The recent news that the total value of the UK stockmarket had fallen $250bn behind that of France came as a shock. The UK now comprises just 3.8% of the MSCI All Countries World index, a share likely to fall as more firms emigrate or are taken over. BHP Billiton and CRH have gone already; Unilever and Shell were bullied by investors into staying, but could change their minds, and others are under pressure to follow.
Simon French of Panmure Gordon calculates that even after adjusting for the lower-quality composition of the UK market (itself a telling characteristic), UK stocks trade on an 18% discount to comparators overseas. Bidders are thus queuing up to snap up bargains.
Commentators assume that this is a recent phenomenon, readily reversible with help from the government. On the contrary: the crisis has been building for 25 years. The UK is like a Jenga tower from which, year after year, blocks have been removed, leaving it close to collapse.
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A global powerhouse
In the 1980s and 1990s, the UK accounted for more than 10% of global indices. Pension funds and insurance companies were major investors in British shares, which accounted for half or more of their equity allocation. This was justified by the global nature of UK companies, which meant that underlying UK exposure was far lower. British companies were good dividend payers, and the tax treatment of payout was generous.
UK-listed companies financed most of the investment in North Sea oil and quickly embraced new technologies. The UK, as much as the US, was at the forefront of the 1990s boom in the technology, media and telecommunications (TMT) sectors. Privatisation resulted in the listing of around 40 large- and mid-cap companies; many more grasped the opportunity offered by the contracting out of services previously monopolised by government. The resulting improvement in efficiency was both profitable for investors and a key factor in Britain’s faster growth.
It all started to go wrong with the election of the Blair government in 1997. Labour had always hated privatisation and was determined to have its revenge. Unable to tax or confiscate investors’ profits, it imposed an arbitrary tax on privatised companies. These companies, seeing the public hostility the government had stirred up, rushed to recommend bids from overseas and private equity.
This reduced their accountability to their British customers, but nobody minded, preferring faceless overseas ownership to a UK-resident board of directors. Later, the government drove Railtrack and British Energy into bankruptcy by severely tilting the playing field against them. The result? Shrunken nuclear-generation capacity and the return to the operational and financial disaster that was British Rail.
In 1997, Labour abolished the tax credit on dividends, initially generating £5bn of additional tax revenue per annum. The Office for Budget Responsibility calculated in 2014 that the extra taxation had increased to nearly £10bn and taken a cumulative £118bn away from pension funds – around £230bn allowing for investment growth. The cumulative cost would now be a multiple of this.
As a result, defined-benefit pension schemes were closed to new members who were switched into defined-contribution schemes. These pension funds were encouraged to invest solely in government bonds instead of equities, which suited the public-sector borrowing requirement very well. Liability-driven investment (LDI) started as a sensible idea for a fully funded scheme to reduce risk, but ended as a desperate scramble for returns as bond yields fell to negligible levels. The increases in bond yields in the last year have irretrievably cost pension funds hundreds of billions.
Sending the wrong message
After the financial crisis, regulators tightened the screws on both pension funds and insurance companies, further reducing the supply of capital to equity markets. Private investors, through Isas, Sipps and investment platforms have taken their place but, sensibly, are much less inclined to favour the UK. Overseas investors got the message that the UK was becoming a hostile place to invest.
Unlike in the US, the technology and biotech sectors in the UK never recovered from the collapse of the TMT sectors. New companies are coming up through Aim and private equity, but the government focuses its attention on areas where we have little competitive advantage while knocking successful sectors. Levelling down, not levelling up, is the British way.
Britain had a huge competitive advantage in financial services, but regulatory crackdowns on banking and insurance, restrictions on banking bonuses and the additional corporation tax on banks have undermined that. Success in the North Sea has led to a windfall tax that absorbed over 99% of Harbour Energy’s profits last year. A windfall tax has also been imposed on renewable energy. It has been sufficient to bring new investment to a grinding halt.
The government is driving out the pharmaceutical sector through NHS pricing. Tourism has been hit by the abolition of VAT refunds on goods purchased in the UK – surely the stupidest policy enacted by Hunt and his Treasury Munchkins. As this implies, the change of government in 2010 only resulted in a ceasefire in governmental attacks on UK businesses, but hostilities have now resumed at an increased pace. The rate of corporation tax was reduced from 28% to 20% in the Coalition years, but it is now back to 25%. Even companies not directly targeted complain about the relentless rise of costly and burdensome regulation.
No wonder Bank of America’s monthly survey of global fund managers consistently shows the UK as the least favoured of developed markets despite its cheapness. This cheapness is the result of investors’ understandable aversion to the UK; that local investors are abandoning UK shares has not
Low valuations have given overseas firms the chance to buy British businesses on the cheap. Kraft bought Cadbury in 2010 and SoftBank bought ARM in 2016 with institutional investors such as insurance firms and pension funds, only too happy to exit at a premium to the prevailing share price in their desperation to quit the equity market. Institutional investors are no longer controlling shareholders, but it’s unsurprising that retail funds with no net cash inflow accept bids when they can recycle the proceeds into other undervalued firms.
A long road to recovery
How can the relentless shrinkage of the UK market relative to the world be reversed? It will take multiple actions by the government, accepted and fostered across the political spectrum. Even then, it will take ten years before international investors, mindful of the UK’s terrible record, accept that attitudes have changed.
There does seem to be a move across the political spectrum to allow pension funds to invest in equities, but be under no illusion about the rationale for this.
Its purpose would not be to improve pension-fund returns or foster the revival of the UK stockmarket, but to provide funds for a financially hard-pressed government to invest in pet vanity projects with plenty of risk and no returns – HS3, perhaps. It would constitute another rip-off of pension funds.
It seems much more likely that the British equity market will continue to shrink as a percentage of the world total. This must surely threaten the contribution of financial services to the UK economy, which was estimated at £174bn, or 8.3% of total gross value added in 2021 (12.5% if related professional services are added on). Investors should beware the siren voices urging them to put their money into the UK, which is cheap for a very good reason. The outlook could change, but it is far too early to risk your savings on it.
Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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