Bad news for the gloomsters

Joe Brent

So, it turns out that the UK is not the sick man of Europe. The latest figures from the ONS1 indicated that the UK's economy has grown by 1.8% since the pandemic started, whereas the previous estimate was a 0.2% contraction. That is a mere 2% difference, or, put another way, a massive £45bn. This is bad news. Bad news for those dead-set on a narrative of UK decline. Gutting then that the UK performed better than France and Germany over the same time period.

Little doubt that this will not stop the naysayers in the City. Share price momentum is a perennially successful investment style. And being bearish has been rewarding. The Small Cap index, which has a more than 60% weighting to the UK by sales, has increased a meagre 4% over the last year. But, it has increased 5%, 45% and 159% over five, ten and twenty years. UK active funds have seen 9% outflows over the last twelve months. But some areas have been seeing inflows and overall there was a 2% inflow reported in September2. UK investors have been net buyers of the US since March. But US investors have been net buyers of the UK all year. Perhaps familiarity really does breed contempt.

Whoever said that words won’t hurt you, was not thinking about stock markets. The negative narrative in the UK has contributed to weak share prices. Excellent UK listed companies like Dechra and Network International, are being acquired. UK companies are re-listing abroad; CRH announced it was moving its primary listing to the US in June. Virtually no companies are listing. And some of those that are, like ARM, are choosing to list overseas. This means fewer, perhaps less quality, stocks with unattractive valuations for those that remain. The Small Cap index trades on a forward P/E of 10.9x, a 43% discount to the S&P. In the last 25 years, it was only cheaper in the GFC and pandemic and both of those turned out to be great buying opportunities. Liquidity dries up from the bottom of the market and creeps upwards, reducing the investable universe further.

Of course weak market conditions and poor liquidity lead to challenging trading conditions for fund managers, which see falling assets under management, and investment banks, which see reduced banking fees and trading commissions. But much more important than that, markets are not functioning properly, particularly at the smaller end, which has serious ramifications for the economy. UK Smaller companies are the growth engine of the UK economy. Public listed companies pay taxes. More so at least than private equity owned ones.

One of the primary purposes of a listing has been for fund managers to provide capital for companies to survive and thrive. The value of a listing was proven only recently during the pandemic when companies turned to markets to fill the hole in their battered balance sheets, or to take advantage of distressed valuations to make acquisitions. The market answered the call, providing £28bn3 of capital. If the market ceases to provide fresh capital, the danger is that it becomes a game of ‘pass the parcel’ for UK equities, where the music gets slower and the prizes get smaller. It’s then just a zero sum game for fund managers.

As many fund managers suffer outflows, they are turning to the companies they own and asking for capital to meet their own redemptions. There have been £29bn of buy-backs in the last twelve months, which is nearly 10% of the FTSE 250’s combined market value of £323bn. 

This topsy-turvy world, where fund managers request capital rather than provide it, is a bad thing. A particularly bad thing at a time when the UK lags in productivity, which requires investment.

Long term, even poorly functioning illiquid markets will adjust. Cheap valuations will attract buyers. Well capitalised companies can buy the asset they know best, themselves. Trade buyers and private equity will buy companies. Overseas buyers can leverage their higher valuation to arbitrage the UK’s lower ones. Fund managers won’t see outflows indefinitely. Data is backward looking and the inflows reported in September just might develop into a trend.

But in this long term we are all dead. In order for this adjustment to happen quickly markets need more capital. Soon.

So what to do? As Ronald Reagan said, the most terrifying words are ‘I am from the government, I am here to help.’ So first, the government should do no harm. Reform to IHT such as cutting the headline rate or scrapping the levy altogether would be popular with many conservative voters as IHT involves taxing an estate which has probably already been taxed. However, IHT is expected to raise £7bn of much needed tax revenue this year, according to the IFS. It is questionable whether now is the time for a change that would principally benefit the richest 1%. It would also be disastrous for AIM as the attraction of AIM for many investors is that that many AIM stocks can be passed on IHT free.

The government is doing a good impression of caring about these issues. There is lots of fiddling that they can do. They can reverse MiFID 2, the much disliked EU regulation which forced financial firms to separate the cost of investment research from trading expenses. It would be desirable to have a level playing field with the US, where there has not been wholesale unbundling. But there will be significant resistance from investors who have undertaken the painful process of splitting research revenues from trading revenues. You can’t put the tooth-paste back in the tube.

The FCA plans to simplify listing rules to help attract a wider range of companies. This could help at the margin if done the right way. But there is no shortage of companies that are looking to IPO. A listing still has many attractions, including an enhanced profile, access to capital and a currency to motivate staff. The problem is the shortage of money, or more precisely the allocation of capital to other areas, most obviously gilts, where the government’s insatiable appetite for capital is crowding out equities. If investors had more money, they would be tempted to buy more of the companies that they know and love at very attractive valuations. They might even have some left over for IPOs.

So if the problem is lack of money, anything that the government can do to help fund flows would be widely welcomed and bring significant benefits to the market and economy. There is an obvious irony in capital markets, which is that the champions of the free markets and low government and regulatory intervention, are seeking government help. But if the cost is low, potentially zero, and the benefits are large, why let a little bit of dogma get in the way. There is also plenty of precedence for this working well, with IHT exemptions for many AIM stocks and tax benefits of VCTs.

Enter the ‘Great British ISA’. The ISA is an amazingly generous tax break for the very few that can afford to use it fully. In the next seven months a couple can save £80,000 in a wrapper which is tax free forever. However, according to HMRC, an average of £44bn p.a. has been invested into cash ISAs since the GFC. However, 62% of the total £741bn in ISAs is held in investment ISAs, telling us something about historic performance, albeit at a time of low rates. Much of the equity investment is also invested overseas4, with no benefit to the UK economy. It would be possible to require future investment in UK companies, just like Personal Equity Plans, which were replaced by ISAs in 1999. The key advantage of this it should have a short flash to bang.

However, if we are to encourage greater retail involvement in equities, it seems only fair that they should be provided with research so that they are not at an information disadvantage, which is a sure route to investment losses. In Rachel Kent’s Investment Research Review, published in July, she identified Research as the ‘golden thread that runs through the UK capital markets’. We agree. Quality research provides insights about a company’s competitive position, industry and prospects and provides the forecasts to help process of price discovery, which is key to an efficient market. But research is expensive to produce. And banks are not public service broadcasters. Research payments have fallen significantly, largely as a result of MiFID and large investment banks have responded by ‘juniorising’ research.  There needs to be a funding mechanism to provide research to retail. There would also have to be a change of rules to allow investment banks to provide research to retail investors.

In his Mansion House speech in July, Jeremy Hunt identified another huge pool of capital. He set out the Compact where two thirds of the Defined Contribution funds agreed to allocate at least 5% of their default funds to unlisted equities by 2030. In his statement, Hunt claimed that this could unlock up to £50bn. And in an important clarification on the web-site ‘unlisted equities’ includes AIM.

Getting some of these initiatives off the drawing board and into practice would result in more bad news, for the gloomsters. The best time to have done this was a long time ago. The second best time is the Autumn statement on 22nd November.

 

Sources:

1. ONS UK growth figures, September 2023 ( Read here)
2. Liberum / Bloomberg
3. Liberum / Bloomberg HMRC
4. HMRC