than the traditional summer going-out season.^[xiv] In our view, an economy that appears to be overall muddling through despite some declines is far better than the freefall many commentators we follow warned would result from energy shortages and sky-high inflation.

Lastly, the domestic stock market’s sector makeup matters, in our view. One of the UK’s biggest headwinds this year is of course high energy prices—petrol, home heating, electricity. But Energy is the MSCI UK Investible Market Index’s fourth-largest sector.^[xv] In our experience, the economy’s pain tends to be those companies’ gain, which has helped overall UK stocks this year, considering UK Energy stocks are up 46.6% this year to date.^[xvi] That may not continue moving forward, as our research suggests stocks have priced in higher oil and natural gas prices’ impact on Energy sector earnings by now, but it was a boon this year. Higher commodity prices (another inflation driver) also helped Materials outperform.^[xvii] Combined with Energy, the two constitute over 20% of the UK stock market.^[xviii] Globally, those combine for less than 10% of the MSCI World Index.^[xix] Sometimes this works against UK returns, but this year it added to them.^[xx]

We have long held that investors benefit by thinking like markets do. Set aside the emotions that seeing and living through bad economic spells can inflict. Tune down sociological matters, like the ongoing industrial actions—whilst they are very real and important issues, we find they generally mean little to corporations’ bottom line in the end, and therefore we don’t think they register for stocks. Look to the future. Consider not just reality, but how that reality squares with forecasts. In our view, surprises matter most and stocks deal in probabilities, not possibilities. If forecasts are universally gloomy and things couldn’t possibly go even worse, then there is a high likelihood of positive surprise—which is usually good enough for stocks, in our view.