UK government must address domestic institutional disinvestment

The irony was as thick as Devon clotted cream and almost as delicious.

At the end of April, Coutts, the UK private bank founded in 1692 that supposedly counts the UK's Royal Family among its clients – though no longer Nigel Farage, founder and honorary president of anti-immigration, populist party Reform UK – announced a “recalibration” of investments for its wealthy customers.

“Currently, about 20% of a standard balanced portfolio here is UK stocks, which is something of an anachronism,” Fahad Kamal, chief investment officer at Coutts, said. “It would be closer to 3% or 4% if it were more commensurate with the proportion of UK stocks in global stock markets.”

Analysts calculate that such a shift at Coutts’ six main funds could amount to the withdrawal of another £2 billion from a UK stock market that UK pension funds have already vigorously disinvested from over the past 30 years.

The exchange now values UK companies on low earnings multiples, leading some to abandon it and making it unattractive for growth companies to replace them through initial public offerings.

Fearing that this might somehow reflect on their own policy decisions, the UK government has announced some plans to restore the domestic capital market of an economy largely dependent for growth on immigration and inflows of foreign capital.

It wants to encourage retail investors into UK stocks and will target them in a sale of a large part of its remaining stake in NatWest, which owns, among other brands, Coutts.

Even if this is priced cheaply, it looks like Coutts own high net-worth clients will miss out as the firm chases mega growth trends such as technology, which, it says, are difficult to access through the UK public equity market.

It is still possible in the private equity market, though. Independent financial advisory firm Ondra Partners counts 56 UK unicorns, private companies valued at $1 billion or more. That compares with 35 in Germany, 27 in France, 18 in the Netherlands and no other European country with more than eight.

However, many of the venture capital and sovereign wealth funds that own large chunks of these UK unicorns are based outside the UK. And so, while they bring employment, tax revenue and investment to the UK, most of the wealth they create accrues elsewhere – and they don’t list in London.

Does this matter?

If earnings growth and stock-market performance are sustainably better in the US than the UK, isn't the answer to make it easier for UK pensioners and other investors to allocate capital there, rather than try to revive a UK capital market that has been in persistent decline for most of the working life of any UK citizen now approaching retirement?

The investment allocators at Coutts are thinking only about what is best for individual clients. Thinking instead about the kind of country pensioners are going to live in makes a stronger case for channelling investment domestically.

Only philanthropists, philosophers and governments can think of the collective good, and I’m not sure I’d want any of them managing money for me.

However, Ondra sees the link between the miserable stock-market performance and people’s lives. Per capita GDP has been declining in the UK. It has fallen 13 places in the global ranking since 1990. This is far more than any other large economy: France being the next biggest decliner, down just four places in the same period.

Many trace today’s feeble UK equity market back to the ending of UK defined-benefit (DB) pension schemes that began around 1990; to regulation that required companies to push capital into their pension schemes instead of into investment; to de-risking and allocation out of equity into UK gilts; and to eventual buyouts by insurance companies that have profited handsomely from UK companies’ desperation to get pension liabilities off their balance sheets.

Today, UK companies have to keep paying out more and more of their earnings as dividends to retain investors rather than re-investing in their own businesses. So, productivity remains low, as do earnings growth and valuation multiples.

That makes it hard to raise new capital for investment.

This is a doom loop. Breaking out of it will require considered and determined action.

Many voices are now calling for the tax advantages of pension-scheme investments to be made dependent on allocating a certain percentage, perhaps 20% over time, to UK equities.

The present UK chancellor, Jeremy Hunt, has tip-toed in this direction, by requiring UK pension schemes to at least disclose the mix of investments between domestic and international. Astonishingly, some don’t even provide that.

But it is just a start. Employers and employees are contributing only 8% of their eligible earnings into pensions. It probably needs to be at least 15%, if not closer to 20%.

Ondra calculates that using tax policy to require a 20% allocation to domestic equities, while mandating a step up in employers’ payments into defined-contribution schemes from 3% to 9% and pooling those schemes would generate £300 billion in productive investment in the UK.

That compares with just £90 billion invested in UK equities today.

As well as incoming contributions, the other driver of pension funds’ growth is performance of the underlying assets they invest in. Gilts produce earnings but no growth. Investing in equities for the long term has, historically, captured growth that investors eventually benefit from by having a bigger pot to put into low-risk, income-producing assets once they retire.

This is very basic stuff.

We will likely hear more at the Mansion House speech in June. Tackling a problem that grew up over 35 years of successive governments taking false comfort from the notion that a service-led economy, attracting foreign workers and capital, did not need a strong domestic equity capital market, will require action by this UK government and the next.

There are radical ideas. Another problem, driven by Mifid unbundling rules, has been the near absence of sell-side research on small- and mid-cap stocks that can become orphaned after listing with no investor following.

Many UK DB schemes are now suddenly in surplus. Ondra argues that the remaining DB pensions system cannot be permitted to be liquidated through insurance buyout and suggests a windfall tax on excess returns from those buyouts.

Perhaps that might boost a sovereign wealth fund that could also take proceeds from windfall taxes on North Sea oil and be independently managed with a view to investing in some of those unloved mid- and small-caps.

If the UK stock market holds up and the government gets its sale of NatWest away, those proceeds could also go into such a fund.

In its own small way, Coutts could contribute after all.