The U.K. stock market has turned into a wasteland as pension funds recoil. Why U.S. funds may pull back too

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One of the less-told stories in financial markets is how the U.K. stock market has become something of a barren wasteland.

On Citigroup’s numbers as of last week, U.K. stocks trade at a price-to-earnings ratio for 2023 of 10.6, compared to 20.7 in the U.S. and 17.2 globally. And while taking out high-flying techs would shave U.S. P-to-E down to 18.4, it wouldn’t have any impact on the U.K. numbers at all. No wonder SoftBank is deciding to list U.K. microchip designer ARM in the U.S. rather than its native country.

Many ascribe the slow descent to an accounting rule change in the 1990s, that any pension fund liability would be reported as a corporate liability. (That change was prompted by the scandal where Robert Maxwell — now known better as the father of Ghislaine — raided his company’s pension fund.) The impact of that change is that these pension funds moved toward a liability-driven style of investing that no longer needed equities. According to Goldman Sachs, equities weightings of corporate pension funds in the U.K. have fallen from two-thirds to “now a rounding error” despite assets rising sixfold over the last 25 years.

That’s a lengthy introduction to an analysis of U.S. defined benefit pension fund flows from J.P. Morgan strategist Nikolaos Panigirtzoglou. These funds rebalance when there’s been positive total returns for equities and negative total returns for bonds. Looking at Federal Reserve data, he says that in quarters where the gap is more than 10%, there has on average been equity selling of $80 billion, and when the gap has been between 5% and 10%, equity selling has on average been around $40 billion. It suggests around $55 billion of equity selling based on the current quarter-to-date return gap, he finds.

U.S. private pension funds are well funded — apart from a recent downward revision of a cool $150 billion, possibly owing to greater than expected investment losses on private assets — but that gives them an incentive to further de-risk, to lock in improvements in their funding ratios. That happened last year when, despite the bond market sell-off that saw the U.S. Aggregate index return nearly -15% in the first three quarters of 2022, the bond allocation of private U.S. defined benefit pension funds actually rose, from 38% to 40%.

Granted, state and local pension funds are rather infamously not well funded, so they don’t have that incentive — but they still have high equity allocations and a bond allocation that is close to a record low of just under 20%, he says. “There is some incentive from an asset/liability mismatch perspective to buy bonds particularly given [U.S. Aggregate] yields at 4.7% remain at attractive levels relative to the past 10-15 years,” he says.

Finally, he notes, bond allocations should gradually increase as a progressively larger share of defined benefit pension fund beneficiaries are close to or in retirement. Bond allocations in the U.S. are dwarfed by those in Europe and Japan.

The markets

U.S. stock futures

were pointing to a weaker start, a day after both the U.K. and Norway central bank hiked interest rates by a half point. Crude futures
slumped over $1 per barrel to $68.36, and the yield on the 10-year Treasury
fell 5 basis points to 3.74%.

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The buzz

Friday sees the release of the flash purchasing managers indexes for June — a similar measure for the eurozone slumped below economist expectations — and Cleveland Fed President Loretta Mester caps a week of Fedspeak with a speech in the afternoon.

rose 4% in premarket trade as the company said it would pay $10.3 billion to settle claims it was responsible for so-called “forever chemicals” in drinking water.

GSK shares
jumped in London trade as the pharmaceutical said it reached a financial settlement ahead of a California trial due to start next month on the Zantac heartburn medication where it didn’t admit liability.

Virgin Galactic shares
fell as the space tourism company said in a filing it seeks to raise $400 million to improve its fleet and scale its business.

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Here were the most active stock-market ticker symbols as of 6 a.m. Eastern.

The chart

The Bank of England made a surprise half-point rate hike on Thursday, responding to stronger-than-forecast inflation. The team at CrossBorder Capital say it is one of the biggest monetary policy mistakes in recent times. They cite this chart, plotting their liquidity index advanced by 12 months — remember, central bank rate hikes take a while to be transmitted to their broader economy — and the orders and output components of a leading industrial survey. Economists at Goldman Sachs separately say they expect another 50 basis point hike from the Bank of England in August.

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