Matthew Tillett
Fund Manager, Premier Miton UK Value Opportunities Fund
Summary
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
- Stock market declines and economic recessions often go hand-in-hand, but the extent and depth can vary enormously depending on the specifics of the situation.
- To understand why, it helps to frame the three key risk factors that can lead to stock market losses: financial risk, valuation risk and business risk. These risks build up during the expansion phase of the economic cycle and materialise during the recession, resulting in losses for investors.
- Examining past economic and stock market downturns using this framework is a useful exercise in helping to determine where the risks may lie today. Whilst there are some clear dangers on the horizon, for UK equity investors there are reasonable grounds for optimism that the current economic downturn may be relatively mild in its impact on the stock market.
Raising the tone
“‘The received wisdom is that risk increases during recessions and falls in booms. In contrast, it may be more helpful to think of risk increasing during upswings, as financial imbalances build up, and materialising in recessions.” Andrew Crockett
“The Bank of England says recession expected to be shorter and less severe” factually states the BBC news website. Indeed, the apocalyptic projections from late 2022 have recently given way to a slightly more optimistic tone, helped by a softening in gas prices, as well as a resilient employment backdrop.
Whatever happens, what is clear is that the economic environment is challenging to say the least, with a recession likely, if indeed it hasn’t already started. How should investors think about recessions? What are the risks? And how does 2023 fare when compared to prior episodes?
What is a recession and what does it look like?
The technical definition of a recession is two consecutive quarters of falling Gross Domestic Product (GDP). GDP itself is defined as the total value of goods and services that an economy produces. It is typically measured in real inflation-adjusted terms, which is an important consideration to keep in mind in the current environment.
These days it seems the mere mention of the word recession can spread fear and panic amongst investors, journalists, and other observers. Yet the truth is that recessions are an unavoidable aspect of the capitalist economy. Since the beginning of modern capitalism in the early 19th century, there have been dozens of recessions, both in the UK and elsewhere.
The expansionary phase of the economic cycle typically sees rising employment, increased business investment and greater risk taking, or ‘animal spirits’, as the economist John Maynard Keynes liked to call it. This very process creates the conditions for the eventual downturn, as the economy over-heats and inflationary pressures build. The catalyst for the change in direction is often a shift in the monetary policy environment, but it can also happen on its own or be triggered by an external event. What matters is that recessions are entirely normal. Investors should expect them to happen fairly regularly.
Why do stock markets often experience severe declines during recessions?
At first glance, this might seem a redundant question to ask. And for sure, some of the reasons are obvious, such as the fact that recessions cause corporate earnings to decline. What is more interesting is to explore the reasons why past recessions have led to such different stock market outcomes. The results have been quite surprising.
The Covid-19 recession was one of the largest on record and saw a rapid 33% decline in the FTSE All-Share Index but was followed by a very quick recovery. The Global Financial Crisis (GFC) ‘Great Recession’ saw a larger and more protracted 2-year long peak-to-trough decline of 49%.
Looking further back, the early 2000s experience was almost as bad, with a 48% decline that occurred over an even longer period, despite the UK economy actually avoiding a recession. The painful recession in the early 1990s in which house prices fell significantly saw only a few 15-20% declines, followed by a strong recovery during 1993.
To understand these differences, it helps to think about the three major risk factors in investing –financial risk, valuation risk and business risk. It is the size of, and interplay between, these risk factors that can determine the performance of the stock market during a recession.
Financial risk
This refers to the balance between equity and debt in a capital structure. Because equity ranks lower than debt capital, it must bear any losses first. Therefore, as the proportion of debt capital increases relative to equity capital, financial risk increases.
During the good times capitalist economies are hard-wired to take on more financial risk. As Company boards, management teams and investors get used to a strong and growing economy there is an unavoidable temptation to take on more risk to enhance returns, especially when everyone else is behaving this way. This is particularly so when the policy environment is supportive, such as when interest rates are low and regulation is light.
The build-up of financial risk during the mid-2000s was the main reason the subsequent losses during the GFC bear market were so severe. A lax regulatory environment, combined with ‘the Great Moderation’, a widespread belief than the economic cycle had been forever tamed, led to the creation of extremely leveraged capital structures. This was particularly widespread amongst banks, real estate and private equity. The recession and subsequent tightening of financial conditions exposed these vulnerabilities, leading to huge losses for equity investors.
Valuation risk
This exists when a company, group of companies or an entire stock market is overvalued to such an extent that substantial losses can occur without a substantial change in the underlying investment fundamentals.
Here it is the psychological side of investing that brings with it the danger. It is the hype and the hubris, the thrill of finding something new, along with an overdose of confirmation bias that creates these situations. One of the easiest ways to spot a systemic valuation risk is when a popular but deeply flawed narrative becomes so widespread that even your hairdresser is a believer.
Valuation risk is the reason why the 2000-2003 bear market was so severe, despite the economic downturn itself being relatively mild. The emergence of the ‘new economy’ narrative during the 1990s led to a speculative frenzy culminating in the 1998-1999 bubble which saw valuations bid up to extreme levels for almost any company perceived to benefit from the growth of telecoms and the internet. A tightening of financial conditions was the likely catalyst for the subsequence crash, but the situation was so extreme that a decline was all but inevitable.
Business risk
Business risk exists when a company is vulnerable to changes in the external environment. It matters in a recession because recessionary conditions are much more challenging operating environments. Falling demand leads to lower sales, lower profit margins and ultimately lower earnings. These effects are not felt evenly across the economy, which is why cyclical companies may see significant share price declines ahead of a recession, whilst defensive company shares can be more stable.
For most investors, business risk is the first thing that comes to mind when thinking about recessions. Yet, on its own, it is arguably the least significant of the three major risk factors. The reason is that it is temporary in nature. Recessions typically last at most a couple of years, and often much less than this. But the equity value of a company is determined by all the future free cash flows it will generate. What happens in any one year makes little difference to this calculation. It certainly pales in comparison to the losses that can result when major financial or valuation risks materialise – as bank investors in 2008 and technology investors in 1999 know only too well!
Business risk is most dangerous when it combines with financial and/or valuation risk. For example, one of the reasons cyclical stocks performed so poorly during the GFC bear market was that so many of them were highly financially leveraged going into the downturn, which not only exacerbated the hit to earnings but also forced many into dilutive rights issues.
The UK stock market in 2023 and beyond
Armed with this risk framework, what can we say about the prospects for the UK stock market in 2023 and beyond?
Start with the good news. The potent risks of the recent past – financial and valuation risk – may not present the same danger today. The cliff-edge experience of the GFC led regulators to impose far stricter capital requirements onto banks and other financial institutions. Most are now very well capitalised making a re-run of the GFC experience unlikely in our view.
Overall financial leverage amongst UK listed corporates has also come down substantially since the GFC, in part because public market investors have become more cautious, preferring to see companies operate with lower levels of debt. There are individual exceptions, but it is hard to see financial risk becoming a widespread systemic issue across the stock market.
It is equally hard to see valuation risk causing major losses. Although the UK stock market was one of the better performers during 2022, this was primarily the result of the high exposure to energy and certain other large economically defensive stocks.
Moreover, the UK has been deeply out of favour ever since the 2016 EU Referendum vote, with the result that most UK stocks have already de-rated significantly, both in absolute and relative terms.
According to Bloomberg, the prospective price-to-earnings (p/e) ratio for the FTSE All-Share Index is a little under 11x, which is low by historical standards and certainly a lot lower than the rest of the world. Analysts at Panmure Gordon have compared the UK stock market with the rest of the world using a range of valuation metrics and conclude that the discount is nearly 40%. Even after adjusting for differences in sector composition, the discount remains wide at almost 30%. Historically low valuations, combined with generally low levels of financial risk, should provide investors with some solace as the economy attempts to navigate the difficult times ahead.
UK stock market valuation discount versus the rest of the world
Source: Panmure Gordon data from 01.01.2016 to 17.01.2023. Past performance is not a reliable indicator of future returns
A challenging operating environment
Business risk is most likely where the main dangers lurk in 2023. The recent period of rising inflation, the cost-of-living squeeze and declining consumer confidence have presented numerous challenges for the corporate sector.
Resilient, well managed companies have, in the main, been able to pass on inflation through higher selling prices. With goods price inflation now coming down rapidly, but upward wage pressures still building, it may become harder for many companies to protect margins, especially those with big labour costs to pay.
In addition, higher interest rates will start to bite as consumers and corporates find themselves having to refinance on more costly terms. The operating environment for UK listed companies is therefore likely to remain challenging for some time, and it may get worse before it gets better.
This is well understood already, evidenced by the continually gloomy financial reporting and forecasting on the UK, as well as the low valuations for UK stocks. But investors would still be wise to err on the side of caution, placing greater emphasis on business model resilience and financial strength, as well as valuation. Such companies are likely to weather the storm better than most. Some may even benefit as weaker competitors falls by the wayside.
There are many great long term investment opportunities amongst UK equities today, but it is also important to remain highly selective. There is no need to take on unnecessary risks against an uncertain economic backdrop, which is a lesson history has clearly taught us.
