Shrinking equity markets are a big problem for Britain

This article was originally published in The Telegraph 

ONE of the big changes during my more than 30 years in the City has been the diminishing importance of the UK stock market.  

When I started out, UK shares represented around a tenth of global indices. Today their share is less than 4%. Back in the 1990s UK pension funds owned a third of the UK stock market. Today their share is in the low single digits. 

It is no surprise that the well-known fund manager Nick Train recently described the London market as a ‘backwater’. Hedge fund manager Paul Marshall a few years ago derided the UK as the ‘Jurassic Park’ of stock market investing. Stockbroker Peel Hunt’s head of research, Charles Hall, recently published an analysis of the UK’s shrinking stock market and declared ‘this really matters.’ 

Hall’s numbers are unarguable. The total number of companies (excluding investment funds) listed in the FTSE100, FTSE 250, SmallCap and Fledgling indices has fallen by around a fifth from 511 to 412 in the last five years.  

As, by definition, the number of companies in the top two indices is fixed, the damage has all been at the smaller end of the market, where the big companies of tomorrow should be nurtured. The number of companies in the Fledgling index has fallen by 28% in five years and by 37% over ten. 

And the real picture is, if anything, worse than this. Strip out the growing number of investment funds within the indices and there has been a 15% reduction in FTSE 250 companies over five years, 25% in the SmallCap and 48% in the Fledgling index. 

In large part this has been driven by the withdrawal of money from UK-focused funds, a trend which is accelerating.  

In the past 18 months, fund flows have been negative in every single month, despite the outperformance by UK shares during last year’s market fall. It is unsurprising, given this lack of interest, that, 2022 notwithstanding, the UK has been a poor relative performer and that British shares stand at a significant valuation discount to other markets, notably the US. 

No surprise either that UK companies are voting with their feet. CRH and Arm have been the two most high-profile losses, but there are plenty of other less familiar names that have either been taken over or decided to list elsewhere.  

Year to date, according to Peel Hunt’s analysis, there have been 16 transactions worth more than £100m which have removed companies from the public market. Over the same period just one company of any significance has floated. As Hall puts it, we are just ‘not refilling the hopper.’ 

How did this come to pass? It’s a long list of reasons.  

One was the backlash against privatisation under the Labour government from 1997 to 2010, which ultimately led to ownership of many companies passing to overseas buyers with, in the case of water, disastrous consequences. Another was the abolition of the dividend tax credit at the start of that government which has been estimated to have siphoned off more than £100bn from pension funds, perhaps twice as much when foregone investment growth is factored in.  

The list also includes the de-risking of pension funds over the years. This has seen so-called liability-driven investment strategies push pension funds into long-dated bonds rather than equities, with catastrophic consequences when bond yields rose dramatically last year.  

All these factors have fed off each other, leading to lower valuations, less interest from domestic and overseas investors and less incentive for companies to consider listing on their home stock market. 

Does it matter as much as Charles Hall claims? Yes and no.  

For the UK economy and the government’s finances it undoubtedly does. A long list of implications includes lower economic growth; lower corporate taxes; a less robust corporate sector that is able to withstand financial shocks due to the generally stronger balance sheets of quoted companies; reduced participation and engagement in the country’s wealth generation; and less vibrant financial and professional services sectors, previously one of our core strengths. 

So, what can be done? Well, it is not as if no-one has noticed there is a problem. Potential changes to the listing rules and the Austin Review of how to make the UK’s capital markets fit for purpose for the next 20 years are steps in the right direction. But there are other things that could be done alongside these. 

Raising corporation tax from 19% to 25% hits domestically focused small and medium sized companies particularly hard. It could be stepped so the full rate is only payable on profits above a certain level, as it already is for banks. Any change could be limited to listed companies to incentivise businesses to float. The capital gains tax regime is also, perversely, skewed against investment in quoted companies. Why, for example, is there no CGT to pay on risk-free gilts while being payable on higher risk assets? 

Other incentives could be introduced. While I’m instinctively against artificially tilting the playing field, the tax benefits of ISAs and SIPPs could conceivably be used in a more targeted way to encourage investment in locally listed companies. And while it is right to encourage pension funds to invest in private assets, why should this recent initiative not be extended to smaller listed companies too? 

I said yes and no to the question of whether all this really matters. That’s because for an investor the significance is probably less than for the country. The UK may be less important as an investment destination than it was when I started out. But if that reminds us of the risks of over-concentration and home bias, that is no bad thing. The shrinking of the UK stock market should encourage us to tap into a global investment opportunity which is much more accessible than it was 30 years ago.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Investors should note that the views expressed may no longer be current and may have already been acted upon. Please be aware that past performance is not a reliable guide indicator of future returns. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.