Is UK Growth a One-Off?

UK Q2 gross domestic product (GDP, a government-produced measure of economic output) unexpectedly accelerated, rising 0.2% q/q after Q1’s 0.1%—beating expectations for flattish growth.^[i] Throughout financial publications we monitor, many observers acknowledged the long-awaited UK recession (an economic contraction over several months or more) has yet to arrive—and some no longer foreast contraction this year. But we don’t think this is much of a suddenly sunny turn in sentiment—rather, we have seen some economists update their projections to longer-term economic stagnation.^[ii] In our view, the sour reaction to mixed, mild growth suggests the Pessimism of Disbelief lingers—a sign to us that economic reality in the UK still has a low bar to clear to deliver positive surprise.

Despite the stronger-than-expected headline growth, the Office for National Statistics’ (ONS) GDP report was a mixed bag. Positively, on a production basis, services grew 0.1% q/q, with 9 of 14 subsectors expanding—notable since the sector comprises the lion’s share of UK GDP.^[iii] Consumer-facing services rose 0.8% q/q thanks to food and beverage services, which the ONS attributed to good weather and an increase in live events.^[iv] The production sector expanded 0.7% q/q and its manufacturing subset rose 1.6%, with transport equipment adding the most (0.9 percentage point) and the ONS citing growth in automobile production.^[v]

Shifting to look at the report on an expenditure basis, strength concentrated in domestic activity. Real (i.e., inflation-adjusted) household consumption grew 0.7% q/q after a flat Q1—which we interpret as a sign of UK consumers’ resilience amidst elevated prices—whilst business investment climbed 3.4% q/q thanks to higher transport investment (specifically in aircraft).^[vi]

That said, UK GDP had its soft spots. Export volumes fell -2.5% q/q, with services down due to a dip in business services (e.g., advertising and market research and management consulting), perhaps signalling some weakness in external demand.^[vii] Moreover, the biggest contributor to GDP growth was government expenditures, which jumped 3.1% q/q on higher spending on public administration and defence.^[viii] Government health spending picked up, too, reflecting rising wages due to a National Health Services (NHS) pay settlement. Whilst government spending adds to GDP, our research shows it isn’t an automatic positive, as it doesn’t reflect private sector demand—the UK economy’s primary driver.^[ix]

Now, Q2 GDP is old news and doesn’t reveal where the UK economy is heading, in our view. The closest it gets: The month-by-month breakdown shows UK GDP rebounded to close out Q2, with June’s GDP rising 0.5% m/m after May’s -0.1% dip.^[x] But that was then. We are in August now, and we think stocks are likely looking well beyond today. That said, the reaction to GDP amongst financial commentators we follow seems telling about broader sentiment. We observed many analysts acknowledge the UK economy was holding up better than they forecast and that the much-anticipated recession hasn’t manifested yet—and it may not at all—which we think indicates some improvement in moods.^[xi]

However, waning pessimism isn’t optimism. Based on our coverage of financial publications, plenty of doubts persist. For example, some observers we follow pointed out the UK’s unexpected economic strength is due to one-off factors, including warm weather boosting the hospitality sector and buoyant growth in the volatile pharmaceutical industry (which supposedly won’t last).^[xii] Also, the one-off holiday tied to the King’s coronation skewed the number of working days in May and June, thereby likely affecting the month-over-month growth calculation based on the number of business days.^[xiii]

We agree these factors affected the data. But this view seems to overlook how one-off events can detract, too—see labour strikes in healthcare and the rail industry weighing on economic activity.^[xiv] These passing developments don’t perfectly cancel, but we think it is telling commentators seem more ready to brush off stronger-than-expected growth than the weak spots—a classic early bull market (an extended period of rising equity prices) feature, according to our research.

Looking ahead, we have observed analysis presuming Britain is doomed to perpetually weak economic growth, lagging its developed world peers in the near and distant future. To us, that is evidence of fear morph—and the Pessimism of Disbelief (yes, the UK isn’t in recession, but its prospects are dim). Economic conditions aren’t bustling, but from an investing perspective, sentiment toward the UK appears pretty dim—suggesting to us a low bar for reality to clear to exceed expectations. In our experience, stocks can do mighty fine in that environment.