Taxing times ahead for the UK

The UK stock market continues to play a diminishing role in driving global equities. Since peaking in the summer of 1998 at over 10% of global equity market capitalisation, the UK has now fallen to a low of just 3%¹. 

This can be partly attributed to the declining share of UK gross domestic product (GDP) in the global economy, the equity market’s low exposure to the fast-growing tech sector and the abolition of the dividend tax credit in 1997 under then Chancellor Gordon Brown. The latter led UK financial institutions (i.e. pension funds and insurance companies) to reduce their holdings of domestic stocks. Regulations in the early 2000s placing a legal obligation on some pension schemes to match liabilities accelerated the flight away from UK equities. 

The Labour government says it wants to make growth a top priority. To achieve this, it needs to create a favourable investment climate for high-growth industries to thrive. This should then encourage local financial institutions to allocate more capital towards the UK. Without bold reforms, UK equities may remain persistently undervalued compared to global counterparts, diminishing the market's appeal to investors. 

Some attractively valued UK firms are benefiting from a flurry of merger and activity deals this year. Though the outlook for Initial Public Offerings (IPOs), where private companies sell shares of its stock to the public on a stock exchange, is still limited. A significant increase in UK IPOs could be considered a sign that the country is becoming an attractive investment destination.

Although it is still early days for this government, initial indicators of its direction can be taken from Chancellor Rachel Reeves’ Autumn Budget and her Mansion House speech. These outlined steps to stimulate investment in the UK economy and financial assets, although the broader economic challenges remain formidable. Given the strained public finances and persistently weak labour productivity, reviving investor confidence in the UK will be a considerable challenge.

In October, Reeves announced a £70 billion annual increase in spending — equivalent to 2% of GDP — over the next five years.² This funding is allocated to both day-to-day spending and capital investment, with half sourced from increased borrowing facilitated by revised fiscal rules and the remainder through higher taxes, primarily via employers’ National Insurance Contributions (NICs).²

The Office for Budget Responsibility (OBR) expects these measures to deliver a temporary boost to GDP in 2025, supported by increased government spending and a rise in the national minimum wage. Though the measures passed in the latest budget are expected by the OBR to have a broadly neutral impact on output growth over the five-year forecast horizon.

It remains to be seen how the tax burden will impact the economy over the long term. The OBR projects that it will rise to 38.2% of GDP by 2029-30, up from 36.4% this year and 5.1 percentage points higher than pre-pandemic levels.²

Higher taxes, particularly on businesses, may undermine competitiveness and deter investment. Retailers, such as Marks & Spencer and Sainsbury’s, have already warned that increased NIC costs could lead to higher prices, potentially straining consumer demand. Balancing short-term economic growth with long-term fiscal sustainability will be essential to achieving the government’s broader economic objectives.

In her November Mansion House speech, Reeves outlined plans to reform the UK pension landscape to enhance investment in domestic financial assets. These reforms aim to improve outcomes for members of defined contribution (DC) workplace pensions and local government pension schemes by channelling more capital into UK companies to support economic growth. Reeves emphasised the goal of creating Canadian and Australian style “megafunds” to drive substantial investment in the UK market.

Implementing this vision presents significant challenges. As of 2023, UK DC workplace pensions allocated only 6% of their capital to UK stocks with 70% going to overseas equities.³ This entrenched preference for foreign investments highlights the difficulty of redirecting significant funds into the UK market. The government’s initial findings from its pension review suggest that institutional reform will be a gradual process. The final report is not expected until spring 2025, which will then inform the Pension Schemes Bill.

The gradual pace of these changes has moderated expectations among asset allocators. Without swift and effective measures to encourage UK pension funds to invest in UK equities, domestic companies may continue to struggle to attract capital. Additionally, the UK faces stiff competition for investment, particularly from the US, where lower taxes and a robust technology sector make it appealing to global investors.

If the Labour government is to fulfil its ambition of boosting UK growth, it must balance pension reforms with broader policies that improve the country’s investment climate. High taxation, as projected by the OBR, could undermine efforts to make the UK an attractive destination for capital. Addressing these structural and fiscal challenges is essential to attract investors back to UK equities and improve their valuations relative to their global peers. 

Despite the challenges, UK equities should remain a consideration in portfolios.  In the near term, UK equity valuations may benefit more from a global economic recovery, as UK companies generate a significant proportion of their revenues from overseas markets. Geopolitical disruptions, such as restrictions on energy supplies, could lead to outperformance in value sectors like energy, where the UK market has significant exposure. 

1. LSEG Datastream/Evelyn Partners
2. Office for Budget Responsibility;  Economic and fiscal outlook October 2024, 30 October 2024
3. Gov.uk, Pension fund investment and the UK economy, November 2024