26th July 2012
The latest set of GDP figures exposed the UK economy as far weaker than expected. There were mitigating factors, such as the wet weather and the Jubilee weekend, but these were largely dismissed as the real reason behind the UK's weakness: "Michael Saunders, economist at Citi, downplayed the effects that special factors may have had on GDP. "There are always special effects. The big picture is that when a recession has gone on this long, we are in a depression."
Mindful Money economist Shaun Richards picks up the potential for depression in his blog on the failure of the quantitative easing programme: "We have spent two years flat-lining at a level of economic output around 4% below the previous peak. In essence this has been the rationale behind my argument that we are more in danger of a depression than a recession. When historians review this period they may conclude that the (possible) depression of the 2010s has already started."
Azad Zangana, European Economist at Schroders, says that the economy has more underlying weakness than expected, particularly in the service sector: "We continue to forecast the economy to return to positive growth in the second half of the year, though we also forecast a return to recession in 2013, partly caused by the Eurozone debt crisis, but also partly caused by a lack of effective policy left available to the Bank of England. We expect the Bank of England to continue its quantitative easing programme beyond November, but we do not expect the programme to have a meaningful impact."
So the economic picture for the UK is bad, so much so that there is now real pressure on George Osborne to resign. However, markets have shrugged off the weakness with apparent ease. Given that the last time there was such a significant economic contraction, the FTSE 100 slipped below 4000, why are share prices holding up?
Importantly, it's the summer, which means thin trading. Trading volumes in the FTSE 100 are between 600-700m per day against normal volumes heading towards a billion. The market often finds its feet in September when investors have had the summer holidays to digest the economic information.
But this may not necessarily mean that markets will fall off a cliff in September. Many investors believe that prices are well-supported at current levels. Alan Greenspan famously chided the markets in the 1990s for their irrational exuberance, but is now predicted a multi-year bull market principally based on cheap valuations: "Another valuation metric, known as the Fed model because it was derived from a July 1997 report from the central bank, shows U.S. equities are close to the cheapest level ever relative to debt. The technique compares the earnings yield for stocks with Treasury rates."
Even the bears on Seeking Alpha admit that shares look good relative to treasuries: "The downside case, that we have a recession and S&P earnings fall from 106 by 15% to $90 say, means that free cash flow yields will fall from 8% to 6.4%. That is still a near 5% equity spread to treasuries, historically an attractive long term buy level.
"On an absolute basis, in a recession P/E ratios would increase from 12.5x today to 14.6x, still below the 50 year average P/E of 16x. Buying stocks at 14.6x recessionary earnings wouldn't be that terrible either."
It may be that the key to unlocking an economy recovery lies in the resilience of stock markets: "Greenspan said the rising stock prices create a "wealth effect" that boosts consumer spending and the overall economy. "So equities play a hugely important role, which I think is grossly underestimated"."
The other option might be that equity markets simply don't believe the figures. They believe that the poor weather and the Jubilee have depressed economic growth and are anticipating greater strength in the latter half of the year. Lower inflation may also boost economic growth. It's certainly an optimistic view, but it has merit.
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