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For professional investors only 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 Contact us 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 Institutional business: +44 (0)20 7011 4444 institutional.enquiries@ bmogam.com 0800 085 0383 [email protected] 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 [email protected] 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 © 2016 BMO Global Asset Management. All rights reserved. BMO Global Asset Management is a trading name of F&C Management Limited, which is authorised and regulated by the Financial Conduct Authority. CM09965 (07/16). AT, BE, DK, FI, FR, DE, IE, IT, LU, NL, NO, PT, ES, SE, CH, GB.