Britain is in recession. After standing still from April to June, the UK economy shrank between July and the end of September. The smart money is now betting on a second three-month period of declining output, which would meet the textbook definition of a recession. But what does all this mean for you and your money?
Property
Recessions and house price crashes have tended to go hand in hand in the UK. The last four recessions have all coincided with slumping residential property values. In each case, the housing crash has started before the economy entered recession, although this is not the same as saying that falling house prices cause recessions. Instead, they have common causes, especially higher interest rates and tighter credit conditions.
It is also worth pointing out that house price crashes last much longer than recessions. The average post-war UK recession has lasted six months, with the longest ones lasting 15 months. But the last three crashes have gone on for an average of just under five years. Things have gone true to form this time around, with the house price crash starting in around July 2007 and the recession beginning around a year later. If the history books are any guide, the recession could end late next year, with the housing crash not ending until 2012.
Shares
You might assume that a shrinking economy would be bad for shares, but it's much less clear cut than that. The two don’t automatically accompany each other. The UK stock market fell by around one-half between 2000 and 2003, but there was no recession during that period. And British shares have gone up more often than not between the start of a recession and the end of it.
It should not surprise us that shares might prosper in a recession. After all, the stock market is forward-looking. Investors probably see recession coming some time before it happens and share prices adjust accordingly. By the time the UK enters recession, investors are already looking ahead to the economic recovery, which is reflected in a rising market. Also, recessions are times of high risk for many companies. To compensate for this, shares have to provide high returns.
Of course, shares haven’t risen during every single UK recession in the last half century or so. An obvious occasion when they didn’t was during the economic turmoil of the early-1970s. That is a relevant example right now, because the current crisis is easily comparable with the one that we suffered three decades ago – and quite possibly worse. But on the other hand, the last two recessions – in the early 1980s and 1990s – ended more than a year after the stock market hit rock bottom.
Growth vs value
Growth shares have tended to beat value shares around the time of recessions. Growth shares are ones that trade on a high multiple of price-to-book value, indicating that investors have great expectations of their prospects. Value shares are those that trade on low multiples. In this case, we are using the MSCI UK Value and Growth indices to represent these two groups.
Over time, value has tended to beat growth handsomely. But around recessions, this tendency has been reversed. One possible explanation for this is that value companies tend to be more economically-sensitive than growth companies, and tend to carry more debt. So, when the economy goes into recession, they are at greater risk of bankruptcy than their less economically-sensitive growth counterparts.
Another possible reason for growth's outperformance over value around recessions lies in bond yields. To boost the economy, the authorities typically slash interest rates during a slump. This causes government bond yields to fall. That’s good for all shares because, given that bond yields are used to value companies, it increases the present value of their future cash flows. But it is especially good for growth shares, because their future cash flows are more distant than those of value shares. Therefore, their current value benefits that much more from lower bond yields.
Sector winners and losers
Two sectors have beaten the wider stock market in each of the last four UK recessions: pharmaceuticals & biotechnology, and healthcare equipment & services. These industries are clearly growth areas, and also have defensive characteristics. Demand for the products they make does not suffer too much in a downturn, as people cannot do without vital medicines or prosthetic limbs just because the economy is doing poorly. These industries are definitely worth considering this time around, although past performance is not necessarily a guide to how things will turn out, especially since it's 17 years since the last recession.
Software & computer services and general industrials have gone up during three out of the last four UK recessions. Software is clearly a growth industry that would benefit from falling bond yields. On the other hand, general industrials would most probably fall into the ‘value’ category. Both these groups have more economic sensitivity than pharmaceuticals and healthcare, which might give us pause for thought before buying them.
Four sectors have underperformed the UK stock market in each of the last four recessions: auto & parts, industrial engineering, media, and non-life insurance. Auto & parts and industrial engineering are clearly both economically-sensitive and ‘value’ sectors whose businesses and shares we’d expect to struggle in a slump. By contrast, media and non-life insurance are less obviously ‘value’ areas, although their activities could easily suffer in hard times. The media industry depends heavily on advertising spending, which is often cut savagely during downturns.
Sterling
You might think that a recession would be negative for sterling, as foreign investors get nervous and dump our currency. But in four of the five recessions going back to 1960, sterling has risen versus the euro, or its Deutsche Mark-based equivalent. The only time it fell against the euro or its predecessor, the ECU, was during the 1973-74 recession, when the pound fell just 3.3 per cent. At the time of writing, sterling had dropped to an all-time low against the single European currency. However, history suggests there’s a decent chance that a euro will cost less than 79p by the time the UK economy comes out of the slump.
One currency has done well against sterling during recessions four times out of five: the Japanese Yen. And on the one occasion the Yen fell, it did so by less than 1 per cent.
The current recession might not be the negative event for sterling that you might assume that it would be. The interesting question is why this should be so. One explanation is that markets are forward-looking and therefore price in recessions well before they happen. There is some evidence that this is the case. In the six months before a recession, sterling has tended to fall against the euro or the ECU. Once the recession actually arrives, it then usually rises against the euro, perhaps reflecting the fact that investors are looking ahead to brighter times.
Gilts
Government bond yields tend to fall in a recession as interest rates are cut. Falling bond yields are the same as rising bond prices. However, bonds went up in price only during the most recent two recessions – they fell during the two 1970s recessions. These recessions were unusual in that they were in times of high inflation. Usually, inflation comes down when economic growth weakens, but back then we had rising prices and weak growth. Inflation is disastrous for bonds. In the current recession, the threat of inflation seems to be subsiding in response to the slowdown in economic activity. The credit crunch is a deflationary influence: as companies pay off debt and reduce costs, price growth is more likely to ease. So 10-year gilts seem set to do well, particularly if the recession proves to be long and deep.
Gold
Investors often buy gold when they are fearful. It has tended to hold its worth during sharply inflationary times, such as the 1970s. But there is some evidence that it might perform well during deflationary times, such as the 1930s. Deflation is perhaps the greater threat today. But gold’s recent performance hardly inspires confidence. Gold and the US dollar tend to move in opposite directions. After falling heavily against many other currencies in recent years, the US dollar finally appears to have hit rock-bottom and has turned around strongly of late. A falling dollar is good for gold, while a rising one is bad for it. Both valuation and momentum suggest more gains to come for the dollar, which may well cause more pain for gold.
