After Rachel Reeves’ Revenge Budget, many of those who had prematurely heralded a turnaround in the fortunes of the UK stock market had second thoughts. They had hoped for some measures, such as a partial lifting of stamp duty, to signal the government’s wish to reverse the UK’s decline. Instead, there were several measures indicating its hostility to the private sector in general and listed firms in particular. The government, it seems, only wants growth of the right sort, financed by taxation, government borrowing, or bullying large pension funds.
Why UK equities suffered from outflows
Past experience of tax increases is that they raise much less than expected, perhaps just half. This is particularly likely when many of the tax increases, such as those on non-domiciles, capital gains and inheritance, are “honesty box” taxes. Meanwhile, rising bond yields are ratcheting up the cost of borrowing. With hopes for productivity-enhancing reforms and deregulation also fading fast, renewed gloom about the UK seems justified. In the stock market, that gloom is supported by a continuing absence of new issues, a multitude of takeovers of public companies and a high level of share buy-backs; £50 billion for the FTSE 100 in the first nine months of 2024.
Insurance companies and pension funds have sold out. They own just 4% of the equity market, down from nearly half in 1997. Net sales of UK equity funds by private investors have re-accelerated, with £1.6 billion of sales of UK equity funds, both active and passive, in October, the 41st consecutive month of outflows. This is partly balanced by inflows into exchange-traded funds (ETFs) but private investors, wealth and charity managers have also sold direct holdings in UK equities and the UK exposure of investment trusts has fallen. Consequently, the UK now accounts for just 3.3% of the MSCI All Country World index, down from 10% 25 years ago. In the late 1990s, the UK started to underperform.
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A series of mega-cap mergers left a market dominated by slumbering dinosaurs while, unlike in the US, there were very few firms that had risen from humble beginnings to the FTSE 100. The market had been swelled by privatisations in the 1980s and 1990s, but the Blair government drove many of these into private equity, insolvency, or grappling with regulation and taxation.
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The government’s cack-handed response to the 2008 crisis crippled the UK’s banks (the US handled it far better) and caused a deceleration in our trend rate of economic growth. Many blamed this on EU regulations – hence the Brexit vote in 2016 – just as they had blamed a deteriorating economy on not being in the EEC in the 1960s.
How Covid affected Britain's economy
Britain’s response to Covid was disastrous for the economy and public finances, so the underperformance of the UK market accelerated. Only then did the UK’s poor performance and its shrinking share of the global total start to attract serious attention. Forecasts of a revival have been based on the cheapness of the UK market relative to elsewhere, even after taking into account its different sectoral composition, notably a low exposure to technology-related and other growth businesses.
This in itself is a damning indictment of the UK’s economic failure, but maybe it is also cheap due to terrible politics and regulation. The good news is that Covid seems to have given UK-listed companies a wake-up call. There are few if any slumbering giants left as all strive to grow revenues, earnings and cash flow. Low valuations have encouraged a steady stream of takeovers, whether from private equity or from overseas-listed companies.
These factors together mean that, although the overall market may continue to shrink, ownership of it ought to be profitable – in the absence of government involvement through regulation, taxation and damaging economic policies, that is. It may well take an economic crisis to force the government to change course, as it did in 1976. The obvious strategy is to wait for such a crisis before buying the UK market, but that may mean leaving it too late.
Markets anticipate change rather than just respond to it, so investing when the outlook is at its darkest (late 1974, for example) often pays off. A financial crisis would probably involve a devaluation of sterling (every Labour government in history has devalued sterling) and that protects corporate profits through the translation of foreign earnings, through the export of goods and services and through reducing competition from overseas.
With the US election and the imminent German election, the pendulum is swinging back towards market solutions rather than reliance on the state. High indebtedness will force governments to retrench or face the bond vigilantes; tax, borrow and spend is not an option. The US market suggests that investors are optimistic about the outlook under Donald Trump and a Republican Congress; if that optimism is vindicated, it will be very hard for the UK and Europe to row in the opposite direction. There may be more than four years until the next election here, but we already seem to have a lame-duck administration.
Some UK managers are not giving up. Gervais Williams, head of equities at Premier Miton, is robustly optimistic. “Despite all the headwinds, the UK market is already outperforming. In terms of total returns, the FTSE 100 has kept pace with the S&P 500 and outpaced the Nasdaq index in the last three years. Excluding the ‘Magnificent Seven’, we are massively outperforming the US, even though local investors and wealth managers are selling as fast as they can.
Our companies are generating surplus cash so fast that they are overwhelming local sellers, while according to investors’ surveys, a few international investors are drifting in. Small caps have been left behind because they don’t have many buybacks. Obviously nobody has noticed, but the UK market has broken out on the upside despite the selling. Any less selling or more international buying and it will go up faster. I think the UK, especially for smaller companies, looks superb and will be the best-performing market over the next 20 years.”
The FTSE 100 index stands just 15% higher than its level of 31 December 1999, representing a compound annual gain of barely 0.5% per annum. The mid-caps of the FTSE 250 have managed a much healthier 4.7%. With the FTSE 100 yielding 3.6%, dividends push the annual return of the FTSE 100 above the average inflation rate of 2.5%. Long-term investors shouldn’t wait for a crisis to buy the UK, but do so now in the expectation of much better returns in due course.
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