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Why is the FTSE 100 rallying as the UK heads towards a recession?

We are all aware of the tragic impact the coronavirus is having around the globe. The need to stay at home has virtually shut down the economy. The knock-on effect is high unemployment, falling GDP and a weaker pound. Few analysts disagree that the UK is heading for a recession, indeed we might actually already be in one.

A recession is defined as two consecutive quarters of negative GDP growth. We have to wait until May 12 to find out the reading for the first quarter of 2020, but it could easily be negative. As for the current quarter, it is unlikely we are going to see the economy grow. Despite this, in the past 30 days the FTSE 100 stock index has rallied over 12%. So why is that? And what does it mean for investors? Have we left it too late to take advantage of quality companies at bargain prices?

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A health barometer?

Usually the FTSE 100 index is seen as a barometer of how well the UK economy is doing. The stock market gauges investor confidence and general sentiment. If we look at the chart over the past few decades, we can see that it has broadly followed how the economy has performed. For example, when the UK sank into a recession with the global financial crisis in 2008/09, the FTSE 100 fell by around 30%. During the growth years from 2013/19, the index rallied to reflect this.

Recession-ready

One of the main reasons why the index is rallying despite us potentially already being in a recession is because it is priced in. This expression is used when the price of an asset already reflects the current situation. For example, if there is a bright yellow jumper which no one wants, it may go on 50% sale. As an investor, we would say the lack of demand is now priced in.

This can be said of the FTSE 100 index. The fall of over 30% in early March reflected the worst-case scenario for the UK due to the implications of the virus. In a way, this drop assumed a recession already, even a depression! The price thus reflected this opinion. So the rally over the past month has come as investors have realised that the worst-case scenario might not actually happen.

The lockdown imposed and the signs around the world of slowing death rates (Wuhan, Italy, Austria etc) over the past couple of weeks have provided optimism in the stock market. The market is still ready for a recession (hence why it is still down over 15% from the peak). But it is nowhere near as bleak as it was a month ago.

My Foolish takeaway

From this, I am doing the following. Firstly, I am not selling any stocks I currently own. If I had sold a month ago then I would have lost out on this rally. Secondly, I am looking to buy stocks which are defensive and could perform well during a recession. Supermarkets and the healthcare sector are good examples here. Yes, those stocks are more expensive today than they were in the depths of crash, but they are still quality companies I feel can grow and reward me once the crisis is over. Finally, I am making sure I keep my finger on the pulse of market sentiment, so I can react quickly whatever happens!

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Jonathan Smith and The Motley Fool UK have no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.