Can the UK equity market recover?

Over the last couple of weeks, we have covered whether or not the UK stockmarket should be considered 'damaged goods' and we've taken a look at the regulatory reforms and economic events that have shaped and challenged the UK equity market. The key question is, what does the future hold for the UK equity market? Can it at least close the performance gap with its peers, even if it never regains its primary role as a venue for UK small and medium-sized businesses looking to list or raise capital?

Despite all of the challenges the market has faced over the last twenty years, I firmly believe in its potential for recovery; indeed, this process may have already begun.

Here are five compelling reasons why I am optimistic about the UK equity market's ability to close the performance gap:

1. Now that UK Defined Benefit (DB) pension schemes have exited the UK equity market almost entirely, they cannot, by definition, do it again.
2. As DB schemes have been closed to new members, Defined Contribution (DC) schemes have taken their place. Although these funds are significantly smaller than the legacy DB funds, their contributions are growing and have overtaken DB contributions, which are falling (total DC contributions are currently about 2x DB contributions). Unlike DB schemes, DC funds do allocate to UK equities, and those contributions grow each year as the number of active contributors grows – currently 18 million. These growing contributions amount to meaningful inward investment into the UK equity market, and these will grow in the future. This is a positive development, but it's important to note that because most of these schemes’ fund management activity has been outsourced to external passive managers, these funds cannot support new issues (IPOs), and they also tend to focus on larger, more liquid index constituents and avoid small and midcap companies.
3. The challenges the UK equity market has endured over the last 20 or more years has resulted in a shrinking population of listed companies. However, this also means that money coming into the market will have fewer places to go. All other things being equal, this positive cash flow will start to have a more material impact on prices.
4. Although the UK stock market has lost the ability to recycle surplus cash flow from mature businesses to those that need it to grow, companies listed in London generate a prodigious amount of cash every year. This cash is returned to shareholders via dividends (£90bn a year), which grow steadily, and share buy-backs, which have expanded significantly in recent years. Last year, buy-backs alone amounted to a not insignificant £57bn. Inevitably, this inward investment and DC buying will outweigh retail investor outflow.
5. Valuation is the crucial factor supporting the UK equity market. Unless the laws of investment gravity have been broken (they haven’t), UK equities will experience a mean reversion to a higher valuation, as they have consistently done throughout history. With no significant institutional selling and a favourable economic backdrop, I believe the time has come for the UK equity market to return to a more 'normal' and significantly higher valuation.

The importance of valuation

Over time, equity valuations have been a poor predictor of short-term price performance, but as the chart below shows, over longer periods, valuation has proven to be a highly reliable and accurate predictor of returns. This chart plots the end-year price/earnings ratios for each year since 1974 against the average annual real total return (including reinvested dividends) over the subsequent ten years for both the UK and US equity markets. The chart shows a high correlation between the starting PE ratio and subsequent long-term returns, with more than 75% of the average annual real return over the ten years being explained by the starting PE ratio.

Over the past 20-30 years, UK equities have traded on a PE ratio between 5x and 25x earnings, with an average PE of 13-14x. At current levels, UK equities trade on an 11x forecast 2024 consensus earnings and 10x 2025. Based on this relationship holding in the future, the predicted next ten years' average annual real return from UK equities should be in the low double digits. Unsurprisingly, this fundamental relationship between valuation and return also holds true in the US equity market as shown in the chart above.

As a sense check, this real return expectation for the UK market is closely aligned with the UK equity market’s aggregated post-tax return on equity, which, at about 15% in nominal terms, correlates closely with the low double-digit real returns anticipated by the relationship highlighted in the chart above.

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Conclusions

The UK equity market has endured a prolonged and painful period of underperformance against its peers for the best part of two decades, which has now left it trading at an extremely low valuation. Not only has the index underperformed, but regulatory reforms have diminished the market itself and left a damaging and irreparable legacy, rendering the UK market incapable of fulfilling a vital role for the economy.

Traditional explanations for this malaise have tended to point the finger of blame inappropriately at the comparative performance of the UK economy, the currency, Brexit, and the different composition of the UK index compared to relevant peers. None of these are credibly causal. Indeed, if economic performance were a factor, the UK market would have outperformed many of its European peers rather than lagging them.

The reality is that regulatory acts of self-harm in the form of pension accounting reform and MiFID 2 have together stripped the UK equity market of its historically largest institutional owner and the market support infrastructure for listed small and medium-sized businesses. It was hard at the time, and even harder now that we can see what damage has been done to the UK equity market, to understand the motivation or point of these profoundly damaging regulatory imposed changes. What is more galling is that the US equity market, which is held up as the benchmark against which all others, especially the UK, are compared, has implemented neither of these changes and is thriving and prospering.

Unfortunately, nothing can be done now to undo the harm inflicted on the UK equity market. However, there are things that the government could implement now that could help the UK market regain some of its former status and make it a more attractive proposition to domestic and international businesses and investors. Interestingly, in the Autumn Statement, the Chancellor emphasised the importance of financial services to the future growth of the UK economy and its Edinburgh Reforms listed a series of measures designed to improve the international competitiveness of the UK financial services sector. Within the list of measures and announcements were several relevant to the UK equity market. Unfortunately, for the most part, these were just calls for evidence or the announcement of consultations on potential future measures. In other words, nothing concrete or immediate and from my point of view. They had all the hallmarks of a Titanic-deck-chair-shuffling exercise. If the current government, or any other for that matter, was at all serious about wanting to help the UK equity market regain its vibrancy, function, and international status, it would first have to properly diagnose what was wrong in the first place. Unfortunately, there is no evidence that this has happened.

Here are my suggestions for reforms that would make a difference, in the medium term, to the overall health and functioning of the UK equity market:

1. A ban on short-selling non-FTSE 100 stocks.
2. The creation of a seeded sovereign wealth fund mandated to support UK plc and its nascent technology businesses, with the management of the fund outsourced to the private sector.
3. Pension and relevant life funds (who receive billions in tax breaks from the UK exchequer) mandated to place a minimum percentage of their funds in listed and unlisted UK equities funded by selling down their international equity holdings.
4. Scrapping a key MiFID 2 measure that banned buying research with commissions on trades.
5. Abolition of stamp duty on share purchases.

In reality, it would take a long time to convince any government to want to do these things, let alone actually get them done. But until some or all of these measures are adopted, international investors might legitimately ask, if you won’t buy your own market, why should we?

Having said all this, the very good news is that despite all the travails the UK market has had to contend with over the last twenty years, and based on the long-term ubiquitous relationship between valuation and future return, I believe that the UK equity market is now poised to correct years of poor performance. We could soon start to see a mean reversion to a more historically normal and substantially higher valuation basis. Fortunately, this mean reversion does not require any assistance from the UK government or regulators nor, indeed, a Damascene conversion amongst DB asset allocators. It just needs more buyers than sellers and my guess is that we are running out of the latter.