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UK economy at a crossroads

Graham Smith

Graham Smith - Market Commentator

Positive soundings on Brexit negotiations were few and far between this week, as EU leaders hardened their stance towards Britain’s latest proposals for Ireland’s customs arrangements. With Britain’s scheduled departure from the EU now just two and a half weeks away and neither side showing any signs of backing down, the possibility of a no-deal Brexit has moved into sharper focus.

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These developments have coincided with renewed concern about the UK economy. While we will have to wait until the release of official data in early November to be sure, some of the latest batch of economic reports have been ominously consistent with the beginnings of a recession.

News back in August that the economy had shrunk by 0.2% in the second quarter of the year was largely brushed aside at the time as a reaction to stronger than anticipated growth over the previous three months. Businesses and consumers stocking up ahead of the first Brexit deadline at the end of March contributed to economic growth of 0.5% in the first quarter1.

However, recent surveys of services, manufacturing and construction and a report this week showing retail sales were 1.3% lower in September compared with the same month a year ago suggest economic growth may have remained absent during the third quarter as well2.

If it did, then Britain has already entered a technical recession, irrespective of the eventual results of negotiations in Brussels.

Take a step back though, and events may take on a less clear-cut guise. The public positions of politicians may have hardened over recent days, but that ought to concentrate minds too on how much there is to lose on both sides from a disorderly withdrawal.

Meanwhile, it is by no means certain that the UK is on the brink of a recession because a number of critical drivers remain robust. For an economy about two-thirds driven by consumer spending, low unemployment, rising wages, and oil prices that consistently fail to sustain gains even in the face of geopolitical shocks are economic tailwinds. Unemployment was just 3.8% in the May-July quarter, while wages increased by 4.0% on a total pay basis4.

Supporting this notion came data on Thursday showing the economy grew by 0.3% in the three months to August, boosted by strong film and TV production. Economic output would now have had to have shrunk sharply in September for there to be a contraction overall in the third quarter⁵.

Perhaps that’s one of the reasons why – and notwithstanding a shocking day for world equities a week and a half ago – that the UK stock market is holding up reasonably well. At the time of writing, the FTSE 100 Index remains about 7% ahead since the start of this year6.

Investors may need to tread more carefully this autumn, even though shares have broadly held up in the face of danger so far. We shouldn’t be fooled. The relative stability of the UK’s major stock indices has had as much to do with sterling weakness lifting exporters, as it has any confidence in economic conditions improving at home.

Indeed, this summer’s flurry of improvements among Brexit High 50 stocks – which tend to be domestically exposed companies with the most to lose from a hard Brexit – have been largely reversed since the end of September7.

Even so, the reason why now might be just the wrong time to give up on the UK takes us back to where we broadly came in. Expectations have been pummelled by Brexit uncertainty, leaving scope for a possibly counterintuitive rebound in share prices.

Catalysts – most likely not currently factored in – could be interest rate cuts, tax cuts – either for businesses or consumers or both – or more government spending should the economy remain weak.

Finally, the stock market currently trades at modest valuation levels compared with history and other world markets, suggesting fundamentals would not act as a barrier to a rebound.

For instance, the MSCI United Kingdom Index – which tracks the performance of 97 large and medium-sized UK companies – has a dividend yield of 4.7% and trades on just 12 times the amount companies are expected to earn over the next year. That compares very favourably with world equities – which yield about 2.5% and trade on 16 times 2020 earnings8.

Despite this, and given the range of current uncertainties over Brexit and the economy, it would make sense not to be too exposed to one investment style or another at this time. A combination of both value and growth oriented styles of investing can have their place in a well-balanced portfolio. Differing combinations of the two can provide capital growth, income or, most likely, some of each.

Fidelity’s Select 50 list of favourite funds encompasses proponents of both styles. The JOHCM UK Equity Income Fund invests only in stocks expected to yield more than the FTSE All-Share Index in future. Every stock also has to have the potential to deliver capital appreciation. This naturally leads to a contrarian investment style, favouring companies undervalued or underappreciated by the market as a whole.

The LF Lindsell Train UK Equity Fund is a very different type of investment proposition, with its “defensive growth” bias. Blue chip multinationals with strong brands feature heavily in what is a relatively concentrated portfolio of around 20 to 35 stocks. Current large holdings include Unilever, Diageo and Burberry.

Source:

ONS, 09.08.19
IHS Markit, 03.10.19, and BRC, 08.101.19
ONS, 14.01.19
ONS, 10.09.19
⁵ ONS, 10.10.19
London Stock Exchange, 10.10.19
Cboe Brexit High 50 Index, 10.10.19
MSCI, 30.09.19

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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