2020 was an 'annus horribilis' for the UK economy. Gross Domestic Product (GDP), the conventional  measure of a nation's economic output, was first calculated in the aftermath of the Second World War, and the measure has never previously dropped by more than 4.1% in a single year. However, the Bank of England's GDP models go back centuries, and suggest the 2020 contraction – the UK economy plummeted by 9.8% amid the fallout from the coronavirus pandemic – is the most significant drop since the great frost of 1709, when the economy fell by 13%. An extraordinarily cold winter had caused rivers and canals to freeze over for several months in Britain and much of northern and central Europe, claiming a substantial number of lives and bringing trade to a standstill.

The current downturn is the most severe in the G7 and steeper than that experienced by almost any other large economy: GDP fell by 3.5% in the US, by 5% in Canada and Germany, 5.6% in Japan, 8.3% in France, and 8.9% in Italy. The UK did fare better than Spain, however, where the economy collapsed by 11% last year. Whilst no sector of the economy was left unscathed by plummeting demand, much of the deterioration has been ascribed by economic commentators to the country's reliance on the services sector, which makes up 80% of the economy and which was hit particularly hard by the constraints of lockdown.

Source: Office for National Statistics/Bank of England February 2021

In December, with looser Covid restrictions in the run-up to Christmas, the economy expanded by 1.2%, having shrunk by 2.3% in November during the second English lockdown, and, in the final quarter of 2020 as a whole, the economy expanded by 1.3%, countering expectations earlier in the autumn for a renewed fall in GDP as the pandemic worsened.1 As a result, the UK narrowly avoided what would have been its first 'double-dip' recession since the 1970s, i.e. a period when the economy recovers from recession, only to sink back rapidly.

Despite some signs of resilience over the winter, analysts are predicting continued economic decline over Q1 2021: with the toughest lockdown restrictions since the first wave weighing down activity until April, output is set to remain well below pre-pandemic levels, exacerbated by some adverse impact from increased trade barriers with the European Union. Exports to the EU in January, the first post-Brexit month, fell by £5.6 billion, over 40%.3 Given that background, and the fact that the UK has reported Europe's highest coronavirus death toll and amongst the world's highest in terms of deaths per head of population, one might be tempted to suggest that there is little in the latest data to support a mood of optimism. A deeper examination inclines one to believe otherwise however.

A key factor driving more upbeat forecasts would undoubtedly be the success of the UK's vaccination programme relative to its European peers, vaccines being the single most important measure in the staging of a sustainable comeback following the ravages of COVID-19. By the beginning of April, the UK had administered circa 37m vaccine doses, roughly the same as Germany, France and Italy combined, and almost half the European total. At over 55 cumulative doses administered per 100 residents, its inoculation rate is over three times higher than that of its continental neighbour.2

This out-performance has markedly raised market expectations of a Q2 economic resurgence, as lockdown measures are gradually relaxed: businesses and households have remained in something of a holding pattern for many months now, such that the Bank of England's chief economist, Andy Haldane, has described the economy as like a "coiled spring", precipitating pent-up growth when the COVID-19 shackles are fully discarded and the economy is firing "on all cylinders" once more.

The UK household savings ratio (household savings as a proportion of household disposable income) has climbed from 9.6% in Q1 2020 to 29.1% in Q2 2020, a record high since 1987, before declining in Q3 and Q4 to 14.3% and 16.1% respectively. For context, following the global financial crisis of 2008, the UK savings ratio peaked at just 13%. Meanwhile, total household debt was £1,858 billion in Q3 2020, up only 2.4% on the year before.1 The savings ratio is an average, of course, and so it remains to be seen how much of this recent rise will prove to be ‘precautionary’ and how much will translate into consumption as the world returns to normality. The marginal propensity to consume varies, needless to say, by income band but the prospects are nevertheless encouraging.

UK corporate finances paint an equally promising picture in the main. Whilst recent months have broadcast a steady drumbeat of business failures – particularly in the retail and hospitality sectors, with Arcadia Group (owner of Topshop, Dorothy Perkins, Burton and Miss Selfridge), Debenhams, Jaeger and Café Rouge all going to the wall – British businesses find themselves in surprisingly rude health. Whilst earnings certainly declined in 2020, the effect was much less pronounced than in the 2008 financial crisis or the recession of the early 1990s. Whilst buoyant corporate bank balances are not a common characteristic of recessionary times, a recent report by the Resolution Foundation4, a think tank, highlights that British businesses have rarely been so awash with cash.

Despite the severest downturn since records began, the magnanimity of the government's policy response – access to £87 bn of cheap finance, the £59 bn Coronavirus Job Retention Scheme and £16 bn of direct grants – has enabled UK firms to withstand the effects of the pandemic considerably better than most had anticipated. Insolvencies in 2020 were down by a quarter on 2019 levels, whilst the last nine months of 2020 saw UK businesses bolster their bank balances by £118 bn, or over 30% of GDP (see chart below), in marked contrast to an average inflation-adjusted decline of circa £40 billion over the past four recessions.

Although a sizeable proportion of this additional cash is a function of taking on additional debt, the UK’s corporate debt-to-GDP ratio remains well below the levels seen during the aftermath of the financial crisis.

The explanation is not as unfathomable as it seems. First, the impact of the recession has been asymmetrically spread: whilst 'bricks and mortar' retailers, travel and hospitality have borne the brunt, other sectors have got off lightly. Indeed, many in the technology, healthcare and home delivery fields have prospered. Figures from the Office for National Statistics published in The Economist newspaper reveal that over 40% of UK firms claim the pandemic has had either no impact on their earnings or has enhanced them.5 Second, as we've seen, the majority of the cost of any reduced output has been met by the government's deployment of various significant support initiatives.

Cash-rich UK businesses are widely anticipated to put their substantial, newly-assembled war chests to work, and chiefly in two forms – capital expenditure and corporate acquisition – both of which will enhance the prospects for the UK economy, and thus equity markets. According to data from the London Stock Exchange-owned research business Refinitiv, six weeks into a post-Brexit 2021, the value of domestic mergers and acquisitions activity was £7.9bn, a three-year high. This is reflective of a growing optimism about continued recovery, the fact that the UK market has been unloved – and undervalued – for some time now, and the UK’s 'no tariffs, no quotas' trade deal with the EU removing a large degree of ongoing uncertainty.

Whilst larger firms have been prudently building their cash, smaller firms are likely to be less flush, a phenomenon that has not gone unrecognised by Job Curtis, portfolio manager of The City of London Investment Trust, a flagship trust within the Janus Henderson stable investing predominantly in UK large cap, multi-national companies. As economic growth improves from the second quarter onwards, both in the UK and overseas – it’s worth remembering that circa 70% of FTSE 100 company revenues are generated overseas6 – it should be a supportive background for both earnings and dividends.

The unloved banking sector has outperformed, largely on the back of the prospect of stronger economic growth and the regulator permitting a return to dividend payment, unlike in 2020. The Trust's holdings in Barclays and Lloyds were among its best performers in Q1 therefore. Further welcome dividend surprises were experienced in the mining sector, where City of London has large holdings in Rio Tinto, BHP and Anglo American. As at the time of writing, City of London is one of only four investment trusts to have increased its dividend for over 50 consecutive years, a remarkable achievement given that the UK has experienced 10 bear markets since the launch of the FTSE All-Share index in 1962.

They say that cash is king … in the remaining months of 2021, we may be about to find out.

 

1Source: Office for National Statistics, 31.03.21

2Source: Our World In Data/University of Oxford, 05.04.21

3Source: Office for National Statistics, 12.03.21

4Resolution Foundation, On Firm Ground, 10.02.21

513.02.21

6Source: Interactive Investor, 25.08.21

7Source: AIC/Morningstar, as at 17.03.21

 

Glossary

Bear market: A financial market in which the prices of securities are falling. A generally accepted definition is a fall of 20% or more in an index over at least a two-month period. The opposite of a bull market.

Gross domestic product (GDP): The value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). It is usually expressed as a percentage comparison to a previous time period, and is a broad measure of a country’s overall economic activity.

For a full list of terms, please see our glossary.