The troubled performance of credit and equity markets in the last six months suggests the chance of an imminent UK recession has risen. We’re not calling it yet but it pays to know what happened in the last financial crisis to avoid missteps.
We studied the FTSE 350 earnings-per-share and stock price trends seen during 2008/2009. The comparisons are imperfect but there are three key points.
Defending the defensibles
First, it’s striking how during the last financial crisis share prices in defensive sectors such as healthcare, consumer staples and support services far overshot what subsequently proved to be small earnings downgrades.
Yes, this can be justified by higher risk premia across all equities but it arguably represents a mispricing given that the risk of long-term capital loss is ostensibly lower. Defensives were the best through-cycle performers (2007-12) and also began rallying off the lows first. We think their performance this time round will be more robust.
Today, current multiples relative to the ’08-09 crisis suggests three sectors that stand out for cheap access to structural growth – aerospace and defence, support services and healthcare.
Next come what we call the ‘ultra-cyclical’ stocks – housebuilders, real estate, banks and financial firms. Downgrades now among these sectors would lift the probability of a recession sharply. Ultra-cyclicals that were downgraded first in ’08-09 were also downgraded the hardest.
There are clear idiosyncrasies about the last cycle, most notably that financial leverage across the market was higher, particularly at the ultra-cyclicals.
That said, the market now appears to us much further ahead of the fundamentals than in 2008. Back then, when the FTSE 250 was down 15 per cent from its peak we had begun to see real earnings downgrades at the ultra-cyclicals.
Currently, there is scant real world confirmation that justifies such a sell-off. Either you believe the market is a better discounter now than it was eight years ago or you conclude the market is simply a touch oversold.
It feels cheap but…
Value stocks – those which trade on the cheapest multiples - have underperformed their quality counterparts by 28 per cent since mid-2014. Should we start buying them?
Only if you think the market is wrong on the economy. Our analysis shows this underperformance doesn’t get close to reflecting a recessionary scenario. The divide between value and quality could widen a further 50 per cent before it looks stretched.
This will bring investors’ focus back on the balance sheet. As credit spreads rise we continue to prefer companies with cash. Whilst buying stocks purely on their dividend yield has worked well in the past five years or so, this approach underperforms in a recession.
We see our 'safe yield' picks – stocks where we see the dividend as less likely to be cut – as a better option, despite yields being optically lower.