The City’s stock exchange disaster has been decades in the making

Dysfunctional capital markets are a cause, not a symptom, of poor economic growth

‘Take a whole load of investors out of the game and, guess what, liquidity dries up’

On the face of it, the fact that CRH, the world’s biggest supplier of building materials, has said it’s quitting the FTSE 100 and moving its listing from London to New York shouldn’t have caused massive ripples. But then Flutter Entertainment, the gambling company that was formed by the merger of Betfair and Paddy Power, revealed it is weighing a similar move.

Worse, Arm, the Cambridge-based microchip designer, has decided to list in the US despite heavy lobbying from both Boris Johnson and Rishi Sunak. And, perhaps most shockingly of all, the Financial Times reported that Shell, the UK’S largest quoted company, considered moving its listing in 2021. Granted, it decided against. But this is a bit like finding out the ravens held talks about leaving the Tower of London.

Why are so many British companies upping sticks and moving their listing to America – or at least thinking about it? One prevailing suggestion is that it is a result of the UK’S economic decline. This gets things precisely backwards.

There are specific reasons for all the recent moves: the majority of CRH’S revenues are now generated in the States; with the ban on sports betting lifted, the country now offers huge growth potential for gambling companies; tech companies attract higher valuations and energy companies get an easier ride in the Land of the Free.

But that shouldn’t blind us to the British market’s underlying malaise. The number of listed companies fell 12.5pc in the three years to May 2022, accelerating a longer-term trend. Even worse, the total market capitalisation of UK shares has fallen relative to the size of the economy for the past two decades. Clearly something is amiss. What’s going on?

The textbooks will tell you that there is no difference between the different forms of financing corporate endeavours – be it issuing shares, issuing debt or taking out bank loans. The textbooks are wrong. That’s because they fail to take into account the tax-deductibility of interest payments.

Private equity firms often describe debt as a “tax shield”. Over the past 15 years it has been particularly impregnable because interest rates have been close to zero.

This has allowed private equity firms to buy companies, load them with debt, pay very little interest, and use what they do pay to offset the corporate tax bill.

How, one might reasonably ask, is a publicly listed company supposed to compete with that? (And that’s before we get into all the performance box-ticking that public companies have to go through to appease the proxy shareholder services, the corporate governance zealots and the ESG goons.) Many have given up trying.

At the same time, regulators have accidentally disincentivised investors from owning shares. UK pension schemes, insurance companies and retail investors own assets worth roughly £5.6trillion. This is the biggest pool of capital in Europe. However, just 12pc of this money is invested in the UK stock market and less than 4pc trickles down below the FTSE 100.

To understand why, rewind the clock to 2001, when the Boots pension scheme, one of the largest in the country, sold off equities amounting to just over £1.7bn and invested all of its assets in bonds. At the time there was quite a lot of scepticism about the move in the investment community because equities outperform bonds over almost any time period you care to mention.

However, in the subsequent years, other companies did the maths and discovered the accounting rules and pension regulations did indeed mean maximising investment returns was far less important than matching future liabilities.

Bank of England data show that defined benefit, or “final salary”, pension schemes reduced their allocation to UK equities from 48pc in 2000 to just 3pc in 2021.

This has created a downward spiral. Take a whole load of investors out of the game and, guess what, liquidity dries up. When it falls below a certain level some funds are prevented by their own risk management rules from buying those shares. This results in the whole market suffering from a valuation discount. And, eventually, companies realise they are worth more elsewhere.

In fairness, the Government has at least spotted the problem. The so-called Edinburgh Reforms contain provisions that are designed to make it easier for institutional investors to hold equities again (though whether they are enough to move the dial remains to be seen). Rising interest rates should help reduce the relative attractiveness of debt financing.

Better still would be if the Chancellor levelled up the tax treatment of equity and debt.

When asked about all this last week, David Schwimmer, chief executive of LSEG, the parent company of the London Stock Exchange, said: “The pension funds in this market have dramatically reduced their exposure to UK equities in favour of fixed income over the last 20 years – really dramatically. That raises some interesting questions.”

But Xavier Rolet, his predecessor, is much more explicit about the extent of the problems he thinks this trend has created.

He argues that “the significant long-term productivity and growth deficit suffered by European economies” is at least in part due to “the punitive fiscal and regulatory framework applied to equity markets, as opposed to the massive taxpayer subsidies afforded to debt markets and bank lending in particular”.

In other words, Britain has, in common with other European countries, decided to make equities a second-class asset class and inadvertently encouraged the biggest investors to forsake them.

In so doing, they have created a system that is more or less incapable of funding the next Google, or Facebook, or Tesla, or whatever.

Dysfunctional capital markets are not indicative of weak economic growth and poor productivity; they are what is retarding economic growth and productivity.