Publication of the Bank of England’s February Inflation Report on February 6th marked a staging post in a painful return to acceptable inflation in the UK. While progress toward containing inflation is real, there is persistent worry over disappointing growth both in demand over the short term (2025 GDP growth forecast reduced to 0.75% from 1.5% in November), and in supply side capacity over the medium term (annual rise in productive potential may now be as low as 0.75%, putting the longer-term estimate of 1.5% at risk). It looks as if both demand and supply developments are adverse and a threat to the Treasury’s credibility.

Meanwhile, last October’s Budget from the new Labour government did, at the time, provide an opportunity to assess the capacity for sterling assets to finally deliver an attractive buying opportunity to patient offshore investors. In fact, so far in 2025, FTSE100 has begun to outperform other markets, admittedly from a dismal base. Economic circumstances have since proved a turbulent backdrop to the Chancellor’s efforts to travel a path of fiscal prudence while encouraging growth. Growth, in fact, is much weaker than estimated four months ago. Regardless of fault,; long- term funding costs are up almost 50 bps since late October, though better than post January’s spike. The net result is that any safety margin or ‘headroom’ allowing for adverse events has by now evaporated, with the crunch coming on March 26th when the Office of Budget Responsibility (OBR) publishes updated forecasts to be used in the Chancellor’s Spring Statement.

The good news is that lower inflation after some energy spikes this year may allow the Monetary Policy Committee to cut interest rates through this year, with markets now expecting two further 25 basis point cuts through 2025. This will help support cyclical recovery but the real challenge is to raise sustainable growth rates. The loudly exclaimed, primary objective of government policy is to raise sustainable output from its post-2008 average of just above 1% p.a. by pulling on a variety of levers (see below). 2025 was viewed to be the peak year for growth in GDP, at 2.0% (now likely to be significantly downgraded), before rates slip back to below 1.5% after 2026. The reality is that any growth objective, in itself, competes with a variety of other ‘deliverables’ such as social equity, regional growth balance and a wholesale regeneration of public services in quality and scale.

The ‘gloom-loop’ in domestic UK sentiment of course contains elements shared by its European neighbours – sclerotic growth with weak investment spending, demographic pressure on public spending and deep distrust over acceptable immigration levels. This is further compounded by specific challenges in the UK, such as loss of EU single market access, planning approval blockages and an inefficient tax system that is not overtly friendly to inbound investment. Like the rest of the world, a tariff war led by the Trump Administration carries risks for any export-led expansion, though the UK appears less vulnerable given the big services component in trade with the US and the small surplus we run with the country.

Little evidence of a friendly investor environment is to be found in the spending and tax plans set out in the first years of the government’s fiscal strategy. True, changes to inheritance tax and carried interest provisions were less severe than expected and the elimination of non-domicile tax status was expected. But there was no big start to tax reform overall, for instance on stamp duty. The big message was that fiscal spending was raised by 2% of GDP over the next five years, partly on the back of £40- plus billion of additional taxes raised largely from what is considered a tax on employment tax (employers’ national insurance contributions). The revenues are in reality spent in areas that could be considered as unproductive.

In the face of weak rates of investment, over the last decade, the core of the government’s ‘bold’ growth strategy within its fiscal plan was a significant £110 billion rise in public spending focused especially on emission targets in 2030. Yet, as a result, government investment remains flat as a share of GDP, rather than increasing . Significantly, the OBR predicted little consequential impact on growth and productive capacity by 2030. This calls into question the likely return from such outlays and the extent to which crowding-out of private investment dilutes any overall economic benefit

Beyond the Budget impact, our own sense is that offshore investors will look to a number of sign-posts in a successive rehabilitation of the UK as an attractive area for investment.

What we see as necessary but not sufficient achievements over the next five years:

A stable and credible fiscal strategy that minimises the need for a further round of taxation in 2026.

A close partnership between the Bank of England and the Treasury in managing relations with financial markets, especially in government debt post the Mini-Budget disaster of September 2022.

A real sense of momentum and radical thinking around how and where the UK might align with the European Union, especially as the 2020 trade deal (TCA) comes under review in 2025.

To really get change sufficient to excite offshore investors, we need to see some meaningful advances in at least some of the following influencers of long term prosperity.

Planning deregulation across construction and infrastructure investment
A faster, smoother and rational system of planning approval with prompt judicial review. Above all, a planning system that accounts appropriately for the consequences of a refusal.

Meanwhile, a 10-year infrastructure plan is expected to be announced early in 2025.

Tax reform
A clear need here to recalibrate a highly complicated tax system replete with exemptions and biases. Capital gains and stamp duty tax is but one example, but also treatment of the self-employed relative to other taxpaying classes.

Raising pensions savings and altering its allocation in a growth-friendly manner
There is a pressing need to reduce a very fragmented but enormous tax savings industry. Local government pension funds have started the process of consolidation, with the new government pressing for the same with defined benefit pension schemes. Improved efficiencies would lower costs and support longer term investment time horizons. Importantly, it would allow resources to be devoted to the expertise and analysis of unlisted and illiquid assets. In doing so, the industry might ultimately support a set of national industrial champions in new areas of science and technology.

Outlook
The UK’s current economic position presents both challenges and opportunities. Achieving stable growth, policy coherence, and structural reforms could make sterling assets an attractive investment for offshore players. However, without concrete progress on these fronts, the UK risks remaining trapped in its 'gloom- loop.'

On a more positive note, the seeming undervaluation of UK equities is drawing buyers to the markets, offering the potential for some absolute performance in 2025. UK equities have been trading at significant valuation  discounts  compared  to their global counterparts, particularly the US market. Corporate activity has acted as a catalyst for outperformance. Share buybacks have increased, and foreign companies have demonstrated a growing appetite for acquiring UK assets. Notably, 2024 marks the highest level of M&A activity in the UK since 2018.

Asset managers, such as the UK-based Jupiter, note that stocks are currently the cheapest they’ve been in 50 years, suggesting potential for absolute performance. However, investors should remember that this assessment largely reflects the UK market’s relative undervaluation compared with an exceptionally expensive US equity market. The current price-to-earnings (P/E) ratio of 12.2x, is broadly in line with the five- to 10-year historical average of 11-12x. This raises the question: what makes the current environment different? A wave of takeover activity might offer the best hope for a sustained re-rating of the market.

Chart 1: MSCI UK P/E Multiples at Long-Term Averages

Source: Bloomberg

Bill O'Neill - Non-Executive Director & Investor Committee Chairman

21st March 2025

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