Recession or rebound, that is the question? - ZISHI

Recession or rebound, that is the question?

Some say the secret of good investing, like good comedy, is all about ‘timing’.

The UK economy recently slipped into recession, but the markets have appeared to retain their sense of humour, perhaps ignoring the ‘set-up’, and waiting for the ‘payoff’. Market participants hate uncertainty and in recent years, investors in the UK markets have had to endure it in abundance. The possibility of the UK going into recession, i.e. two successive quarters of negative growth in GDP seems to have been an ever-present cloud hanging over the markets for at least the past 5 years.

The last recession was caused by the Covid-19 epidemic but we had zero growth the quarter before and the fact that the economy was only in recession for the minimum two quarters was largely as a result of ‘pent up demand’ by households who had not been able to spend their money during lockdowns and government policy which included the general public being financially incentivised to ‘eat out to help out’.

Once this support had evaporated, war broke out in Ukraine and austerity returned, the question for many was not would the economy slip into recession but when and how long a recovery may take.

In other words, will it be a ‘shallow’ recession or a ‘deep’ recession.

We have experienced deep recessions previously; the last one followed the credit crisis in 2008. This consisted of 5 consecutive quarters of negative growth in GDP and was the deepest since the second world war.

The scale of the current recession appears to indicate that this will likely to be a very shallow recession. A decline in GDP of 0.1% in Q3 followed by a decline of 0.3% in Q4 is ‘technically’ a recession in the UK but in certain other countries this would not actually fit into this description. In fact, unlike some others in Europe, the UK economy grew in 2023 albeit by the minimum margin of 0.1%.

There were other announcements of economic data at around the same time as the 4th quarter 2023 GDP figure was announced which gave market observers far more cheer. Earnings are growing at a faster than anticipated rate, unemployment is lower than expected, inflation has been falling and consumer confidence appears to be higher than in 2023. This does not have the hallmarks of a deep recession. Indeed, as Andrew Bailey recently told MPs, by historical standards “this is the weakest recession by a long way.” On that positive statement perhaps, we can take a tour round some of the main UK markets and see what that may tell us about the future trajectory of the economy.

Bond markets

In normal market conditions, the yield curve is expected to be upward sloping as maturity increases.

The reasoning behind this normal upwardly sloping yield curve is known as liquidity preference theory. Whilst all gilts are usually very liquid, investors are exposed to greater risk if they lend money for a longer period. The purchasing power of the nominal will be eroded by inflation in the time between the date of their investment and the date of maturity.

Gilts with a longer maturity date will be exposed to more inflation risk and so a rational, risk averse investor would expect a risk premium in the form of a higher gross redemption yield.

In addition, the prices of bonds are inversely related to a change in yield. Bonds with a longer duration are more sensitive to changes in yield. So longer dated gilts would fall by more than shorter dated gilts if interest rates were to rise.

This is why, in a growth phase of an economic cycle, the yield curve would be expected to steepen. Markets would be anticipating higher inflation and for central banks to take action to control it by increasing interest rates.

In a recession, the opposite would apply. It is not unusual to observe an inverted yield curve where the bond market is pricing in decreases in interest rates by central banks to stimulate economic activity. This is known as ‘pure expectations theory’.

As can be seen from the chart below, the current gilt yield curve is inverted in ranges 2Y vs 1Y, 5Y vs 2Y and 10Y vs 2Y. This is not surprising given the signals from Central Banks that we can expect some reductions in interest rates this year. Andrew Bailey told a parliamentary committee that he was “comfortable” with investors betting on rate cuts this year, although he also asserted that the economy was “showing distinct signs of an upturn” after the recession last year.

 

 

UK Equity Markets

The FTSE100 started 2024 at about 7,721. It has experienced a couple of brief dips since then, bottoming out at about 7,446 in mid-January. At the time of writing, it is now above 7,700.

The FTSE100 has only seen modest growth over the past ten years, about 13% to be exact. This compares very unfavourably with the S&P500 which has increased by approximately 178% over the same period.

Whilst the S&P500 has recently reached all-time highs, the UK equity market has, for some time, found itself in a low/no growth scenario.

A positive take on this is that this low base could present investors with a golden opportunity should confidence return. Whilst the average dividend yield is nearly 3.8% there are some large constituents of the FSTE100 offering much higher dividends for those seeking more of an income bias.

The FTSE250 has been a bit of an unloved space by many since Covid-19 and it is down by about 13% since the start of 2020.

There are potentially some bargains to be had in both the FTSE100 and FTSE250 indices on a fundamental’s basis. There are some very large companies trading at very low Price/Earnings multiples and low price to book ratios. Company balance sheets can of course change, and past performance is not a guide to future performance but if the economic headwinds of the past turn into tailwinds, we may look back at this moment as a key turning point.

Some companies, like housebuilders, arguably stand to benefit most from a reduction in interest rates and this sector could represent value in the medium term. Housebuilders often pay very attractive dividends representing the opportunity for jam today as well as jam tomorrow.

In the UK, there was some recent positive data in the form of the composite Purchasing Managers Index. The PMI is a measure of the prevailing direction of economic trends in manufacturing. This rose in February climbing to a nine-month high of 53.3, with reports of a solid improvement in customer demand. The 50 mark separates growth from contraction.

Investment trusts investing in the FTSE250 have been trading at large discounts for some time now. Any change in sentiment could have a dramatic impact on the share prices of these investments if there is a combination of narrowing discounts and a growth in the underlying portfolios.

Property

Sadly, this asset class presently remains in the doldrums.

According to the RICS UK Commercial Property Monitor Q4 2023, occupier demand remained negative overall (-7%) although this was an improvement on the previous quarters -12%.

There were marginal improvements across the different sectors, but the market was said to lack significant momentum. The positive news came from the largest number of respondents (33%) who believed that the market had bottomed out.

The aforementioned survey noted that prime locations, with significantly higher footfall, outperform secondary units and energy efficiency also remains of significant importance.

Alternatives

Gold

Long regarded as a ‘risk off’ asset, the price of gold can reflect market sentiment and investors risk appetite. The price of gold is still about 11% up on last year but has been levelling out in the past two months. There is still a lot of uncertainty around the world and gold will appeal to many in these troubled times especially given the proven diversification benefits when combined with equities.

VIX

Also known as the ‘fear index’, the volatility index can also help gauge investor sentiment. Short volatility strategies involve taking bets against volatility and there is evidence of an overcrowded short side of the options market indicating that traders are expecting low volatility. The VIX level would certainly support this theory since it is presently sitting a near historical lows. There is concern amongst some that history may repeat itself in the US when there was a big sell off in 2018 which resulted in a ‘flash crash’ as options were unwound around their expiry date.

In conclusion, the timing and magnitude of the recession announcement has doubtless helped avoid mass hysteria in UK financial markets. In fact, there was far more positive economic data released the very same week than the headline grabbing ‘recession’ announcement.

In the short term much uncertainty remains, world peace, we are in an election year in the UK and the US, and the timing of interest rate decreases are still not known. UK markets may be poised for recovery but someone or something needs to light the touchpaper.

At the conclusion of their feature film, The Life of Brian, Monty Python sang ‘always look on the bright side of life’. Perhaps we should focus on the positives of recent announcements and see this recession for what is surely is, a good set-up before the pay-off. As to who will be laughing at the end of the show, we will have to be a little more patient, after all, “they who laugh last, laugh a little longer”.

Source: Article “Recession or rebound, that is the question?” was written by The ZISHI experts, and published in the Advice Matters Magazine | 2024 | Vol 01 | Edition 01

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity.

Contact us

Please do get in touch with us at info@thezishi.com if you’d like more information about how we can help keep your knowledge, policies, and procedures up-to-date.

 

 

Magazine cover

Register for free to access the full magazine, exploring Equality and Inclusion regulation, global uncertainties, and FCA operations.

Download magazine

You might also be interested in:

See all courses
  • Executive Certificate in Global Financial Markets

    £1,999 3 months

    VIEW COURSE
  • Executive Certificate in Project Finance

    £2,359 3 months

    VIEW COURSE
  • Introduction to Derivatives

    Provided on request

    VIEW COURSE
  • CISI Chartered Wealth Manager

    £2,800 2 days

    VIEW COURSE

You need to login first to add to Favourites

My Account