The UK stockmarket is cheap – but is it cheap for good reasons?
Compared to other developed-world markets, UK stocks are remarkably cheap. But a number of factors means the discount could be well-deserved, says Max King.
As has been regularly argued in MoneyWeek, the UK stockmarket has been left behind global markets.
UK-listed shares, especially those that are domestically orientated, have underperformed their overseas competitors and comparators and are now cheap.
But are they cheap for a reason? I’m going to look at the other side of the argument this morning – and give a contrarian view on the contrarian take.
Rocketing public spending could hold back the UK stockmarket
There are a number of explanations for the UK stockmarket’s underperformance. These include Brexit; political uncertainty; the aversion of overseas investors; international diversification by UK investors; the “value” rather than “growth” focus of the UK market; and entrenched poor momentum.
This, so the argument goes, is set to change thanks to a good economic outlook, strong growth in corporate profits, more managerial dynamism and irresistible valuation anomalies.
The UK stockmarket’s better performance this year is the start of a long-term trend, with overseas bids for UK companies endorsing the opportunity. But is there an argument that the UK is cheap for very good reasons?
Brexit was always going to be a short-term negative for the UK economy. But it offered the potential – if the government grasped the opportunity to escape the constraints and costs imposed by the EU – of being a long-term positive. In football parlance, the UK would start a goal down but that didn’t mean the game was lost.
In reality, the UK has shown little interest in breaking free, continuing to shadow EU regulations and practice and compromising free trade deals to protect farmers and domestic industry.
During the pandemic, the UK spent like a drunken sailor while eurozone countries, constrained by budget rules, were far more cautious. UK public spending has ratcheted up at the cost of private sector growth. In the EU, it hasn’t. The score is now 2-0 or 3-0 to Europe.
As a result of this, public spending in the UK is now over 40% of GDP, the highest ever excluding wartime, while public sector net debt is almost 100% of GDP, the highest since the early 1960s. When interest rates rise, as even the inflation optimists expect, debt servicing costs will rise, increasing the deficit and debt further.
Productivity growth in the public sector has historically been negligible; an encouraging improvement some five years ago is by now almost certain to have been reversed. This explains why ever-increasing amounts of money have to be shovelled into the NHS and other public services to such little effect.
The increasing share in GDP of the low productivity public sector must slow overall economic growth, while the private sector is squeezed by the resource demands, especially labour, of the public sector.
Increased spending has, in turn, precipitated the biggest ever increase in taxation. In 2019, the UK’s tax-to-GDP ratio was 33%, slightly behind the OECD average. That is set to rise to 35% in 2022 and further thereafter.
Ostensibly, half of the 2.5% increase in national insurance contributions falls on employees and half on employers. But many employers will respond by reducing pay rises while the increased costs to the public sector will mean either further increases or reduced services.
Why tax rises are adding to political risk
This tax increase will further reduce domestic economic growth. Supposedly, the increase is to pay for a catch-up in NHS treatment, but will then be diverted to social care. It could as easily be attributed to the monstrous extravagance of the HS2 rail project; the “track and trace” programme; and the waste and fraud of much of the pandemic spending.
This makes the increase politically toxic for the government, especially as it breaks a key pledge from its 2019 election manifesto.
In 1992, Michael Portillo, then a government minister, predicted that increasing taxes would be suicidal for the then-Conservative government. Kenneth, now Lord, Clarke, the chancellor, proceeded to raise taxes and the Conservatives were routed at the 1997 election.
History is set to repeat itself; electorates do not forgive broken promises. Keir Starmer may appear unimpressive compared with Tony Blair in the 1990s but that does not matter.
In the February 1974 election, the Labour party, led by the discredited former prime minister, Harold Wilson, lost millions of votes, yet still emerged as the largest party. In a second election later that year, he won a narrow overall majority and Labour ruled for four and a half disastrous years.
In 2023-2024, abstentions plus increased votes for Liberal Democrats, Greens and others are likely to hand Starmer’s Labour Party victory, even if its vote, or share of the vote, doesn’t rise.
Such a government is not going to shrink the state or cut taxes. Tax increases will be targeted at investors and “the rich” (in practice, as always, the middle classes) but also at companies.
The rate of corporation tax will rise to at least 25% and perhaps 30%, hitting corporate earnings. Businesses with overseas earnings will be protected by devaluation, but domestic businesses will have the additional problem of stagflation.
Every period of Labour government in 100 years has seen a permanent devaluation, while devaluations under the Conservatives, such as in 1992 and 2016, have subsequently been clawed back.
Even if the Conservative Party seeks to return to its principles by kicking out Boris Johnson, the electoral outlook will be bleak. After four consecutive victories under three discredited leaders, the electorate will be sceptical and revert to its usual preference for “level down” over “level up.”
Under this outlook, UK equities deserve to trade at a discount to global equities. Short-term outperformance is possible but likely to be unsustainable. A portfolio tilt to Japan or emerging markets looks more attractive for the long term than to the UK but global funds or equities should be the core of any portfolio.