Britain grew again in Q1 2016, but you could be forgiven for thinking otherwise. The popular reaction to Wednesday’s UK GDP release fits somewhere between “meh” and “harrumph” (frowny face implied). Modest growth that sits near the top of the developed world, for many, isn’t reason enough to cheer. Because services do all the heavy lifting, while heavy industry mostly limps, most see UK growth as unbalanced and therefore unsustainable. Such was the reaction—again—to UK Q1 GDP, which grew 0.4% q/q (1.6% annualized), a tick slower than Q4 2015’s 0.6% q/q (2.4% annualized).[i] Services grew 0.6% q/q, but the other three sectors—agriculture, industry and construction—all contracted. But take heart! Nothing here should imply the UK is losing steam, or extra-vulnerable because growth relies on services. Actually, it’s the opposite. The hefty service sector helps insulate Britain from the economic impact of a global manufacturing and trade slowdown. Mass sentiment might not appreciate this, but UK stocks should.
It is generally well-known that heavy industry has struggled globally for months. JPMorgan’s Global Manufacturing Purchasing Managers’ Index (PMI) has flirted with contraction on and off since mid-2015. US Manufacturing PMI contracted from October 2015 through February 2016. Industrial production has slowed markedly in China and fallen often in the US, Europe and Japan. Trade is quite choppy, too, with several major regions struggling. As interconnected as global supply chains are, it is fairly natural that UK heavy industry would feel a pinch as well. The steel industry’s struggles—highlighted by the Redcar plant closure late last year—add another headwind and, according to earlier reports from the Office for National Statistics (ONS), bear much of the blame for weak industrial production in early 2016. Add in the oil industry’s well-known problems—mining and quarrying fell another -2.2% q/q in Q1—and heavy industry’s latest detraction from GDP is no surprise.
If the UK were a manufacturing-heavy economy, this might be enough to tip the country into recession. But it isn’t! Like all advanced economies, Britain has evolved. Services, communication and information dominate, as they do in America and much of developed Asia and Western Europe. It’s tempting to jeer this development, as heavy industry’s historical role inspires abundant affection, and it’s very sad when old mining and factory towns become shadows of their former selves, but it isn’t a net negative for Britain’s economy. For one, it’s no coincidence that life expectancies have grown leaps and bounds as the service sector has become responsible for an increasing share of jobs. Quality of life has also improved for retirees, who are far less burdened by old work-related injuries or decades of exposure to certain toxins. And service-sector jobs have enjoyed faster wage growth during the ONS industry pay dataset’s limited history. Since January 2000, service sector wages have risen 60.8%, compared to 55.6% for manufacturing.[ii]
Having a big service sector—and wide diversity within that big service sector—helps insulate UK GDP from manufacturing and oil’s troubles. We reckon Brits didn’t envy Canada when it briefly tipped into recession last year, as its service sector didn’t grow enough to offset the Energy industry’s decline. Chinese leaders are desperate to cultivate a giant service sector to reduce their own reliance on construction and manufacturing, seeing them as increasingly unsustainable sources of growth. Much of the developing world covets what the UK has. Services-led growth, with a healthy shot of technology, is basically the Holy Grail.
Much of the angst over services stems from 2008, when UK financial services took a huge hit. Considering the UK’s reputation as the world’s financial leader, most presume “services-led growth” is a euphemism for “financial services-dependent growth.” But this isn’t so. Yes, the broad “business and financial services” category is the service sector’s single largest component, responsible for about 40% of services output. But finance is actually only a smidge of that. If you put on your reading glasses, leaf through pages and pages of data tables in the latest Index of Services report and do some math, you’ll find finance is just roughly 6% of the total industry. It has also grown much more slowly than the broader service sector over the past two years—1.6% for finance, compared to 5.8% for total services.[iii] Britain is far, far more diverse than most give it credit for.
This diversity is a strength, pure and simple. An economy led by a vast array of services is more balanced than an industry-led economy, not less. Yet because almost no one sees it this way, sentiment toward the UK economy remains dreary—for stocks, that’s just fine. It keeps expectations low, creating plenty of room for positive surprise. Those surprises, over time, should help propel UK stocks higher.
[ii] Office for National Statistics, as of 4/27/2016. January 2000 through February 2016.
[iii] Office for National Statistics, as of 4/27/2016. Total service industries and financial service activities except insurance and pension funding, February 2014 – February 2016.