Kleinwort Benson: UK growth is picking up…so what?

25th July 2013

It is clearly very good news that the UK’s economic pick-up is looking increasingly sustainable with several surveys now sending a more consistent message about the recovery.

But does this mean it is time for cautious investors to be piling into the stock market with their hard earned cash? Well you might but not because share prices follow economic growth because they don’t.

Mouhammed Choukeir, Chief Investment Officer at Kleinwort Benson has issued the following note explaining why the growing economy may be irrelevant for investment returns looking at the experience in the UK and academic work in other markets.

Rescue to recovery

GDP grew by 0.6 per cent at an annualised rate in the UK over the second quarter, following an increase of 0.3 per cent over the first quarter. This momentum is remarkable considering that fears of a “triple dip” recession have dominated newswires this year. Indeed, there are many aspects of this growth to indicate that the recovery, while slow by historical standards, is sustainable. The UK Purchasing Managers Index (PMI) monthly survey, a leading indicator of growth, has been demonstrating expansion for each of the last three months; a first since early 2012. Another survey conducted by the British Chambers of Commerce (BCC) shows that exports are at their highest level since 2007 and that confidence in turnover and profitability is high; many businesses are expecting to hire more staff over the third quarter. The change in mood is well-captured by a Treasury spokesman, who said the economy was transitioning from “rescue to recovery”. 

But is the economy connected to share prices? Not in reality.

While we are sanguine on UK economic growth, we are careful not to be influenced by it from an investment perspective.

A simple theoretical model would suggest that if the economy is growing, then consumers spend more, companies earn more and companies are therefore worth more. As such, share prices rise. It is simple and logical. However, the reality is very different to this simple logic.

In reality, investment returns have no correlation whatsoever with economic growth or the lack thereof. Consider recent evidence: during the economic doom and gloom years since the crisis, the UK economy has contracted in real terms – it is currently about 4.0 per cent below its pre-crisis peak in the first quarter of 2008. In the same period, however, the FTSE All-Share index has returned 12.4 per cent; that return shoots up to above 35.0 per cent if dividends are included.

The evidence for there being no correlation between UK equity market returns and economic growth in the UK is even stronger over a longer time frame. Since 1963, the correlation between annual GDP growth and equity returns is near zero  and in fact, slightly negative. On a quarterly basis, it is even less correlated.

But is the UK a unique case?

One could argue that the UK is a unique case. However, in their highly regarded book Triumph of the Optimists, Dimson, Marsh and Staunton analyse 16 markets over 100 years, and they find no relationship between economic growth and stock market returns. No matter how you cut it, growth appears to have nothing to do with stock market returns.

As prudent investors, we depend on the evidence of how markets behave in practice. We find that asset class returns can generally be explained by four variables: valuation, momentum, sentiment and the prevailing economic climate (which is not the same as economic growth). If the market is cheap, trending upwards and oversold while the economic climate is favourable, then the prospects for returns are attractive. If the market is expensive, trending downwards and overbought while the economic climate is unfavourable, then the prospects for returns are unattractive. Economic growth is not a factor.

Investment implications – UK still has favourable investment opportunities

Relative to other regions, UK equities are attractively valued on some measures (including trailing dividend yield and forward price-to-earnings), particularly following the recent sell-off. On other measures, however, UK equities appear at fair value (e.g., price to book), or expensive (e.g., free cash flow yield).

Nevertheless, we believe the UK equity market still has favourable investment opportunities. We continue to favour House builders as we see a housing recovery with sound fundamentals and continued government support. We also favour the Travel & Leisure sector due to increasing momentum for consumer spending. Furthermore, we find significant value within the Mining sector; coupled with very negative sentiment across the investment community, the case for miners is stronger still.


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