Why UK markets aren’t leading as the global energy crisis fades
Rare candour from a central bank
Over the past six months, the Bank of England stood out for its candour. It was the first (any maybe the only) central bank to forecast a recession due to the 2022 energy crisis, having started prepping the market and the public with that baseline view at its August MPC meeting. BoE officials also highlighted UK exceptionalism. To them, the UK’s inflation surge and cost of living crisis mainly reflected a supply-side shock, whereas countries like the US were mainly facing a problem of excess demand.
A year into the Russia-Ukraine war, current conditions and the outlook seem to have changed dramatically. Oil and gas prices are actually down year-on-year; the cost of living crisis is talked about only half as much (according to Google searches); and the BoE has been revising up its projections to show a shorter and shallower recession.
The UK’s up, but it’s not leading
If the UK was one of the unluckiest victims of the energy price shock, it seems the economy and sterling markets would have benefitted disproportionately from the oil and gas price unwind, even if only short term. But outperformance versus other regions has not happened. ?Summary measures of growth momentum like PMIs show UK manufacturing and services recovering from autumn 2022 lows, but these moves are comparable in magnitude to what is occurring in the Euro area and the US. China, of course, remains the standout given its reopening.
On UK asset prices, absolute performance is respectable but relative performance is not. The FTSE 100 is up about 6% this year, so about as much as the S&P500. UK large caps did make a record high in February, but this achievement is cold comfort given their astronomical underperformance versus Tech/Growth biased indices like the US over the past decade (chart 1). UK small and mid-caps (FTSE 250) have also gained about 6% this year, but this is less than the Russell 2000’s 10% advance. It’s true that the US small cap market is more weighted towards Tech (15%) than the FTSE 250 (4%), but it is also notable that there was little performance divergence between these two indices until the Brexit vote in 2016 (chart 2).
Chart 1: This year’s all-time high on the FTSE 100 is almost imperceptible against its long-term underperformance versus the S&P500, given Big Tech’s influence on the latter. S&P500 vs FTSE 100 indexed to 100 in 1986. Blue bars indicate US recessions. Source: YCharts.
Chart 2: UK small and mid-caps (FTSE 250) tracked the Russell 2000 closely, until the Brexit vote in 2016. Russell 2000 vs FTSE 250 indexed to 100 in 1987. Blue bars indicate US recessions. Source: YCharts.
In Rates, 2Y yields are up globally due to growth surprises (+45bp in US, +50bp in Euro area, +30bp in UK), which is why the GBP and EUR haven’t moved much versus USD (they’re down less than 1%). The more important EUR/GBP cross rate has been stable. ?
UK High Grade Credit has tightened about 15bp this year, so only a few basis points more than US High Grade. The big trade value trade in global credit has passed -- it was to buy UK High Grade at 250bp during the Truss government’s policy inanity, since spreads then reached recession levels. This article What to do with the UK’s cheap markets from October discusses that brief disconnect between UK and other spread markets. The only remaining disconnect globally is US MBS, which is the only major spread market to fully discount a recession already.
What’s problematic: a short cycle plus pre-existing conditions
Why not more relative outperformance by the UK economy and its assets? I think the short answer is the best one: the cyclical lift will be brief, while the structural drags will persist. On cyclical lift, I doubt the UK’s mini-upturn will endure much beyond H1 because inflation has overshot the BoE’s target by too wide a margin to dissuade the MPC from maintaining its restrictive stance. The UK’s real policy rate could be at least 1% this year, compared to estimates of potential growth of 0.5% to 1%.
Even if the UK manages to avoid recession despite this rates backdrop, there will still be Equity and FX market spillovers from likely recessions in the US and Euro area, given where the Fed and ECB intend to steer rates. Despite the FTSE 100’s defensive characteristics, it has always managed to match the S&P500’s drawdown during high-stress periods (chart 3). Sterling too tends to underperform given the UK’s poor balance of payments position (current account deficit, and a second-tier reserve currency).
Chart 3: Despite its defensive features, the FTSE 100 has still experienced drawdown equivalent to S&P500 during US recessions. Peak-to-trough drawdown on S&500 and FTSE 100. Blue bars indicate US recessions. Source: YCharts.
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If all major economies will face the same, inter-linked fate eventually later this year, then it is probably the structural factors which continue to constrain the UK economy and markets, even when they lift. Brexit’s interrelated drags on business investment, labour supply and productivity have no comprehensive policy solution under the Conservative government, nor under the Labour one that will likely follow. So there is no reason for long-term optimism around what the Windsor Framework (for improving the Northern Ireland Protocol) may mean for undoing the 2016 vote’s damage to potential growth and long-term capital flows.
What could be different in 2023-24
Overall, I am slightly positive on UK markets (expecting stable credit spreads and low single digit equity returns) in H1 for the same reason I hold these views globally – there is a brief growth upturn due to lower energy prices and China’s reopening, and it will take several more months for a restrictive Fed and ECB to snuff those revivals out. I also think that a value-biased market like the FTSE 100 can buck its historical trend and outperform the S&P500 during the next recession, because I believe that Energy and Metals (and therefore producer equities) will experience high lows during the next downturn due to supply-side commodity constraints and much stronger company balance sheets. But the UK has too many pre-existing conditions to think that either the economy or its markets can outperform other regions persistently on value considerations alone.
Links to recent articles on global macro strategy
Why today's Bank of Japan decision isn't sticking to USD/JPY (Jan 18, 2023)
What the last 100 years has to do with the next 12 months: Risk premia, mean reversion and 2023 return forecasts (Jan 3, 2023)
Further evidence that 10Y bond yields have peaked, and what that path means for other markets (Nov 11, 2022)
What to do with the UK’s cheap markets (Oct 18, 2022)