MARKET UPDATE: Recessions good for UK stock market?

From August 2007 we were all crushed by the weight of gloomy media analysis about the “credit crunch”. Yet a large part of the population (confirmed by a number of surveys) simply shrugged their shoulders. Arguably there never was a “credit crunch” as defined by Ben Bernanke many years ago, before he became chairman of the Federal Reserve. And the damage was largely confined to a narrow band e.g. those involved with property, banks that had lent recklessly, hedge funds that had borrowed recklessly.

In fact once the Bear Stearns rescue took place in March 2008, investment market sentiment turned on a sixpence, and a recovery began. As if to acknowledge that the worst of the credit crisis was over, even the oil price drifted back to $100.

And why not? For years we all clamoured for more affordable house prices, less consumer borrowing, and more prudent lending. At a stroke, we were getting all our wishes come true. So long as 95% of the population was employed and (mostly) living where they wanted to, the economy could cope with the unwinding of the credit crisis, and come out the other side with a more stable economic environment, much less reliant on credit.

The stock market recovery did not last, and in May the atmosphere changed. The overwhelming factor from May (not new, but more obvious to one and all) was inflation. Oil went up through $130, and retail prices were up sharply, petrol prices in particular. As if to add insult to injury the ECB said it might raise interest rates (to slow the EU economy and, in theory, reduce inflationary pressures), and the Federal Reserve hinted at the same in early June.

Unlike the credit crisis, inflation infects every household and every business in the UK, and this spooked the stock markets. Yet the inflation risks are very possibly being over-stated. Rising prices in the UK will have a deflationary impact, causing demand to fall across the economy, and prices too, except for those driven by global demand.

In so far as the oil price is a major concern, there is already clear evidence that consumer behaviour is adjusting, and reducing demand for oil. For example, US motorists drove 11 billion fewer miles in March, the largest ever recorded decline, and Europe has seen even larger cutbacks in fuel consumption. In addition a number of emerging economies have begun to reduce domestic subsidies on oil prices, which should also dampen demand, and, eventually, prices. Even so, oil prices could yet spike up through $150 in the short term, triggering stock market falls to the final low, before a stock market recovery begins in earnest.

Wages preoccupy bankers
The “we’ll be tough on inflation” comments from the Bank of England and other central banks were about influencing wage increases, as labour is a much more significant cost for business than energy. The idea that interest rates going up in the UK or EU may help ease the greatest inflationary pressures, which are largely triggered by booming emerging economies, does seem perverse. So look at what the central banks do, not what they say.

Unemployment vital indicator
Unemployment is the key to what happens next. Even the relatively small number that might find themselves in negative equity would mostly cope providing they continue to be employed.

Widespread rises in unemployment across the UK economy might occur if high inflation pressures persist. Rising costs would put profit margins under intolerable pressure, it will be very difficult to pass on the cost increases to customers, so laying off staff is the obvious option.

Yet in a recent survey the OECD reported that UK unemployment should only rise from 5.4% to 5.8% by the end of this year, which is still less than the 6% average between 1995 and 2005.

Recession - should we be worried?
Central bankers and economists are notoriously bad at forecasting recessions. For example, earlier in the year it was assumed that the US was already in recession; it wasn’t, and now the OECD predicts it will not happen at all. Nonetheless, it pays to be vigilant, and to better understand how it might impact your investments.

There have been five major UK recessions since the First World War, not a huge sample, but it is nonetheless instructive. These periods were 1920-21, 1929-32, 1973-75, 1979-82, and 1989-93. The first occurred when a post-war boom was stopped abruptly (and deliberately) by Government spending being cut sharply, and the second by the shock waves from the 1929 collapse of the US stock market.

The pivotal event in causing the 1970’s recessions was an oil price shock, not just a shock because prices went up suddenly, but also because they were triggered by war and revolution respectively. The 1973-75 downturn would never have been anything like as bad if controls on bank lending had not been removed in 1971, fuelling a speculative boom across all asset classes.

The downturn from 1989, unlike the others, was not triggered by an external shock, simply rising interest rates. In the previous few years euphoria and over-optimism had become entrenched. The UK populace (consumers, homebuyers, property developers, bankers, stockbrokers) was allowed to gorge, and it didn’t have the experience or commonsense to know when to stop. At least not until 1989 when, in the wake of interest rate increases (from 7.5% to 15%) there was a rapid collapse in confidence.

The key element (except in 1989) was a shock (a random external event) laid on top of inherent vulnerability. Though many will think that the “credit crunch” has played the role of the shock, there was no cataclysmic collapse in confidence. The banking system wobbled, but is rapidly being re-capitalised. And the world is awash with cash; in fact if the great economist JK Galbraith was with us today he might point out that unlike 1929 there is plenty of money washing around the globe which, ultimately, puts a floor under asset prices.

This “shock” plays a vital role in the unfolding of a major recession, because it causes the (positive) state of mind of consumers and businesses to change overnight. History shows clearly that consumers don’t wait, for example, for unemployment to rise before changing their behaviour.

We are still quite close to events, so judgement is not easy, but it is absolutely clear that in May/June 2008 the behaviour of consumers and businesses changed as inflation pressures surged. Inflation is having a marked and widespread impact on confidence, and pressure on household budgets will trigger fundamental changes in spending habits.

It is not clear that this change in behaviour, and reduction in demand within the UK economy, will be sufficient to trigger a major recession. For example, with the two prior “oil shocks” the scale was quite different - in one month in 1974 the oil price trebled, and in 1979 the oil price went up by 200%. This is in contrast to where we are now, the oil price having been going up for a number of years, reducing the element of shock, and the direct economic impact is also much lower, about a third of that in the 1970s. Yet the credit crisis has created an additional vulnerability.

Perhaps we will not experience a major recession in the style of the above precedents, but an extended period of subdued growth in the UK is highly likely.

Living in the UK will feel more uncomfortable, but as a UK-based investor the global opportunities are very encouraging, as we cover elsewhere, and some asset classes are already displaying outstanding value (such as corporate bonds).

As an aside, we should add that the UK economy should not be confused with the UK stockmarket, which has a strong international edge, with two-thirds of earnings being generated overseas, particularly amongst the larger quoted businesses. More generally we would also question whether recessions are bad for stock markets in any event.

Are recessions bad for stock markets?
Not necessarily. The UK stock market actually rose in three out of the last four recessions, as you can see in the chart, below left. This is because longer term investors take advantage of depressed share prices and look through the temporary period of weaker corporate profits. What is particularly interesting now is that valuations are already at a low ebb and, in price earnings ratio terms, have been falling since 2000.

Therefore history strongly suggests that if the UK or US economies enter recesssion later in 2008 or 2009, their stock markets will already be past the worst. This also tallies with our technical analysis of the UK stock market, set out in our July e-commentary, and also in section 4.7 in much more detail.

UK stock market and recessions past

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