Weighing the Good and Bad in UK GDP

Has a UK recession begun? That is the question headlines globally explored Thursday when news broke that, while UK GDP grew in Q1 overall, it declined in March—with consumer-facing services seemingly leading the way down. As the consensus viewpoint goes, that isn’t a good sign for a country that swallowed steep cost of living increases in April, ratcheting up the pressure on households. And we don’t totally disagree. Yet we do think investors benefit from taking a broad, measured view—of the silver linings as well as the clouds.

Now, considering we are nearly halfway through May—and stocks are forward-looking—Q1 GDP is pretty ancient history. But it is worth a look regardless, at it provides more clarity on the trends stocks should have already priced, and the contrast between full-quarter and March figures seems to have hit sentiment.

Or, it should provide more clarity. After reading through the entire data release from the UK Office for National Statistics, we hesitate to draw sweeping conclusions for good or ill. As the release explained, Q1’s figures are subject to more uncertainty and revision than usual due to some recent methodology changes that statisticians are still ironing out. Those affected trade (particularly trade with the EU) as well as consumption. Pandemic-related skew also lingers due to the way public services—particularly the National Health Service—are accounted for in GDP. Lastly, because government services aren’t sold at market prices, the inflation adjustment applied to it is largely imaginary. In the release, the ONS takes great pains to discourage readers from comparing results from quarter to quarter.

With that caveat out of the way, the data were rather mixed. GDP grew 3.0% annualized, with a 2.2% annualized rise in consumer spending contributing nearly half of headline growth.^[i] That figure is inflation-adjusted, so for at least the first part of 2022, spending managed to overcome higher prices. Its contribution was also offset perfectly by a purported drop in government spending, which is partly a figment of the aforementioned inflation math—a guesstimate of an accounting entry. And, more realistically, in part the end of COVID testing and tracing and the vaccination booster drive. On the investment front, it was a mixed bag. Business investment fell -1.8% annualized, but that stemmed entirely from supply shortages hammering spending on transport equipment (down -32.8% annualized).^[ii] Investment in tech and communication-related equipment (23.7%), intellectual property products (13.7%), dwellings (22.5%) and other structures (40.7%) was quite strong.^[iii] Government investment, which the ONS noted was primarily in buildings, jumped an astounding 133.2% annualized, but we wouldn’t make much of that.^[iv] Inventories also provided a sizable contribution after falling for most of 2021, suggesting companies finally replenished depleted stockpiles.

Whether that turns into an inventory overhang remains to be seen, which is where the gloom over March GDP comes in. Output fell a mere -0.1% m/m, and the series overall is rather volatile, with frequent one-off drops.^[v] But the details were discouraging in light of the issues widely summarized as a “cost of living crisis.” Retail trade dropped -2.8% m/m, and that was before April’s headwinds set in. Most observers expect spending on goods to deteriorate further as the higher household energy price cap and recent stealth tax hikes kick in. Fair enough, but as the ONS noted, the global automobile shortage contributed a bunch to the drop—that is a supply problem, not necessarily a demand problem. Outside that category, consumer-facing services did relatively well: The nebulously named Other Personal Services, which was the largest positive contributor to consumer services, rose 4.0%.^[vi] Meanwhile, another big detractor was property rentals, which are a pretty widely reported political sore spot given the ongoing tussle over buy-to-let.

None of this is to dismiss the pain from high fuel, food and household energy costs. But even here, there are perhaps some reasons for optimism. For one, global oil and natural gas prices have cooled recently. One thing the UK has going for it is that it produces much of its own energy, making its energy prices less sensitive to currency swings than, say, Japan (energy commodities are priced in dollars, so when an energy importer’s currency is weak, oil and gas priced in dollars are even more expensive when converted to local currency). Also helpful, mining and quarrying activity—which includes North Sea oil and gas production—jumped 2.8% m/m.^[vii] Production of coke and refined petroleum products, which is the manufacturing subset that includes gasoline refining, soared 5.7% m/m, on the heels of February’s 3.9% and January’s 2.3%.^[viii] It may take time to show up in fuel prices, but the industry is responding to consumers’ acute pain and needs—both in the UK and globally. Mind you, we think high gas prices create winners and losers rather than hurt spending and GDP, as spending on fuel is still consumer spending—and the UK economy is overall quite energy-efficient, limiting high energy costs’ overall impact. But we also know the pain on many households is severe on this and several other fronts, so any relief would be welcome. It may come sooner than many think.

As for stocks, we think they look forward—not backward. The UK’s headwinds aren’t small, but they are also very well known. Energy costs have been top of mind for over half a year now, since a shortage of wind power sent natural gas prices soaring and put several energy suppliers out of business, tied to price controls. Those same price controls mean that April’s increase was also penciled in months ago—just as the Bank of England recently penciled in another increase for this coming October. Again, this isn’t objectively good, but stocks don’t deal in terms of “good” and “bad.” In our view, they weigh whether economic reality is likely to be better or worse than the consensus expects over the next 3 – 30 months.

And on that front, well, expectations are low. Recession chatter, swirling for weeks now, plays into that. So does the drumbeat of reporting and political wrangling over the cost of living crisis. More recently, worries about a potential trade war with the EU if Foreign Secretary Liz Truss unilaterally discards the Northern Ireland Protocol have sent prompted a fresh wave of dismal forecasts. And stocks have noticed. Though the MSCI UK IMI Index is outperforming global markets year to date, it has trailed during this downturn’s April – May downdraft. The why behind volatility is always harder to know than the what, but we can see a strong argument that stocks have priced UK economic fears in a hurry, at least to some notable extent.

At any time, even in a global expansion, there will always be pockets of weakness as well as strength. Perhaps the UK is one of those weak pockets this year. Perhaps that will translate to a recession, using the popular definition of two consecutive GDP contractions. But there is also precedent for a growing world to pull weaker countries along. The UK itself is evidence of this. A decade ago, which happens to be the last time inflation topped 5% in Britain (due primarily to a value added tax increase), data initially showed the UK endured a double-dip recession in 2012. It wasn’t an easy time for many. But UK stocks soldiered through, as did UK households. The economic downturn was short, and eventually data revisions wiped the recession from the history books, with 5.0% annualized growth in Q3 2012 separating contractions that Q2 and Q4.^[ix] Growth returned in earnest in 2013, kicking off a multiyear positive run—and UK stocks participated in the rest of that decade’s global bull market.

Bad news that hits the wires when stocks are slumping can hit sentiment disproportionately. But it is important for long-term growth investors to keep a cool head, put data in context and resist the temptation to extrapolate bad results either forward or globally.