UK GDP – measure for measure

Despite current, difficult GDP comparisons, our analysis leads us to believe there will be a dramatic improvement from here on, putting the UK at the top of the league table. This should boost the outlook for UK equities and, specifically, for quality UK domestic businesses, which form a significant part of our portfolios.

The Office for National Statistics (ONS) released preliminary data on Wednesday showing that GDP in the first quarter of 2021 had fallen (year on year) by -6.1%. But the real shock to the UK economy in 2020 did not become fully manifest in GDP numbers until the second quarter of 2020, when the first lockdown was in full force, and UK GDP fell by -21.4% YoY.

Chart 1 highlights the nadir of economic output (in Q2 2020), and a decline in GDP that proved in the UK to be far greater than declines experienced in both the Euro-zone, and also in the US.

The dotted lines in figure 1 overlay the evolution of consensus forecasts of earnings for the next twelve months (“NTM”) of stock markets in each country / region (indexed to 100, and in local currency). Not unsurprisingly, consensus market estimates mirrored pretty much exactly the shape of GDP and were scaled broadly in line with reported macro-economic activity.

The UK has a very open economy, and indeed companies comprising the FTSE All share Index source around 70% of their revenues from outside of the UK (source: Factset). Accordingly, it might instead be expected that UK earnings revisions be more closely aligned with international GDP expectations.

However, figure 1 shows how estimates of corporate earnings in the UK fell significantly more than their international peers.

We are currently in the middle of figure 1 around Q1 2021, with UK GDP and earnings estimates still lagging international peers. But, what we believe is key for investors in UK equities, is that according to consensus the outlook in the UK for GDP improves dramatically from here.

Three key questions arise from this analysis:

1.       Was it really that bad in the UK (relative to peers) in 2020?

2.       Will the recovery really be a strong as expected in 2021?

3.       How will the expected recovery in the UK affect companies and markets?

In order to answer the first two questions, it is important to appreciate that there are significant differences between countries in how they each measure GDP, which distorts international comparison. 

A fall in activity for the NHS??

The most relevant area of difference is how countries record the volume of “non-market output” - and in particular how healthcare and education are measured.

In the UK, according to the ONS, GDP statistics relating to public sector activity are based on volume indicators, such as the number of scheduled treatments for healthcare, or students enrolled for education, and not actual spending.

Applying this strict approach, and despite hospitals being pushed to the limit (and beyond) to deal with the pandemic, the ONS measured output of the NHS fell in 2020.

Surely, nobody actually believes that real economic activity in the NHS declined. Indeed, the very notion is so far removed from reality that it is perhaps surprising we have not seen or heard any mention of the statistical anomaly anywhere outside of isolated reports of diligent economists, and the ONS itself!

The problem is therefore not the actual activity in this area of the economy, but the basis of measurement. However, the corollary of this is that in Q2 2021, as the vaccine takes effect, restrictions ease, so will the volume indicators in the NHS and indeed across the public sector naturally ramp back up. And all from an “artificially” lower base.

As for question 3 – an indication of what is priced-in by the markets is given in figures 2 and 3

In figure 2, we plot the actual and expected level of GDP activity for the UK (dark blue line, indexed to 2019=100), alongside NTM earnings expectations (through to 31 March 2021 – see light blue line), as well as the total return on the FTSE All-share Index (through to 11^th May 2021 – see green line).

The chart illustrates that consensus estimates suggest UK GDP activity will recover to pre-pandemic levels in early 2022. The return to the base level has largely been mirrored by recovery of total return on the All-share Index (as at 11^th May 2021), although earnings expectations for the NTM still remain around 14% below where they were at the start of the pandemic. Some optimism around recovery, but still quite cautious for the longer term. 

Figure 3 shows similar analysis for the US with comparison made to the S&P 500 (in local currency). The chart illustrates that the market consensus expects GDP in the US to recover beyond pre-pandemic levels as early as Q1 of 2021, and shows earnings estimates for NTM are already almost 4% ahead of those expected pre-pandemic.

And for that, the market has bid up the S&P 500, delivering a total return over 30% since 31 December 2019. That strikes us as being an awful lot of optimism already priced in.

Is it time for the UK to catch up?

When looking at earnings revisions in the early stages of the pandemic, it might be argued that the FTSE All-share has a greater proportion of “cyclicals”, which weighed on estimates on the downside. However, it is therefore also reasonable to expect that earnings in these areas of the market might recover more strongly when coming out of the pandemic.

But it is the change in leadership of growth in economic activity that is to us most significant. The bounce in earnings estimates from the low of Q2 2020 to end Q1 2021 has already been already greater in the UK (24.3%) than it has in the US (20.4%). However, the bounce in total return over the same period was significantly less at +15% for the FTSE All-Share, compared to +30% for the S&P 500.

All said, this should boost investor sentiment in the UK and the outlook for UK equities really should pick up as we move towards the summer. As a result of which, we believe the valuation gap with the US really should begin to close.