2nd August 2016
Steven Bell, chief economist BMO Global Asset Management, examines the data.,
“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
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.
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.
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*.
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 thedata in hand, we think analysts are underestimating the severity of the immediate downturn in the UK’s economy. This is not good 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 inthe 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.