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Audience

Why a recession may not lead stockmarkets to fall

18/08/2020

For the first time in more than a decade, the UK economy has entered a recession.

Glossary

For explanations of the investment terms used throughout this article.

View the glossary

That the value of economic activity has fallen consecutively for the first two quarters of 2020 can come as no surprise to anyone. The imposition of a lockdown to halt the spread of the new coronavirus made it an inevitability.

Yet the size of the economic contraction is shocking. Compared to the first three months of the year, the UK’s gross domestic product (or GDP) fell by 20.4% – the largest decline on record by a long way.

Recession is worrying for a number of reasons. A decline in national economic output will tend to be reflected in lower household incomes, higher unemployment, and stretched government finances, among other things. Even relatively short recessions can leave lasting scars on society.

Perhaps surprisingly, though, GDP statistics are not a reliable bellwether for where stockmarkets are heading.

Markets move quickly

Historically, markets tend to move ahead of bad economic data. Rather than waiting for it to arrive, investors typically act on the basis of their expectations.

By way of illustration, the UK economy contracted by 2.1% in the first three months of 2020, during the onset of the coronavirus pandemic, compared to the fourth quarter of 2019. The FTSE All-Share Index of UK listed company shares delivered a total return (the combination of capital growth and income) of -25.1% in the same period.

Subsequently in the second quarter of 2020, as the UK economy shrank more dramatically, the FTSE All-Share registered a positive total return of 10.2%.

A similar trend occurred during the global financial crisis, just over a decade ago. Having plummeted by 30% in 2008, the FTSE All-Share recovered almost fully in 2009, despite the fact the UK economy remained in recession for the first half of the year (and registered practically zero growth in the second half).

This may be counterintuitive, but it should not come as a surprise. After all, the stockmarket isn’t a reflection of economic activity, but of investor confidence in the future profits and shareholder returns that companies can deliver.

While short-term pessimism may cloud their outlook, investors in company shares tend to take a multi-year, and in some cases multi-decade, view. This means they are attributing a value today to the potential profits that companies can generate in future years.

So, although the pandemic will continue to weigh on company profits for the foreseeable months, investor confidence in the future, beyond the pandemic, fundamentally improved between March and June 2020.

Investors should remember that past performance is not a guide to future performance.

Why long-term growth matters

Although economic growth is not necessary for individual company growth – take the recent success of certain technology and healthcare stocks, for instance – it does matter in the aggregate. If there is less economic activity, then there is less income to be spent on the goods and services that companies produce.

Over the longer term, economic growth is therefore important to the returns investors can make from company shares.

For investors in the UK stockmarket, however, it is worth bearing in mind that the trajectory of global growth matters more than the domestic economy. This is because many of the largest companies listed in London generate most of their earnings from overseas. Among constituents of the FTSE 100 Index, 76% of revenues were generated abroad between 2007 and 2015.

Optimism amid the gloom

The fortunes of some sectors of the stockmarket are inherently more tied to economic growth, global or domestic depending on the footprint of their business.

More cyclical sectors – including finance, energy and housebuilding – endured a tougher first half of 2020 than those whose goods or services enjoy more reliable demand, like utilities and companies that make basic or essential consumer goods. In turn, the former would be expected to outperform their steadier counterparts during an economic recovery.

While the spectre of acute uncertainty looms for now, a recovery in the UK and global economies is forecast for 2021. In its June 2020 outlook, the International Monetary Fund projected global growth of 5.4% in 2021.

For now, government policies and spending are limiting the economic damage of the pandemic in the UK and elsewhere. With the cost of government borrowing at or near record lows for most developed economies, many have pledged further spending to support economic recovery and longer-term growth.

Government support has its limits, and may not be able to catalyse economic growth as hoped. Nonetheless, so long as there is optimism about the future, stockmarkets can continue to perform well – even in the face of economic gloom.

The views expressed in this document should not be taken as a recommendation, advice or forecast.

Past performance is not a guide to future performance.

The value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.