Is Britain doomed?

With reelections in the UK coming up and moderately high inflation still being hard to combat over the world, it’s a good a time as any to do a deep-dive and evaluate the British economy and stock market. Brexit has had undeniable effect on the UK economy as well, Goldman Sachs says that "the UK has significantly underperformed other advanced economies since the 2016 Brexit referendum, with lower growth and higher inflation". Their analysis shows that the British economy is 5% smaller than it would have been had it remained in Europe. Moreover, UK debt spending has been increasing at a concerning rate year over year. The IMF listed the UK in its Fiscal Monitor publication last week as one of four large economies that “critically need to take policy action to address fundamental imbalances between spending and revenues”. They project UK debt to hit 98 % of GDP by the end of the decade - which would still leave the country below the US, Italy and France, but the IMF say that they are concerned about the direction of Britain’s borrowing position. Since 2016 Consumer prices in the UK have risen by 31%, compared with 27% in the United States and 24% in the Eurozone. The FTSE 100 index has in recent years solidly underperformed European and American stocks. Is the decline simply caused Brexit and its consequences or is there more to the steep decline of the British economy compared to America & Europe?

The London Stock exchange has seen its trading volume decline significantly in recent years and a number of British companies have even started listing their shares on other markets, perhaps due to the underperformance of British IPO launches like Deliveroo.  According to Bloomberg, companies raised just $1 billion dollars on the LSE last year, the lowest amount of capital raised on the exchange since 2009. While some of this decline can be explained by a global reduction in the number of IPO’s – and an increase in funding from private equity over that period, the fact that the British based chip designer ARM chose to list in New York last year is indicative of Britain's declining reputation. Two years ago, Paris overtook London as the largest stock market in Europe as the total market cap of London-listed equities has fallen more than 30 % from its peak in 2007. Over the same period, the market cap of US listed stocks has tripled. It would be easy to blame this all on Brexit, but Britain’s decline as a global financial center began well before 2016.

The research from Dimson, Marsh and Staunton at London Business School shows how the relative sizes of global equity markets have changed from 1899 to the present day. Their data shows that it’s not just the UK market that has fallen in significance over the last 124 years. Today, the US market accounts for more than 60% of total world equity market value with Japan in second place, the UK in third and China in fourth. Towards the end of the 19th century, faster economic growth in the US allowed it first to catch up and then to overtake Britain in terms of GDP per capita. By the late 1920’s, the gap had widened such that American real GDP per capita was 131 % of that in the UK. While British growth slowed somewhat, American growth accelerated, driven by unprecedented productivity advances and a switch of technological leadership from Britain to the US. In recent years, when compared to US stocks, British stocks just seem to move sideways, and this might be because British stocks are cheap or because American stocks are expensive, for example, the FTSE is today trading at a price to earnings ratio (Share Price/Earnings per Share) of 14 compared to the S&P500’s PE of 23 meaning that you can buy a dollar of earnings in the UK at a roughly 40% discount to the price in the US.  However, it’s not necessarily reasonable to compare two markets in that manner, as the UK market is heavily weighted towards sectors like banks, natural resources and mining, and not the high growth tech stocks that make up almost 30% of the S&P500. On the other hand, it’s not necessarily fair to compare the two indexes as the UK market is heavily weighted towards sectors like banks, natural resources and mining, and not the high growth tech stocks that make up almost 30% of the S&P500.

As Robert Armstrong pointed out in a recent FT article, investors have been paying more and more for growth stocks rather than value stocks in recent years. Armstrong argues that the UK stock market is facing a triple jinx at the moment— with smaller companies on average than in the US, which are more weighted towards value sectors than US indices are, and which are – by definition - outside the US. While these factors may explain a big chunk of the underperformance, they don’t explain everything, as UK stocks are not only trading at a discount to US Stocks, but they are also trading at a wide discount to European stocks. Furthermore, the gap between US and UK stocks widened considerably since 2016 and the disparity between UK and European stocks started to emerge in 2016 as well. When we look at the biggest stocks in the FTSE 100 you see companies like Shell, HSBC, Unilever and BP. These are companies that make and sell their goods internationally. While they are UK listed, they are not solely focused on the UK market and Brexit shouldn’t affect these companies.

London’s attractiveness as a listing venue, in particular for technology stocks appears to have become tainted in 2021 when tech stocks like Deliveroo and Wise were listed on the LSE, only to quickly see their share prices slump. Venture Capital firms argue that this happened because the institutional investors that dominate the London market don’t understand tech and that they were looking for cashflows rather than growth – unlike American investors. It is hard to know if these firms would have performed better, if listed on the Nasdaq rather than the LSE. Especially when about 40% of the demand for European IPOs come from US investors. Stock market liquidity, research coverage and regulations will matter a lot too.  With regard to liquidity, the UK unlike the US and Germany charges a half a percent stamp duty for share purchases (a form of financial transaction tax). This tax reduces stock market liquidity (as it encourages investors to trade less) making it cheaper to buy and sell securities abroad than in the UK. Oddly enough the UK regulations exempt cryptocurrencies, ETFs, contracts-for-difference and spread-betting from stamp duty, which possibly even drains liquidity from equities in favor of these products.

In the city of London, a well-worn explanation for the UK stock price discount is that due to regulations introduced 20 years ago, British pension funds have spent decades reducing their stock exposure in order to buy bonds. On top of this British institutions have also been busy diversifying internationally over the same period, leaving less domestic capital available for investment into UK listed stocks. The regulation in question was introduced in the early 2000s, when the British government brought in new rules requiring companies to hold pension deficits on their balance sheets. This triggered a big shift among UK pension funds out of the stock market and into bonds. In the early 1990’s UK pension funds owned about one third of UK listed companies, today they own under two percent of UK listed stocks and foreigners now own 58%.

Oliver Jones at Rathbones published some interesting research in January trying to understand if British stocks are actually cheap, and if they are, what’s causing the discount.  Jones built a regression analysis that adjusted for the size, the profitability and the sector composition of the UK market. He analyzed a pool of more than 1,000 global stocks — 140 of them being UK listed. He found that the average UK stock’s forward PE ratio is 16% lower than the average stock listed elsewhere in Europe and 32% lower than the average stock listed in the United States. He went on to compare valuations based on other characteristics, such as sales growth, profitability, and interest coverage, finding that in each case, firms with higher scores for these characteristics have higher PEs. Which is what you would expect as investors are willing to pay up for stocks with higher growth and higher quality. Jones found that even after accounting for these factors, the UK discount remains large, at about 22 %, meaning that firms in the same sector with identical growth and quality characteristics are cheaper if they’re listed in the UK rather than in the US. The research found that that the UK discount emerged after the 2016 Brexit referendum as when the analysis was performed using older data no statistically significant UK discount relative to the US was found. Jones found that the same discount appears to be applied to multinationals as to companies that earn all of their revenue in the UK, which he argues doesn’t really make much sense. He dismisses the pension fund argument, pointing out that the timing of the appearance of this discount doesn’t line up with the UK pension fund regulations and he concludes that the most likely explanation for the UK’s valuation discount is a general pessimism toward UK equities after the Brexit vote. He backs this argument up by highlighting a Bank of America survey of global fund managers, which shows a deterioration in sentiment towards UK stocks in the second half of the last decade – around the time of the Brexit vote. It’s quite possible that global investors feel that the UK had a good deal within the EU and irrationally ended it and this reflects badly on how the country is being run in general. The constant turnover in political leadership (4 different Prime Ministers in 7 years) since the Brexit referendum might have reinforced the feeling that the country is in disarray.  

Perhaps the way UK stock markets focus on old economy stocks when compared with US indices say something about the future expected return of British Stocks? Well, the research from Dimson Marsh and Staunton at LBS shows that markets at the beginning of the 20th century were dominated by railroads (which were the tech stocks of their day). They point out that of the US firms listed in 1900, some 80% of their value was in industries that are small or extinct today; the figure for the UK is 65%. They go on to highlight the high proportion of today’s companies that come from industries that were small or nonexistent in 1900. The largest sector globally in 2024 is technology. In prior research, Dimson Marsh and Staunton analyzed whether investors should focus on new industries and avoid the old declining sectors. They found that both new and old industries can both reward and disappoint investors equally. What matters most, they found is whether stock prices correctly embed expectations. Essentially, any business can be a good investment if you invest at a good price. Their research shows that while railroads have been the ultimate declining industry over the period of their research. In the period since 1900, railroad stocks have actually beaten the US stock market, and outperformed both trucking stocks and airlines since these newer industries emerged in the 1920s and 1930s. They found that if anything, investors may have placed too high an initial value on new technologies, overvaluing the new and undervaluing the old.  The takeaway being that valuation matters more than an ability to spot the new “new thing”.

Meghan Greene, an external member of the Bank of England’s Monetary Policy Committee pointed out in a recent FT article that expected growth in the UK is significantly lower than expected growth in the United States and that potential growth is made up of two main components — potential productivity growth and labor supply. She points out that the UK looks worse than the US on both fronts. A 2004 paper by Broadberry & Irwin shows that in 1850 Britain led the world in terms of productivity, American workers at the time produced roughly 10% less than British workers, but by 1910 America had taken the lead and US workers now produces 25% more. After two world wars and the loss of an empire, Britain’s labor productivity was below that of not only America, but also France and Germany. In the global financial crisis, a productivity slowdown hit all countries, but UK’s productivity slowdown was particularly severe.  Between 2009 and 2019 its productivity growth rate was the second slowest in the G7. Greene points out in her FT article that investments is one way to boost productivity growth. In macroeconomics, investment means additions to a nation's capital stock of buildings, equipment, software, and inventories – so it doesn’t mean buying stocks – it means investing money in the things that make workers more productive. Business investment in the UK was essentially flat between 2016 — the year of the Brexit referendum — and 2020, and this lack of business investment does make intuitive sense over that period as there was a huge increase in business uncertainty. A business owner isn’t going to spend money on new manufacturing equipment or expand their office space when it’s unclear what new trade regulations might be in the pipeline.  

 An Economist article from 2022 highlights that Britain has consistently invested less than France, Germany and America, and that Britain also consistently spends less on research and development. US business investment growth on the other hand outstripped that of all other advanced economies in the period since 2016. The other factor that Greene argued could have increased expected growth in the UK is labor supply. Greene points out that the difference in labor supply between Britain and the United States is also stark. Labor market participation in the UK has not recovered to the pre-pandemic trend, while participation in the US has exceeded the pre-Covid trend. Figures from the OECD show that in terms of labor force participation, the UK is a significant outlier among its peers, all other G7 nations now have more people working or looking to work than before the pandemic, while more than a fifth of working-age adults in the UK are deemed not to be actively looking for work. A total of 9.25 million people of working age are now classed as economically inactive, up from 8.55 million in February 2020.

The Economist article about Britain’s low levels of investment and R&D argues that adjustments for the capital available to workers explains almost all the gap between GDP per hour worked in Britain and France, and explains about a third of the gap between Britain and Germany. The Economist argues that while Britain has been successful in encouraging young people to go to university, the nation has struggled to equip workers with the specific skills that employers demand. They highlight that while Britain has world-beating research universities, it struggles to spread the knowledge developed at those universities to companies. Compared with the US, for example, the UK relies relatively heavily on universities and less so on national labs, which tend to be more focused on applied research. On average, Britons take out patents at about half the rate that Americans, French and German citizens do.

The research seems to show that British stocks are indeed cheap relative to US stocks and that some of the discount is down to pessimism around Brexit (and that some of that pessimism may even be unfounded). UK business activity rose more than expected in April and a recent uptick in M&A activity in UK stocks where deals with multiple offers and high premiums have been announced could possibly signal that investors are starting to recognize the value in British stocks. Britain is now in its sixteenth year of anemic productivity growth, and while many of the drivers behind the productivity slowdown were global, about half of the slowdown in the UK can be attributed to a failure to invest in capital and skills.