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Is there a recession around the corner?

Sophie Lund-Yates looks at the current health of the UK economy, whether there’s a recession looming and what this could mean for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article isn’t personal advice. If you're not sure if an investment is right for your circumstances, please seek advice. All investments and their income fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

Let’s start with GDP

GDP stands for Gross Domestic Product. Put simply, it’s a measure of the total market value of all goods and services produced within a country in a given year.

That means the output of a UK factory making products for an American company would also be counted in the UK’s GDP.

Why does it matter?

GDP is important because it can be used to identify a recession. A recession can be defined as two or more consecutive quarters of falling GDP. In other words, this shows that the economic output of a country is shrinking over a prolonged period.

Lower domestic output is related to a few things, and one of these is an increase in unemployment. When people are unemployed, or their jobs don’t feel as secure, demand within the economy is stifled as people don’t spend as much money. In turn, that lower demand results in lower production as companies reduce their outputs. This can then mean more job losses and so the declines can be self-perpetuating.

Is that what’s happening at the moment?

The UK isn’t officially in a recession, but one is expected. GDP fell 2% in the three months to March. This is the fastest fall since the 2008 financial crisis, and only reflects one week of lockdown. That means the data is going to get worse before it gets better. The contractions come as huge chunks of the UK’s economy were simply “switched off” overnight – everything from hotels to building sites downed tools.

One reason a recession’s likely is because even when the economy is opened up again, demand might not recover straight away. Millions of furloughed workers and business owners that have seen revenues and profits fall to close to zero might keep non-essential spending to a minimum. That would keep economic output subdued.

UK Gross Domestic Product: Quarter on Quarter growth (%)

Source: ONS 13 May 2020, accessed 14 May 2020

What can investors do?

Some industries are more closely linked to the economic health of a country. These types of businesses are known as “cyclical”, because they follow the ups and downs of the economy.

Companies involved in construction for example tend to do well when economic output is strong. The same can be said for businesses involved in manufacturing or packaging, for example. It stands to reason that if an economy is expanding, these activities are in higher demand.

Banks are also classic economic bellwethers. In good times banks lend more money, customers are less likely to default on payments, and as a nation we’re more likely to deposit higher amounts of cash.

Of course, the cycle cuts two ways. When the economy is doing well, it will boost these businesses. But when the economy contracts, as in recessions, it can be painful. We can see in the graph below that in general banks tend to perform less well when economic growth is slow.

Performance of bank shares vs the UK economy

Past performance is not a guide to the future. Source: Thomson Reuters Datastream 21May 2020

So, avoid cyclical companies?

Not necessarily.

In times of economic hardship, there can be opportunities. There’s no denying the pandemic has hurt global economies, and it’s too soon to tell how deep the cuts have been, or the extent of subsequent recessions. But we still think that gradually, economies will begin to recover in the future.

It could be worth considering sectors that are better placed to benefit from this recovery. Cyclical companies can offer opportunity here, especially because their share prices tend to suffer when the economy does. This could mean that if the cycle starts to move upwards again, investors could benefit. Of course, we have to remind you that share prices can go down as well as up and there are no guarantees.

What should I look for?

Severe economic downturns can be painful for individual companies, and some will be hurt more than others.

While we think now could be a good time to consider cyclical companies, it’s important to focus on the quality of any company you’re considering investing in. Just because a business operates in a cyclical industry doesn’t necessarily mean it will participate in an economic recovery.

The most important thing to remember is these businesses are more sensitive to being over-burdened with debt. Because revenues and profits will fall more sharply than for a non-cyclical business in times of economic contraction, financial health is even more important. When profits are subdued it can become harder to service the interest payments on debt.

This was the trouble contractor Carillion found itself in before falling into administration – which serves as a stark reminder of the dangers of debt. It’s important to do your research.

One thing investors can do is to take a look at a company’s net debt to cash profits (EBITDA) ratio. No company is the same, but if a cyclical company’s debt is much more than twice the size of its cash profits, we’d view this as uncomfortable.

The other thing to consider is how a company was performing before times of economic difficulty. If a manufacturer was struggling, or losing market share before a recession, the chances are it will find re-gaining its strength more difficult when the dust starts to settle. In these situations, a falling share price can be justified and reflect the challenges ahead.

On the other hand, if a business was doing well and was able to generate healthy profits and cash flows when times were good, there’s a stronger foundation. In these cases a share price fall can reflect more general concerns about the risks involved in cyclical companies during tough times – not a warning sign about the specific company at hand.

Things to remember

Cyclical companies can offer opportunity in times of uncertainty, but they’re also higher risk. We always say it’s important to focus on the quality of individual investments, and that’s especially true at the moment.

We recently wrote about how the current crisis has changed the way we look at shares, and you can read it here.

We can’t predict what’s going to happen, and ups and downs are almost guaranteed from here. That means it’s important to make sure you hold a good balance of different investments in your portfolio, it’s your best defence against market turbulence.

Overall we want investors to remember that the biggest opportunities often come in difficult times, for those willing to choose carefully and take a long term view.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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