Swedish Lessons for Investors

What caught my eye this week including the latest UK fiscal madness, Europe's green trilemma, signs of life in the UK stock market and Boris Johnson's curious new job

Photo by Mark König on Unsplash

1. Lords of Misrule

I was delighted to see that the Wealth of Nations was quoted on the floor of the House of Lords this week. Speaking in the debate on the Budget Responsibility Bill, which is designed to strengthen the role of the UK’s fiscal watchdog, Baroness Patience Wheatcroft cited John Crompton’s recent post on the absurdity of Britain’s fiscal framework not taking account of unfunded liabilities such as public sector pensions.

She contrasted the row over the government’s decision to scrap the winter fuel allowance for pensioners at a saving of around £1.5 billion to help fill a £22 billion in the public finances with public sector pay rises billed as costing £9.4 billion but which will actually give rise to unfunded pension obligations worth between £3.5 billion and £4 billion every year that do not appear in the government’s debt figures. She called for a radical rethink of government accounting:

A proper net worth finances method of accounting, dealing with government expenditure over the longer term, would enable a much more effective long-term view to be taken of the costs and benefits of investment.

Wheatcroft’s intervention prompted two interesting responses. The first was from Lord Davies of Brixton, a Corbynite former trade union pension expert. He insisted that there was no need to include unfunded pension liabilities in the national accounts because they would be funded by future taxation. In other words, since the state can levy whatever tax it wants, that should itself be considered an asset.

To my mind, Davies’s argument merely underlines why a net worth approach is necessary. Those taxes will be paid by future generations. The idea that the liabilities that they will be expected to meet should be hidden from the public strikes me as profoundly undemocratic. That powerful vested interests should fear transparency is not surprising. But voters deserve to be told the truth.

Perhaps they soon will be. The second interesting intervention came from Lord Livermore, the Treasury minister, when closing the debate. He said:

To further address the point made by the noble Baroness, Lady Wheatcroft, I point out that the Chancellor said, in her Mais Lecture earlier this year, that she

“will report on wider measures of public sector assets and liabilities at fiscal events, showing how the health of the public balance sheet is bolstered by good investment decisions”.

This is very encouraging. As I wrote at the time, I thought that sentence in Reeve’s Mais Lecture, almost entirely ignored by the legacy media, was significant and it is good to know that she is not backing away from it. Indeed, the last week produced two further compelling examples of why a new approach to public accounting that pays greater attention to the national balance sheet is urgently needed.

The first was Lord Darzai’s jaw-dropping review of the desperate state of the National Health Service. Amid a catalogue of policy failures, he noted how maintenance and capital spending had been sacrificed amid spending squeeze’s with disastrous consequences for the NHS’s productivity and public health:

The backlog maintenance bill now stands at more than £11.6 billion and a lack of capital means that there are too many outdated scanners, too little automation, and parts of the NHS are yet to enter the digital era… Some £4.3 billion was raided from capital budgets between 2014-15 and 2018-19 to cover in-year deficits that were themselves caused by unrealistically low spending settlements.

The second was the publication of the Office for Budget Responsibility’s latest Fiscal Risks and Sustainability Report. This showed public debt on a current trajectory to hit an eye-watering 274 per cent of GDP over the next 50 years.

According to the Financial Times, Reeves is planning to tweak the fiscal rules in her budget to change the way that the government accounts for losses on the Bank of England’s bond portfolios (as I discussed here). This could give her up to £16 billion of extra “headroom” for increased borrowing. But if the chancellor is going to borrow more, it is even more important that she takes steps to reassure both the markets and voters that the money is being well spent in ways that will improve the public sector balance sheet. All the more reason to embrace net worth.

2. Europe’s Green Trilemma

Dani Rodrik wrote an agenda-setting article nearly 25 years ago in which he posited “a political trilemma for the world economy”. The Harvard economics professor wrote that advanced forms of globalization, the nation-state, and mass politics could not coexist. Societies would eventually settle on (at most) two out of three. His prediction then was that it would be the nation state that ultimately gave way. But his trilemma has framed the debate over globalisation and the rise of populism ever since.

Now Rodrik is back with a piece in Project Syndicate that identifies a new trilemma that haunts the world economy and it is equally troubling:

This one is the disturbing possibility that it may be impossible simultaneously to combat climate change, boost the middle class in advanced economies, and reduce global poverty. Under current policy trajectories, any combination of two goals appears to come at the expense of the third.

This trilemma is particularly relevant in the context of Mario Draghi’s comprehensive report into how restore the competitiveness of the European Union economy. The least convincing part of what was an otherwise admirably straight-talking study by the former Italian prime minister was the sections on the green transition.

Draghi notes that EU energy prices considerably higher than those in the US, with electricity prices that are 2-3 times higher and natural gas prices 4-5 times higher, driven primarily driven by Europe’s lack of natural resources. What’s more, they are likely to stay higher for some time yet because fossil fuels will continue to play a central role in energy pricing at least for the remainder of this decade. That is already having a material impact on the EU economy:

Around half of European companies see energy costs as a major impediment to investment – 30 percentage points higher than US companies. Energy-intensive industries have been hit hardest: production has fallen 10-15% since 2021 and the composition of European industry is changing, with increasing imports from countries with lower energy costs.

As Draghi says, in time the transition to clean energy should bring down energy costs. But in the interim, European industry faces higher costs because the EU’s decarbonisation goals are also more ambitious than its competitors:

The EU has put in place binding legislation to reduce greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels. The US, by contrast, has set a non-binding target of a 50-52% reduction below (higher) 2005 levels by 2030, while China only aims for its carbon emissions to peak by the end of the decade. These differences create massive near-term investment needs for EU companies that their competitors do not face.

For the four largest energy intensive industries (chemicals, basic metals, non-metallic minerals and paper), decarbonisation is projected to cost EUR 500 billion overall over the next 15 years, while for the “hardest-to-abate” parts of the transport sector (maritime and aviation) investment needs stand at around EUR 100 billion each year from 2031 to 2050. The EU is also the only major region worldwide to have introduced a significant CO2 price

Draghi insists that if Europe’s ambitious climate targets are matched by a coherent plan to achieve them, decarbonisation will be an opportunity for Europe. But he also warns that if Europeans fail to coordinate their policies, “there is a risk that decarbonisation could run contrary to competitiveness and growth”. That challenge is made even more complicated by the fact that some of the cheapest technology for meeting these decarbonisation targets is now Chinese:

The EU aims to achieve a minimum of 42.5% of its energy consumption from renewable sources by 2030, which will require it to nearly triple its installed capacity for solar PV and more than double its wind power capacity. In addition, the EU has effectively abolished the internal combustion engine from 2035, when all new passenger cars and light duty vehicles registered in Europe must have zero tailpipe emissions. Based on current policies, Chinese technology may represent the lowest-cost route to achieving some of these targets.

As Draghi says, Europe must confront some fundamental choices about how to pursue its decarbonisation path while preserving the competitive position of its industry. But his report is conspicuously light on what choices it should make. Implicitly, he seems to suggest that industry could be spared some of the costs of the transition via some form of subsidies, perhaps even funded by common debt, though this would simply transfer the cost to current and future taxpayers. European industry could also be further shielded by tariffs, including the EU’s new carbon border adjustment tax, which aim to level the playing field with countries with higher emissions. But this simply transfers the cost onto poorer countries, as Rodrik warns.

What is certain is that the political stakes could not be higher. As Draghi says:

Most importantly, the “European Green Deal” was premised on the creation of new green jobs, so its political sustainability could be endangered if decarbonisation leads instead to de-industrialisation in Europe – including of industries that can support the green transition.

That is the essence of Rodrik’s trilemma. Ursula von der Leyen is expected next week to announce the line up for the new European Commission, having failed to do so last week. I expect that this condundrum will come to dominate the Commission’s energies over the next five years, cutting across as it does all the most sensitive EU dossiers: energy, climate, finance, the economy and external relations. How it is resolved will have profound consequences for Europe, the world and the planet.

3. Swedish Lessons for Investors

Back in April I wrote a post on how Brexit had wrecked the stock market, noting the extraordinary underperformance of UK shares since the 2016 referendum. Since then, it is fair to note that UK stocks have had a good run, with the FTSE100 up close to 7 per cent, outperforming several other markets and asset classes, as the chart below from Goldman Sachs shows. The investment bank now expects the index to rise to 8,800 over the next 12 months, up from 8,273 today.

Any recovery in UK stocks is highly welcome, and maybe this time, the perennial bulls will finally be right. Given the turmoil in many other parts of the world, it is not surprising that the UK now looks relatively more attractive. Nonetheless, the recent rally barely begins to reverse the spectacular underperformance of recent years or remove the deep discount at which UK stocks trade relative to American and European shares. According to Goldman, the UK weight in MSCI World index has fallen to 2.2% from 5.3% in 2010.

Over the last 10 years, the FTSE 100 has delivered a 6% per annum total return, versus 8% for Stoxx 50, and 13% for the S&P 500. Some of this underperformance is due to weak earnings, domestic political upheavals, and the lack of a large listed technology sector, but much of it owes to a sharp decline in valuation as investors have shunned UK stocks.

As a result, companies without buyers for their stock trade at a large discount to non-UK equity, and often look to buy back shares; in fact, the only net buyers of UK equities in recent years have been corporates via buybacks, and the total shareholder yield for the FTSE 100 is twice that of the S&P 500.

One consequence of these years of chronic underperformance - and the focus of my essay - is a collapse in the number of companies listed on the stock market, as a result of a dearth of new listings and an exodus to other exchanges. This remains an existential challenge to the City, a point picked up on my former colleague Merryn Somerset Webb, a columnist at Bloomberg, in a podcast interview with Mark Slater, chairman of Slater Investments Ltd. Slater warns that the pipeline of new issues has dried up and that below the FTSE 100, the market “is sick”. Given current trends, we may not have a UK stock market “in a meaningful sense, in five or 10 years.”

What caught my eye is that both Goldman Sachs and Slater have identified the same culprit for the slow death of the London market. Here’s Goldman:

The issue is not that foreign investors are refusing to ‘buy British'” our analysts write. Foreign investors own around two-thirds of the UK market cap. Rather, the issue is “a dearth of home-grown equity investing.”

Similarly, Slater says that with corporate defined benefit pension schemes spending most of the last 20 years de-risking and effectively going into “run-off” mode, “we’ve had roughly a trillion of outflows” in a market that’s “worth just over two trillion.” 

Blaming domestic investors for the stock market’s woes has become very fashionable in City circles over the last few years. Indeed, this narrative was given a further boost last week by a new report by New Financial, a City think-tank, which found that British pension funds invest a smaller proportion of their assets in the domestic market than those of almost every other developed country.

The proportion of their assets that UK pension funds allocate to UK equities has fallen to 4.4%, compared with our estimate last year of 6.1% and down from over half of their assets 25 years ago… This allocation to domestic equities is among the lowest of any developed pension system around the world with only Canada, the Netherlands, and Norway having a lower allocation. It is less than half the weighted average allocation to domestic equities across our sample excluding the US.

Personally, I am pretty sceptical about this explanation both for the low valuation of the UK stock market and the lack of IPOs. Looking at Mario Draghi’s report into how to improve the competitiveness of the European Union economy, I noted this paragraph on the role of pension funds, or the lack of them in the EU:

In 2022, the level of pension assets in the EU was only 32% of GDP, while total pension assets amounted to 142% of GDP in the US, and to 100% in the UK. Moreover, EU pension assets are highly concentrated in a handful of Member States with more developed private pension systems. The combined share of the Netherlands, Denmark and Sweden in EU pension assets amounts to 62% of the EU total.

It’s pretty clear from this, that a lack of home bias among pension funds cannot be the main reason for UK underperformance. After all, European bourses are all more highly valued despite much smaller domestic investor bases. That said, Draghi did go on to make this interesting observation in relation to Sweden’s success in inducing its citizens to invest in shares:

Partly as a result of this, Sweden has a deeper capital market, relative to its GDP. This high level of retail investment has also translated into a booming IPO market with more than 500 IPOs over the past ten years, which is more than Germany, France, the Netherlands, and Spain combined. An important driver of the deep capital markets are the pensions funds that have large holdings of domestic equities.

For a fascinating analysis of Sweden’s thriving capital markets, I recommend this piece from earlier this year in the Financial Times. But while there are certainly important lessons here for the rest of Europe, it is not clear that Sweden is doing anything that Britain does not do already. Indeed, it is possible that Draghi has the causality the wrong way round: that Sweden has a high level of retail investment because it has a vibrant ecosystem of small and medium sized companies to invest in.

Britain’s problem, as I noted in this recent essay for Prospect, is that it simply doesn’t have an exciting pipeline of IPO candidates. That is partly a reflection of an economic model that has evolved over the last 40 years that is characterised by specialisation in hard-to-scale services and a high degree of foreign ownership of domestic industry.

There is clearly an intense lobbying campaign by vested interests in the City ahead of the October budget and the government’s review of pensions for new tax breaks and rules to increase domestic investment in UK shares. I am sceptical it will make the slightest difference to the valuation of UK stocks or the pipeline of new issues. It may make a few bankers a bit richer but it will most likely leave a lot of savers a bit poorer. I hope Rachel Reeves has the sense to resist.

3. What Boris Johnson Did Next

Most corporate chief these days take extreme care to safeguard their reputations which in a world of social media can be won and lost in an instant. So why would the boss of a US mining company want to be associated with the only British prime minister ever to be forced to resign in disgrace? I enjoyed looking into Boris Johnson’s new job as co-chairman of a new environmental consultancy, Better Earth, alongside Amir Adnani, the Iranian-Canadian chief executive of Uranium Energy Corporation, in this piece for Prospect.

It is not clear what Adnani, who appears to be Better Earth’s sole shareholder, wants from Johnson and his Tory acolytes who will be working for the start-up. But the fortunes of UEC, which was last year accused by a hedge fund of “being managed more like a penny-stock-pump-and-dump than a legitimate mining company”, are closely tied to the price of uranium, which is itself linked to the global take-up of nuclear power. And Johnson as prime minister was such an evangelist for nuclear power that he proposed that Britain should build a new reactor every year. He even had a meeting with a senior UEC executive in the House of Commons to discuss nuclear power that was not recorded in his official diary. As I wrote:

Of course, that meeting may also be why Adnani is joining the board of Better Earth rather than Johnson joining the board of UEC. After all, if it were the other way around, the advisory committee on public appointments could hardly have concluded that “you did not meet with, nor did you make any decisions specific to [UEC] during your time in office. Therefore the risk that this appointment can reasonably be perceived as a reward for decisions made in office is low.” Instead, Johnson can claim to be merely joining a private consultancy whose clients, as the committee notes, are unknown and whose sole shareholder is a Nevada-registered entity. Meanwhile, Adnani now appears to have a world-class booster on his payroll, plus the mysterious talents of Baroness Owen of Alderley Edge.