Assessing the UK and Japan’s ‘Recessions’

Two big gross domestic product (GDP, a government-produced measure of economic output) releases hit the wires yesterday, and we think it is fair to say they weren’t pretty. Japan’s Q4 output fell -0.4% annualised, its second straight contraction, knocking it down the rankings to the world’s fourth-largest economy (behind the US, China and now Germany).^[i] Meanwhile, UK GDP fell -0.3% q/q (-1.4% annualised), also its second consecutive quarterly drop, qualifying both countries for the recession label based on one popular definition.^[ii] Whilst the broader universe of commentators and economists we follow hashes out whether either or both of these countries actually qualify as recession sufferers, we think the takeaway for investors here is simple once you factor in the principle that stock prices reflect all widely known information: Stocks are well aware of both countries’ headwinds, which manifested long before successive GDP reports confirmed them.

Japanese GDP may be down for only two quarters running, but domestic demand notched its third straight decline. Its slide began in Q2 2023, when household spending fell -2.7% annualised and business investment dropped -5.5%.^[iii] But exports’ 16.2% surge was more than enough to offset domestic weakness and lift GDP by 4.0% annualised that quarter.^[iv] Not so in Q3 and Q4, when domestic activity continued slipping and export growth wasn’t strong enough to mask it. In our experience, some might be tempted to call Q4 an improvement given the rates of contraction slowed across the board: Household spending’s decline eased from -1.4% annualised in Q3 to -1.0%, business investment’s decline moderated from -2.4% to -0.3%, and GDP’s -0.4% drop was much slower than Q3’s -3.3%.^[v] But a decline on a decline is no improvement, in our view. Plus, we find economies don’t follow laws of physics, we think it would be a stretch to argue slowing contraction is a sign the contraction is bottoming out. So we won’t.

Whilst Britain’s decline was steeper than Japan’s in Q4, we think its underlying indicators were a smidge more encouraging. Household spending’s decline slowed from -3.4% annualised in Q3 to -0.6%, whilst business investment flipped positive, growing 6.3% annualised after Q3’s -10.7% decline.^[vi] But trade was weak on both sides of the ledger, with exports and imports (which we find represent domestic demand) in the red.^[vii] So, not a great report, but as with Japan, not new or surprising, in our view. The Bank of England (BoE) and economists globally have been pencilling in a UK recession for about two years now, and they initially projected it would start in late 2022.^[viii] So far, the country’s GDP decline is tardier and milder than forecast.

So in both places, we think falling output is old news to stocks, which our research finds are forward-looking. Yet, interestingly, their domestic stock markets are diverging. Japanese stocks are jumping and continually hitting post-bubble highs in yen, whilst UK stocks are drifting sideways after last year’s pullback.^[ix] Are markets signalling Japan is secretly in much better shape than Britain? We doubt it—this seems mostly about market composition to us. Japan has several large multinationals that capitalise on external demand, which the aforementioned export tallies seemingly confirm finished 2023 on a strong note. To these companies, domestic demand matters less to earnings, likely adding tailwinds for Japanese markets. Therefore, it seems to us stocks are accurately reflecting the domestic/external demand divide.

UK markets, however, are much more cyclical and value-orientated in general—heavy on Financials, Energy and Materials.^[x] Energy underperformed world stocks bigtime last year, which we think says a lot about how oil prices defied expectations amongst commentators we follow for a jump—and says little to nothing about UK economic fundamentals.^[xi] Britain’s Financials have stronger UK economic ties, and they are flat since last spring, which we don’t find shocking considering lending spent most of 2023 in the red.^[xii] But more broadly, UK stocks are heavily value-orientated, and value has struggled globally for a long while.^[xiii]

In any case, we don’t think markets are screaming red alert—they seem to be assessing the situation and moving forward. Most importantly, Japan and the UK are 6.1% and 3.8% of global market capitalisation, respectively—and 4.2% and 3.0% of global GDP.^[xiv] In our view, there are far more and bigger variables affecting global returns and growth. Simply, shallow contractions in the UK and Japan likely aren’t enough to tip the world into recession—not when the US and many others are still growing.^[xv] Case in point, world stocks hit new highs this month.^[xvi] We think they are looking forward, at likely earnings growth over the next 3 – 30 months, not back to what two economies did as 2023 wound down.

Looking ahead, we don’t think the UK and Japan are challenge-free. Both have well-known domestic headwinds, in our view. But we find many are structural (long-running and part of the background), not cyclical—they are issues these countries have already shown they can grow through. So to us, the most likely scenario is that a growing world soon pulls them along. Our research suggests expectations toward both remain rather low, so we don’t think it is likely to take much pull for their economies to deliver positive surprises.