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Is the UK already in recession?
July 2016
“Economic forecasting … is the extrapolation from a partially known
past through an unknown present to an unknowable future.”
Denis Healey, UK Chancellor of the Exchequer to the House of Commons,
November 1974
Steven Bell
Chief Economist
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It is just over a month since the Brexit vote and market sentiment has lurched from
doom and gloom to an uneasy optimism. The longer-term impact on the UK economy
will depend on policies as yet unknown and negotiations over the terms of our divorce
from our European partners, many of whom face national elections next year. The
future is truly unknowable; the best we can do is to make an informed guess.
Chart 1: Equity volatility (FTSE 250) post Brexit
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17,000
FTSE 250 Index level
Adviser sales:
24 June
• Brexit announced
• Cameron to quit
17,500
14 July
BoE decides not to
cut base rates
20 July
S&P 500
reaches
record high
4 July
Farage
exits UKIP
16,500
1 July
Carney promises
to ease policy
16,000
13 July
Cameron
resigns
30 June
Boris exits
leadership election
15,500
bmogam.com/adviser
12 July
May to become
new PM after
Leadsom
withdraws
7 July
Gove eliminated
15,000
Discretionary sales:
+44 (0)20 7011 4444
14,500
May
6
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bmogam.com
May
13
May
20
May
31
Jun
8
Jun
15
Jun
22
Jun
30
Jul
8
Jul
15
Jul
22
Source: Bloomberg. As of July 2016. The FTSE 250 consists of the 250 most highly capitalised companies outside of
the FTSE 100.
Bearing in mind Denis Healey’s words, we can at least attempt to improve our ‘partial’
knowledge of the recent past. In particular, we examine whether the UK is already in
recession. According to the single most accurate and timely indicator of UK economic
activity, shown in Chart 2, the answer is ‘yes’. The latest observation for the Composite
Markit Purchasing Managers’ Index (PMI) is based on a survey of over 1,000 UK
companies taken after the Brexit vote was announced. It showed the biggest decline
since the Global Financial Crisis of 2008-09 and, based on a regression and some
assumptions, points to a 0.4% contraction in gross domestic product (GDP) in the third
quarter of 2016 compared with the previous quarter.
Continued
6
PAGE 2
UK Composite PMI
Chart 2: Latest PMI points to negative growth in Q3 2016
UK Economic Growth (GDP vs Composite PMI)
3
60
UK GDP
1
55
0
50
-1
45
Forecast based on latest PMI
Output Index
2
% quarter / quarter
Forecast based on latest PMI
65
UK Composite PMI
-0.4%
40
-2
-3
1998
35
2000
2002
2004
Forecast based on latest PMI
2006
2008
2010
2012
2014
2016
Source: Bloomberg, Markit, BMO Global Asset Management, July 2016.
Note: Forecast of GDP based on regression equation GDP = 0.098 x PMI - 4.83 using quarterly data from Q1 1998 to Q1 2016. The monthly PMI data are averaged over the three
months in the relevant quarter. The forecast for Q3 2016 is based on the assumption that the PMI average for the quarter is equal to the latest figure of 47.7 which relates to July.
Table 1: The ‘Top 16’ Indicators UK Current Activity
% Weight
Next release date (2016)
Construction PMI
10.7
02 August
Unemployment (Claimant count)
9.7
17 August
GFK Consumer Confidence
9.7
29 July
Manufacturing PMI
8.7
01 August
8.7
03 August
7.8
30 July
CBI Distributive Trades Survey
7.8
27 July
CBI Industrial Trends Survey
6.8
21 August
Employment
5.8
17 August
Nationwide House Prices
5.8
28 July
Industrial Production
3.9
09 August
Consumer Credit
3.9
31 July
Aggregate Hours Worked
2.9
17 August
Imports
2.9
10 August
Exports
2.9
11 August
Retail Sales
1.9
18 August
2008
Services PMI
Mortgage Approvals
2010
2012
Source: Goldman Sachs
PMI = Purchasing Managers’ Index. CBI = Confederation of British Industry
Note: Based on the Goldman Sachs Current Activity index. This is a statistical ‘black
box’ which selects those indicators that exhibit the best ‘co-movement’. More
formally, it is the first principal component of the data set, the weighted average
that minimises the unexplained variance of the data. The data are first normalised
by subtracting their respective means and divided by their standard deviations. The
weights in the above table relate to their normalised values.
The decline in the PMIs was not only substantial, it was
greater than the market consensus. This is important because
forecasters were already expecting flat or negative growth in the
UK. The Bloomberg compilation of private economic forecasts
was conveniently compiled the day before the PMI data were
published. The median projection for quarter-on-quarter growth
was zero for Q3 2016 and -0.1% for Q4. Were the Bloomberg
consensus to be updated today, it would probably show a
recession for the second half of this year*.
2014
2016
The PMIs may be the best single indicator of economic activity
but other data can add incrementally to our understanding.
Table 1 shows the 16 most important economic indicators
according to the Goldman Sachs Current Activity Index. There
are several interesting features of this list. The importance of
the PMIs is evident – they occupy three of the top five slots. But
it is surprising that the PMI for construction, a relatively small
sector in terms of GDP which is not included in the Composite
PMI, is ‘number one’. We think this reflects the importance
of construction as a proxy for all sorts of other economic
activity and its ‘multiplier effect’. The latest observation for the
construction PMI was 46.0, even weaker than the composite.
It was compiled before the Brexit vote was known and will
presumably fall further. It adds to the recessionary picture.
What does all this mean for markets? Using this statistical
approach is a key component to judging whether the UK is in
recession and, if so, calibrating its breadth and duration. With the
data in hand, we think analysts are underestimating the severity
of the immediate downturn in the UK’s economy. This is not good
*
Unlike the US, the UK does not have an official definition of recession. Two quarters of negative growth, the most commonly used definition, is the approach we follow here
though it is not without its problems: for example we would consider a hefty decline in GDP in one quarter followed by tiny increases thereafter as a recession.
Continued
PAGE 3
news for domestically-orientated UK equities where analysts’
estimates of UK company profits look too high (revisions since
Brexit have been tiny). Sterling is also likely to remain weak
which would support companies with high overseas earnings,
many of which feature in the FTSE 100. We also expect that the
Bank of England will cut base rates by at least 0.25% when they
meet on 4 August and announce a package of other measures
(though they may resist buying more gilts).
A note of caution is warranted here. We are not alone in taking
a negative view of the UK. Moreover, many UK fund managers
have been forced sellers as their clients have redeemed. There
is a great deal of negative sentiment already priced in.
A much more significant market move is likely if and when
the data start surprising on the upside. The future may be
unknowable but my guess is that the economic downturn in
the UK will be short as well as sharp. That is not to deny that
Brexit may have negative long-term effects on the UK, but the
immediate impact is to postpone expenditure, much of which
will eventually take place.
Judging this requires peering into Healey’s unknowable future.
Much will depend on the new Chancellor’s Autumn Statement.
A major fiscal expansion could easily offset the post-Brexit
downdraft. The negotiations with the rest of the European
Union (EU) are another important factor, including the need for
clarification over the position of the 3 million EU citizens living –
and therefore consuming – in the UK. The turn in the news
flow could even be triggered by the next set of PMIs, if they
show a bounce.
Much has changed since Denis Healey’s words were uttered
back in 1974. He had been the victim of some appalling forecast
errors by HM Treasury who did not use the statistical techniques
described here. The PMIs did not exist. We now have better
survey data and use better techniques to transform the myriad
of different indicators into an overall measure of economic
activity. Careful attention should be paid to these data and, if our
guess is correct, the next big move in the UK will reflect signs
that the economy is bouncing back.
Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management
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