The Outlook: May 2018 economic
commentary

Commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges.

When “bad” news is “good” news

Back in February, US president Donald Trump took to Twitter to vent his frustration regarding the performance of the equity market: "In the “old days,” when good news was reported, the stock market would go up. Today, when good news is reported, the stock market goes down. Big mistake, and we have so much good (great) news about the economy!” 

At the time, Trump was referencing the drop in the US stock market that occurred in the wake of data showing stronger-than-expected wage growth for American workers (see our March commentary). But his comments illustrate a more general misconception that “good” domestic economic news should automatically translate into a rising stock market.

To be fair, the vagaries of the equity market make it difficult to predict how investors will react to a particular piece of economic news - even for a self-proclaimed ‘genius.’ Stronger-than-expected economic data might be viewed favourably by equity markets if it heralds the end of a recession. However, it might not be welcomed at a time when there is little spare capacity in the economy and the focus of investor concern is rising inflation and higher interest rates.

The economy is not the stock market

It is easy to fall into the trap of assuming that an expansion in a country’s economy will boost corporate revenues and profits, and thereby result in a commensurate rise in that country’s stock market. There are multiple reasons why this is not the case. For a start, not all companies will be listed on the stock market. And even for listed companies, the profit share of GDP and the valuations that investors place on those earnings is likely to vary over time. Crucially, companies will derive revenues and profits from overseas, and multinationals might do relatively little business in the country in which they are listed.

This is famously the case with our own FTSE 100, the constituent companies of which derive around 70% of revenues from overseas. Even the FTSE 250 mid-cap index, which is held up as being more dependent on the domestic economy, derives almost half of sales outside the UK. To put this in context, the equivalent overseas exposure for the S&P 500, the main US equity benchmark, is closer to one third.

This in part explains why “bad” news on the domestic UK economy has turned out to be “good” news for UK equities. Markets had seen a May interest rate hike as a near certainty only a month ago. However, a recent spate of disappointing economic data - including a slowdown in GDP growth to just 0.1% q/q in Q1 - has weighed on rate expectations and prompted the Bank of England (BoE) to leave policy unchanged at its meeting on May 9. In turn, with the pound falling to a 4-month low against the US dollar and a weaker currency boosting overseas earnings, the stock market welcomed the news.  

A boost from the oil price

In addition, given heavy exposure to the energy sector, UK equity markets have also benefited from the latest rise in the oil price following President Trump’s decision to pull out of the Iran nuclear deal (a development deemed as “bad” news by Trump’s European counterparts and most observers). Energy makes up approximately 17% of the UK equity market (think Shell, BP), compared with about 6% in the euro-area and the US. With the global energy sector leading the run-up in equity prices since the end of March, sector composition has been a key factor in helping UK equities outperform. In local currency terms, the MSCI UK equity index has returned close to 10% since the end of March, while the equivalent euro-area and US indices have delivered 6.7% and 3.5% respectively. 

In light of these considerations, it would appear that the relevance of domestic economic data to UK equity market investors is not so much to provide an early steer on earnings trends, but rather as a potential influence on interest rates, bond yields and the currency, which in turn impact the equity market. Of course, profits in domestically-focused industries such as construction will be more sensitive to UK news. But given UK equities’ elevated international exposure, it is global trends that matter more for underlying earnings.  

Recent experience has shown how a relative deterioration in UK economic data versus the US, ushered in a slide in sterling which, via the earnings effect, has proved supportive of UK equities. Related to this is the impact that disappointing economic data has on depressing bond yields via interest rate expectations. Against the backdrop of poor productivity growth and uncertainty over Brexit, concern over the UK’s longer-term growth prospects has been one factor weighing on UK gilt yields at a time when US bond yields have been drifting higher. 

Yield premium

For UK-based investors faced with a choice between stocks and bonds, and who don’t want to incur currency risks or hedging costs, low gilt yields enhance the relative attractiveness of UK equities. The UK equity market might be vulnerable to a rise in bond yields given its “defensive” composition (i.e. high exposure to non-cyclical sectors such as consumer staples). But the FTSE 100’s current dividend yield of 3.8% still offers a healthy 231 basis point premium over the 10-year gilt yield of 1.49%. By way of contrast, the same cannot be said in the US, where both the 10-year yield of 3.02% and 2-year yield of 2.55% now exceed the S&P500’s 1.9% dividend yield.

None of this guarantees that the UK equity market’s recent outperformance will continue. The BoE appears confident that the slowdown in Q1 was largely a result of adverse weather conditions and will prove temporary. A renewed uptick in the economy could see policymakers re-adopt their hawkish rhetoric, prompting the pound to appreciate. The international partners might thrash out a new deal with Iran that eases tensions in the middle-east and sees the oil price fall back. Such “good” news could result in headwinds for the FTSE.

And then there is Brexit of course, arguably the biggest factor impacting the UK’s longer-term outlook. The precise form of the UK’s new relationship with the EU still remains unknown. Given the fact that overseas holdings account for nearly 30% of outstanding UK government bonds, it is not inconceivable, although not probable, that a no-deal Brexit could knock foreign investor confidence and result in sterling, gilts and UK equities selling off in tandem. Under this scenario, it would be difficult to see a silver lining in the “bad” news. However, for now at least, recent “bad” news has been “good” news for UK equities.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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