Is the UK the most attractive European economy for investors?

With falling inflation, a cut to interest rates, renewed business optimism and a new government, Britain's economy seems a better bet than France or Germany

Recent economic data has been more positive in building the case for international investors to pile back into UK government bonds. Getty Images

Once labelled the "sick man of Europe", the UK economy is anything but nowadays.

Despite slow economic growth, a lingering cost-of-living crisis and some enduring effects of Brexit, there have been definite green shoots of recovery spotted by economists over the past few months.

Inflation has fallen back to the Bank of England's 2 per cent target, gross domestic product growth has held its own and business confidence is doing well.

British manufacturers had their best July in two years, with factories increasing output and new orders at the fastest pace since February 2022.

"UK manufacturing has started the second half of 2024 on an encouragingly solid footing," said Rob Dobson, director at S&P Global Market Intelligence.

Meanwhile, a survey by the Institute of Directors of optimism among business leaders regarding the prospects for the UK economy, showed a huge improvement in July and the highest result the Directors’ Economic Confidence Index has achieved in three years.

"This looks like an early vote of confidence in the new government, given the smaller movements in the other economic measures, which point to modest improvement in economic conditions," the IoD's chief economist, Anna Leach, said.

In a finely balanced decision on Thursday, the Bank of England cut interest rates by 0.25 per cent to 5 per cent, the first reduction in more than four years.

Noting that rate cuts are good for businesses and households, Janet Mui, head of market analysis at Brewin Dolphin, said the beginning of the rate-cutting cycle is "significant because central banks don’t tend to just cut once or twice".

"Financial markets are pricing in another rate cut in November and about four to five rate cuts in 2025."

But the welcome that the rate cut received was accompanied by a healthy dose of caution, mainly because economists calculate that inflation, far from being defeated, is predicted to regain a little strength towards the end of the year.

“It’s not safe to assume this is the first cut of many," said Steve Clayton, head of equity funds at Hargreaves Lansdown.

"The Bank of England said there are still inflationary risks, so while it decided a slight reduction in rates was appropriate, it went nowhere near suggesting that significant and sustained cuts are on their radar screen yet."

Nonetheless, the UK economy seems to be "faring relatively well compared to our European peers", Stuart Cole, chief macro economist at Equiti Capital, told The National.

"Look at Germany," he said, "where the economy is basically stalling, unemployment is rising, it is battling a depressed industrial sector and where the services sector is showing no signs of increased activity despite a rise in real incomes."

As such, if there is a sick man in Europe currently, analysts tend to point to Germany, whose economy has struggled in the wake of Russia invasion of Ukraine and is only expected to grow by 0.2 per cent this year.

Indeed, for James Athey, a fund manager at the Marlborough Group, Britain was never really the sickest patient in Europe, even when it looked that way in the wake of Brexit.

"Over the last 10 years, the UK compound growth rate has been higher than Germany, France and Italy," he told The National.

"Since Brexit, there is only France of those four which has economically outperformed [up to the first quarter of this year – the most recent UK data available].

"France is unequivocally not a country we should observe with envy. The parlous state of their economy is a significant vulnerability."

The City of London skyline. A Treasury audit revealed a £21 billon black hole in public spending but analysts say that will not put off international investors. EPA

'Red herring'

But does this mean the UK economy is about to sprint ahead?

Definitely not, say most economists, given that most consumer-facing parts of the UK economy are still having a hard time and, for most Britons, the cost-of-living crisis is still very much clawing away at household budgets.

Britain's new chancellor Rachel Reeves also placed another dark cloud over those household budgets on Monday with the prospect of higher taxes and slashed government spending in an October budget, having announced she and her team had found a £22 billion "black hole" in the UK's public finances.

In the run-up to the recent UK election, Ms Reeves' Labour Party was highlighting that faster economic growth would raise the money to solve the thorny issues in the public purse.

But the "black hole", which Ms Reeves said came about as a result of the former Conservative government's “unfunded and undisclosed” spending commitments, may mean budget cuts and tax rises are brought forward.

However, many analysts point out that about £10 billion of the black hole is attributable to Ms Reeves's decision to award a pay rise of 5 per cent to 6 per cent to public sector workers.

But for others, such as Tim Sarson, KPMG’s UK head of tax policy, the £22 billion "black hole" is somewhat of a "red herring" and "neither surprising, nor particularly huge".

"What’s really at stake is the significantly greater ramp-up in investment and spending demanded over the longer term to keep up with our ageing demographics and restore the quality of public services to peer standards," he told The National.

"For that, this or future governments may need increased economic growth, and some tax rises, and potentially increased borrowing.

"Given tax rates on a number of parts of the population are already high by historical standards, it’s difficult to see tax picking up more than a portion of the bill."

Chancellor of the Exchequer Rachel Reeves. Some investors see her as a safe pair of hands. Others will wait until her October budget before passing judgement. Reuters

Stability after stagnation

Ms Reeves does at least represent stability and there is nothing markets or investors love more.

In the 14 years of rule by the Conservatives, there were five prime ministers, seven chancellors and eight foreign secretaries.

The most stark example of the instability during those years came during the ill-fated premiership of Liz Truss, when a "mini-budget" containing £45 billon of unfunded tax cuts in September 2022, led to investors demanding an additional yield on government debt, something that became known in the financial markets as the "moron premium".

But that is in the rear-view mirror now, said Thomas Pugh, economist at RSM, adding that following a long period of stagnation, the UK economy is "recovering and the stock market is showing signs of life".

"A period of political stability should bring confidence to consumers and businesses alike, which – combined with a return to normal levels of inflation and rising real incomes – will allow consumer spending and investment to rise steadily over the next few years," he told The National.

But while Ms Reeves projects the image of a fiscally prudent Labour chancellor in the same vein as Gordon Brown about 30 years ago, the party's enormous 158-seat majority in the UK parliament also lends a high degree of policy stability.

"The clear-cut election result in the UK in July also contrasts strongly with France, whose political travails could be weighing on the euro, and even the US, where a close, fractious presidential contest is possible and a contested result a possibility,” Russ Mould, investment director at AJ Bell, told The National.

As such, investor appetite for UK government bonds or gilts has been strong of late and if the new chancellor maintains prudence with the UK's finances, there is little reason why that strength cannot continue.

"Demand for gilts from overseas may well increase if this fiscal conservatism is maintained – particularly if, as we expect, such conservatism is absent in the US and the eurozone remains marred by instability and divergence," Mr Athey told The National.

No 'magic bullet'

So, while the UK economy is still finding its feet again in terms of growth, the £22 billion "black hole" in the fiscus is of little concern to economists, even given its ability to make headlines and its use a political point-scorer.

As regards the investment case, the UK economy continues to look more attractive than some its G7 peers and many investors will take the position that when it comes to where to put their money, it is often the case of placing it with the best of a bad bunch.

"It is true that in recent weeks there has been a strand of conversation out there which suggests that international investors see the UK as having entered a period of relative stability – certainly relative to the likes of France and the US," Mr Athey said.

"This should certainly support international capital flows into the UK, particularly given how well sterling has performed of late."

While the UK economy is no Olympic sprinter at the moment, it is certainly less sluggish than it was even at this time last year, but there remains some doubt that its fitness levels are of the order to deliver the growth it needs.

Mr Cole told The National that international investors are "caught between a rock and a hard place at the moment" and the UK economic outlook is "at risk of deteriorating going forward".

"I am not convinced yet by the growth story and think a lot of what we are seeing is a short-term bounce from last year’s recession rather than anything more structural, that is, more the speed of recovery rather than the size of the economy in the long run," he said.

"Taxes are going to have to rise and there will no doubt be an increase in borrowing too, and I do not believe that Labour has found the magic bullet to suddenly place the UK on a higher trend rate of growth.

"If I was an international investor, I would be waiting to see exactly what this new Labour government means, and that certainly means waiting for October’s budget and next year’s spending review."

Being cautious may be the prudent strategy at the moment, but for James Sproule, chief UK economist at Handelsbanken, it shouldn't be forgotten that the fundamental reasons for investing in the UK have not, and have never, altered.

"The UK has long been one of the easiest countries in the world in which to invest. The things that sit behind this ease of investment are as much cultural as anything else [language, legal systems], so they are not going to fade quickly," he told The National.