Broad Economic Recovery In The UK, But Equities Lag

The latest data on the United Kingdom economy confirms that the recovery continues and is wide-based. The UK equity market is also advancing – but not at the pace one might expect in view of economic performance.

The preliminary estimate of third-quarter growth in the United Kingdom's GDP is 0.8%, slightly more vigorous than the second quarter's 0.7% advance. The increase over a year earlier was 1.5%. In comparison, Germany's year-over-year increase in GDP for the third quarter is estimated at just 0.6%. It is noteworthy that the German economy is already above its previous peak, while the UK economy is still 2.5% below its pre-recession high in 2008.

Several recent indicators imply that the UK economic recovery will continue in the coming months. The OECD Composite Leading Indicator for the UK rose again in September to 101.2, up 1.6 points from a year earlier. The Purchasing Managers' Index for Manufacturing for September showed that in August the spurt in the sector continued, with the increase in the quarter proving the strongest since the first quarter of 2011. Even more significantly, the PMI for services, the most important sector of the UK economy, continued to be very strong in September, completing the best quarter for UK services since the second quarter of 1997. Market demand and business confidence increased, led by financial services.

Job creation reached a new peak in September. While the unemployment rate remained at 7.7%, the strength of the economy suggests this rate may fall to 7% well before the end of 2016, the date projected by the Bank of England. That is the rate set by the BOE in its forward guidance as the threshold for possibly raising the benchmark interest rate above the current 0.5% level.

On the negative side, real pay in the UK continues to fall. Core earnings growth has slowed to its most sluggish pace since that statistic began to be tracked in 2001, and it has been overtaken by the rate of inflation, which, at 2.7%, is well above the 2% target of the BOE. Retail sales managed a solid advance in the third quarter, but the squeeze in real pay constitutes an important headwind. Another negative is the slowdown in the rise in export orders in September, which occurred despite the exchange rate still being some 20% below the rate reached before the financial crisis and despite the recovery in the UK's export markets.

These two negative factors may help to explain why the equity market's performance has lagged behind the advanced-economy benchmark so far this year, despite the strength of the UK economy. The MSCI Index for the UK equity market is up 13% year-to-date, considerably below the 18.4% increase in the benchmark MSCI EAFE Index and even farther below the 22.8% increase in the MSCI Index for the Eurozone's equity market. This period of underperformance may be ending. Thus far in October, the UK index is up 3.8%, slightly above the 3.7 % advance in the EAFE benchmark but still short of the 6.3% gain for the Eurozone. We are maintaining a UK position in our International and Global Equity ETF Portfolios.

BY Bill Witherell