Do Recent Upward Revisions to the United Kingdom's GDP Mean the Outlook Is Brighter?
No. Although GDP revisions showing that the UK economy recovered more quickly and strongly from the COVID-19 period than was initially thought are welcome, the country faces headwinds to growth in the coming quarters. We continue to recommend holding UK equities at benchmark weights.
The Office for National Statistics (ONS) recently released revisions to historical GDP data that materially altered the picture of how the UK economy recovered in the wake of the pandemic. The ONS found that stock building had been much stronger in 2020 than previously thought, while profit margins were higher in 2021, boosting the wholesale and healthcare sectors in particular. The revised data show that the UK economy had recovered to its end-2019 size by the end of 2021, a milestone the original data showed it had not yet reached. In this regard, the United Kingdom was very much in line with its G7 peers, rather than standing out as the laggard. Indeed, the United Kingdom only trailed the United States in its speed of achieving this recovery and was ahead of Germany.
Nonetheless, these statistics are dated, with more recent data indicating the economy is sluggish. For example, the UK economy has expanded by just 0.4% over the trailing one year. This places the country second to last when compared to its peers, with only Germany once more lagging further behind. Other economic data paint a similar picture. Real retail sales are more than 10% below their peak and not showing signs of recovery, lending to the corporate sector has stagnated, and the composite Purchasing Managers Index (PMI) signals a contraction of business activity. What’s more, the particularly weak new orders and new export orders component of the PMI indicate that weakness in the neighbouring Eurozone is an aggravating factor.
On a forward-looking basis, one of the primary challenges for the economy will be the enduring pressure on discretionary spending that is likely to result from a continued rise in the effective interest rate on the stock of outstanding mortgages. This is because most UK mortgages have a short fixed-rate term, usually two to five years. As a result, we can expect to see a cascading effect of households refinancing loans onto higher rates as their old deals expire. Recent Bank of England communications indicating a higher-for-longer rates path seem to reinforce the likelihood of such a dynamic. Many peers, by contrast, will experience a less severe adjustment due to a preponderance of long-term fixed-rate mortgages.
Sticky wage growth (which is itself partly behind recent hawkish rates developments) does mitigate the broader economic malaise to some extent, as real wage growth should become more decidedly positive as inflation subsides. Indeed, the broader labour market has been one of the bright spots for the UK economy, rebounding strongly post-pandemic and in line with peers in terms of cyclical improvement. However, the last few months have shown some signs of softening at the margins that bears watching. Overall, the issue for the United Kingdom appears to be one of low potential growth, at least in the short to medium term. An overarching impediment has been the absence of any meaningful net new private sector investment in the United Kingdom post the Brexit referendum, which has weighed on the country’s productive capacity.
As a result of this outlook, we find it hard to be excessively positive toward UK equities, despite trading at a material valuation discount to global equities (the ratio of the MSCI UK’s forward price-earnings [P/E] to that of the MSCI ACWI stands at 0.63). However, a substantial portion of this discount is attributable to the UK market having higher weights in value-heavy sectors and a large IT underweight when compared to the global index. Once sectoral differences are accounted for, the ratio of forward P/E rises to 0.78. Despite this residual cheapness, we do not see immediate catalysts for UK outperformance. GDP and earnings per share growth are each likely to be both low and lagging in the coming year. On the flip side, negativity on these fronts is priced in to some extent, so positive surprises could certainly drive a re-rating. Nonetheless, we do not have confidence that such surprises will emerge. What’s more, the concentration of the broad UK index leaves relative performance somewhat subject to idiosyncratic drivers that are tougher to forecast.
The value tilt of the UK market is a positive in our view, given we expect value equities to outperform when global economic activity picks up. However, we prefer to express this theme in pure-play fashion by overweighting developed markets value equities against broad developed markets equities. The greater domestic exposure of UK small caps, when compared to the multinationals dominating the broad index, may make them a more interesting means of expressing a positive UK macro view if and when it becomes appropriate to do so.
Thomas O’Mahony, Senior Investment Director, Capital Markets Research