Why Markets Seem to See Through Britain’s Blues

UK GDP for October hit the wires Monday, and in a rather telling sign of sentiment, few noticed. Typically, headlines would bend over backward to explain that the 0.5% m/m rise stemmed primarily from the late Queen’s funeral knocking September’s output, pushing it into October.^[i] Nice, but overall meaningless and not worth reading into. But this year, economic trends aren’t the primary item weighing on sentiment. That honor goes to inflation, so no surprise that the UK CPI report for November stole center stage. While inflation slowed, pundits warned much more pain is in store even if the inflation rate has passed its peak—with more Bank of England (BoE) rate hikes to come. In other words, the same forecasts we have seen all year. Yet against that sentiment backdrop, the UK is one of just four MSCI World Index constituent countries with positive year-to-date returns in local currency. In US dollars, it is the second-best performing country. In our view, this speaks volumes about how markets work.

Indeed, things aren’t exactly going terrifically for the UK economy. GDP contracted in Q3, putting the nation back on recession-watch. BoE forecasts presume one is underway. It was just one of four developed nations to contract in Q3. But unlike Japan, the Netherlands and Luxembourg—all of which grew at least 1.0% q/q in Q2—its slide followed meager Q2 growth.^[ii] Its year-to-date high inflation rate, 11.1% y/y, trails only Belgium, the Netherlands and Italy among developed nations.^[iii] Inflation’s modest slowdown from that to 10.7% y/y in November hardly seems anything to celebrate.^[iv] Yes, there was some relief on gasoline and transit prices, but without seasonally adjusted monthly data, there are no granular trends to investigate, making it difficult to pin down where disinflation is taking hold. So if you are looking at the data alone, it is easy to see why some are making a case for the UK as the latest proverbial sick man of Europe. 

But markets tend not to think in these terms. For one, they are forward-looking. Hence, they pre-price widely expected events, opinions and forecasts well in advance. Recession forecasts have dotted UK financial headlines for over half a year now, likely limiting the power for actual GDP declines to surprise anyone. High energy costs have similarly dominated the national conversation, rendering the UK’s relatively faster inflation a foregone conclusion. The fact that energy regulators “cap” energy prices with a price level that resets (higher) in April and October makes it even easier to pencil in high costs than in other nations where the prices fluctuate more. When the data confirmed these bad expectations, markets mostly sighed and moved on, looking more toward the future—a future where even the biggest pessimists see growth resuming in 2024, which is now well within the 3 – 30 month range that stocks focus on.

Two, markets don’t deal in whether things are objectively good or bad. No one is arguing things are good in Britain right now. High home heating costs are forcing many households to cut back. Stealth tax hikes are cutting into workers’ take-home pay at a time when wages aren’t keeping pace with inflation. But for markets, what matters more is how reality—whatever it looks like—squares with expectations. We imagine it is cold comfort for many of our UK readers, but it does seem that in the realms stocks focus on, things are shaping up modestly better than feared. Energy shortages haven’t materialized. Even at this weekend’s cold snap, the National Grid didn’t have to resort to rationing and rolling blackouts, and natural gas was abundant enough that power providers were able to avoid restarting mothballed coal plants. Factories en masse haven’t had to sit idle due to prohibitive operating costs. Leisure and hospitality has reaped some benefits from the end of COVID lockdowns even with prices up and the World Cup happening on the cusp of winter rather than the traditional summer going-out season. An economy that is overall muddling through despite some declines is far better than the freefall many feared would result from energy shortages and sky-high inflation.

Lastly, sector makeup matters. One of the UK’s biggest headwinds this year is high energy prices—gasoline, home heating, electricity. But Energy is the MSCI UK Investible Market Index’s fourth-largest sector. The economy’s pain is those companies’ gain, which has helped overall UK stocks this year. That may not continue moving forward, given stocks have priced in higher oil and natural gas prices’ impact on Energy sector earnings by now, but it was a boon this year. Higher commodity prices (another inflation driver) also helped Materials outperform. Combined with Energy, the two constitute over 20% of the UK stock market.^[v] Globally, those combine for less than 10% of the MSCI World Index.^[vi] Sometimes this works against UK returns, but this year it was beneficial.

Always remember to think like markets do. Set aside the emotions that seeing and living through bad economic spells can inflict. Tune down sociological matters, like the ongoing industrial actions, that are very real and important issues but generally mean little to corporations’ bottom line in the end—and therefore don’t register for stocks. Look to the future. Consider not just reality, but how that reality squares with forecasts. Remember surprises matter most and that stocks deal in probabilities, not possibilities. If forecasts are universally gloomy and things couldn’t possibly go even worse, then there is a high likelihood of positive surprise—which, usually, is good enough for stocks.