On 31 October, Halloween, Prime Minister Boris Johnson spooked the nation with the announcement of a 2nd national lockdown in England, starting on the 5 November, to help reduce the spread of the resurgent coronavirus. While this is clearly an unfortunate development, we suggest five reasons not to take fright at its potential impact on the UK economy and financial markets.
First, while this is being referred to as the ‘2nd lockdown’, it is very different to what the UK experienced in March and April. At that time, almost all non-essential businesses were closed, as were schools. This time, while the government has revived their simple and successful ‘stay at home, protect the NHS and save lives’ mantra, it is only particular parts of the economy where social distancing is deemed to be difficult which are being explicitly shut. This means non-essential retail, hospitality, leisure and entertainment will close, but other parts of the economy which had shut previously, such as manufacturing and construction, will remain functional. This represents further difficulty for these sectors which have remained constrained throughout, which together represent around 15% of the economy.1 At least from a broad UK perspective the remaining 85% is less directly affected. Educational facilities remaining open is critical to the economy, both for the direct effect and, perhaps even more importantly, the indirect effect - parents being able to continue working, rather than taking time off to care for their children. Teething problems which may have constrained productivity for some when asked to suddenly work from home in March should now likely be resolved.
Second, the UK consumer likely has spending capacity to continue to support the UK economy. Household consumption is the largest element of spending in GDP, usually accounting for around 65%, so the recovery is reliant on continued spending.2 Since the beginning of the crisis we have seen a spike in savings rates as consumption has been curtailed from both demand and supply perspectives. The latest figures show that the average UK worker is currently able to save 28% of their disposable income, which is as high as the measure has been on records going back to the 1960s.3 While there might be many drivers for this, we would speculate that an obvious one would be the relative lack of summer holidays which will have been taken this year. Given this statistic it is perhaps slightly less surprising to learn that after a precipitous fall in retail sales in April, they have bounced back to a level higher than where they had been previously.4 Underneath the headline figures, there has been a dramatic shift from the high street to online (as one might expect) but the key takeaway is that the consumer is able to continue spending.
Third, the global economy is recovering. The global manufacturing Purchasing Managers’ Index, a proxy of global growth rose to 53.0 in October, its highest level since April 2018 and is up significantly from a low of 39.6 last April.5 Given that the index is above the boom/bust threshold of 50, this suggests the global economy is growing. Other markets indicators suggest a rebound in growth. For instance, the copper price, which typically reflect fluctuations in the business cycle, is up nearly 50% from its low in March and is higher than pre-COVID levels.6
Fourth, the Bank of England, which has already proved itself willing to assist with the economic fallout of the crisis having expanded the size of its asset purchase programme by £300bn since March, is likely to provide further stimulus measures.7 Market expectations are for the Bank to provide a further £100bn when it meets on 5 November (coincidently the start of the lockdown). This new stimulus would serve a dual purpose; supporting the weaker macroeconomic backdrop, while at the same time supporting government’s fiscal initiatives by insuring interest rates do not rise. The Bank of England could choose to further expand this policy at future meetings.
Fifth, with respect to the UK equity market, there is already a lot of bad news in the price. Since the UK’s vote to leave the European Union in 2016, a discount has opened in valuation terms between London-listed equities and their overseas peers. While the referendum did bring an additional level of uncertainty to the outlook for the UK, many large-cap companies listed in London derive most of their earnings from outside the UK. The coronavirus crisis has pushed interest rates still lower around the world, which makes those companies which exhibit growth in their earnings (like the ‘big-tech’ firms in the US) more attractive. The UK market is relatively underexposed to these sectors, with larger weightings to financials, materials and energy. This has led these ‘value’ orientated sectors to underperform, further exacerbating the valuation gap between the UK and rest of the world. Looking at a simple average of dividend yield, price-to-book and price-to-earnings ratios (three of the most common valuation metrics) reveals the UK trading at valuation of only around 0.55x the broader world.8 Historically it has traded at a discount on average (circa 0.8x, for some of the aforementioned reasons), but the current situation represents the biggest discount for over 30 years.9 It is difficult to time market exposure using valuations, but extreme readings can result in quick reversions in the direction of the mean.
When PM Johnson announced the lockdown, he also said it was due to end on 2 December, but Cabinet office minister Michael Gove subsequently suggested that a loosening of policy at this time would be subject to also seeing a reduction in infection rates. If this lockdown were to prove ineffective and not achieve this goal, it would therefore need to remain in place. Clearly in this scenario there would be greater economic damage as closed leisure sectors would not be allowed to reopen (albeit probably partially) in time for the Christmas period, among other things. Another related risk is in the job market. So far rising unemployment has been very constrained, thanks in part to the Chancellor’s generous furlough scheme, which had been scheduled to come to an end on 31 October. This arrangement has been extended as part of the lockdown (on slightly less generous terms from the employer perspective) and is now set to end in December. Were joblessness to rise considerably as a result of the withdrawal of the furlough scheme, that would likely hit consumer confidence and therefore spending.
Provided lockdown measures prove effective to reduce the rate of infection, as they did previously, and we do not see a spike in unemployment, we think the UK economy can weather the storm and that the historically wide discount on UK equities will prove attractive when growth returns.
1 Morgan Stanley, UK Economics Mid-Year Outlook | Europe, 14 June 2020
5 JPMorgan, data as at 2 November 2020
7 Bank of England, Asset Purchase Facility (AFP): Asset Purchases and TFSME – Market Notice 19 March 2020
2-4, 6, 8-9 Refinitiv and TS&W calculations, data as at 3 November 2020
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
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This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.