Can a Labour government reverse the fortunes of UK Companies?

The incoming government faces a major economic challenge. It badly needs growth, and it has no money to create it. It will need to pull every lever it has available. One key way it can unlock growth is to revive the UK’s gummed up financial markets, and encourage the free flow of private capital, but will it do it?

The situation is dire.

Today, there is £142.5 billion in UK All Companies funds, £36.9 billion in UK Equity Income funds, and £10.1 billion in UK Smaller Companies*. In April 2016, those figures were £157.1 billion, £58.5 billion and £12billion respectively*. For comparison, assets in the global sector have risen 2.5x over the same period*.

Another £996.5 million bled away from UK All Companies funds in April, £57 million from UK Smaller Companies funds and £283 million from UK Equity Income*. There remains a serious lack of enthusiasm for UK equities. It is noteworthy that only one UK fund – IFSL Marlborough UK Micro Cap Growth – made our list of the most popular ISA funds this year.

Institutional investors have shown a similar disdain for the UK market. In 1997, UK pension and insurance funds owned 45.7% of UK quoted shares**. This has dwindled to just 4.2% in the latest data**. And who can blame them? The performance of the UK market has been lacklustre compared to its international equivalents, so they have made the right choice for their stakeholders.

In April this year, respected stockbroker Peel Hunt issued a warning. On current trends, it said, the FTSE Small Cap index would cease to exist by 2028***. Takeovers from non-UK buyers and companies buying back their own shares continued to shrink the market, at the same time few new companies have come to market.

Can the incoming government help reverse this trend?

Certainly, the problem has finally gathered the attention of the major parties, with politicians recognising that there is a relationship between the stock market and economic growth.

In his time as Chancellor, Jeremy Hunt set out a series of ‘Mansion House reforms’ in July 2023. The speech focused on reform of the UK pension market, with a view to driving improved outcomes for savers and channelling greater levels of funding into high-growth companies under the ‘Mansion House Contract’. He subsequently launched the British ISA and pushed for UK pension funds to disclose their holdings in UK assets.

Learn more about the British ISA and get expert reactions here

Incoming Chancellor Rachel Reeves is unlikely to reverse these initiatives, having also made it clear that she recognises pension funds are important to unlocking a revival in the UK market. If the incoming government can encourage pension funds to invest just a little more in the UK stock market, it could make a material difference.

Reeves has vowed to tackle the regulatory barriers that deter pension funds from investing in UK assets, while also establishing an opt-in scheme for defined contribution pension funds to invest in UK growth assets.

A change in the mood around the UK may help. UK politics is starting to look more stable than many of its European peers (France, for example). Labour is coming to power on a platform of stability and consistency for business, designed to give them greater confidence to invest. The focus on economic growth should help as well. Isabel Stockton, senior research economist at the IFS, says: “A sustained improvement in growth would make us better off, partly by taking the sharper edges off many of the fiscal trade-offs facing the next government.”

Beyond the politics

These measures are all longer-term, but there are shorter-term factors that could galvanise the UK market. For example, the IPO market has revived a little, with consultancy group EY reporting an improvement in listing activity on the London stock market in the first quarter of 2024****. Monzo, BrewDog, Starling and Zopa are poised to come to the market shortly****, which may create an interest in the UK stock market once again.

Performance is improving, particularly among the UK’s mid and small-cap companies. The UK Smaller Companies sector, for example, is the second best-performing over the past three months^. The FTSE Small Cap has beaten the S&P 500 and MSCI World over the same period^^.

Anthony Cross, manager on the Liontrust UK Micro Cap fund, says: “Sentiment towards UK equities appears to be on an improving trajectory. Economic growth, while muted, has turned positive, with the 0.6% expansion registered during the first quarter of 2024 the fastest growth in two years. When combined with inflation which – while decelerating slower than expected – is heading towards target, this has paved the way for a more constructive outlook for UK equities.”

He adds: “The valuations of UK listed companies – and in particular small-caps – remain substantially lower than their long run average and their global peers.”

Alexandra Jackson, fund manager on the Rathbone UK Opportunities fund agrees: “It’s no surprise that investors are warming up to UK equities again. Low starting valuations and limited ownership are colliding with an improving economy and rapidly falling inflation. A noteworthy contrast to the US, where valuations are significantly higher, certain stocks are very crowded, lead indicators are slowing, and inflation looks stickier. The political and economic arguments for avoiding the UK are draining away.”

When the UK market turns, it could turn very quickly, particularly among smaller companies. For those who are most bullish on a turnaround, UK micro-cap funds, such as the Liontrust or Marlborough funds mentioned above, have the potential to bounce significantly.

Those looking to avoid the micro-cap end of the market might prefer, TM Tellworth UK Smaller Companies or WS Amati UK Listed Smaller Companies. For those that prefer a more balanced approach, Rathbone UK Opportunities blends mid and large-cap exposure. Schroder Income is an option for those who prefer to limit themselves to larger companies.

Faster economic growth, greater confidence, financial market reform, and unleashing the power of UK pension funds could all play a role in reviving UK capital markets. It is clear that the new government understands the problem, even if the solution takes time.

*Source: The Investment Association, sector statistics, April 2024 and April 2016

**Source: Corporate Adviser, 4 December 2023

***Source: Investment Week, 3 April 2024

****Source: IG, What are the best upcoming IPOs to watch?

^Source: FE fundinfo, at 2 July 2024

^^Source: FE Analytics, at 2 July 2024