The end of the holiday season will bring with it hopes that the UK stock market can finally break out of its recent torpor. The FTSE 100 index has spent August largely trading in a narrow range between 5,800 and 5,900, and volumes, not surprisingly at this time of year, have been pitiful.

Not that it has been an uneventful month, with the first pause in the US rate-tightening cycle for more than two years and an increase in UK interest rates that caught most investors off-guard. Concern in the US is now shifting from the outlook for interest rates to the outlook for the economy, which is showing clear signs of slowing off the back of a housing downturn.

The extent of the US slowdown will have a crucial impact on prospects not only for Wall Street but also on UK equities as we head into the autumn. If the slowdown proves less severe than some fear, there is a large amount of investor cash sitting on the sidelines that could easily take the UK market higher.

The fundamental underpinnings for the market in terms of equity demand and supply are favourable, as reports out from Morgan Stanley and Citigroup this week make clear. This is because the market is continuing to shrink – more equity is being retired than issued. Citigroup, which gave this trend the unwieldy name of de-equitisation, says the UK equity market has shrunk by 6.3 per cent since 2004. This year alone it has contracted by 3 per cent. Effectively, the buyers of UK shares have been more than mopping up the supply, which includes selling by traditional owners such as pension funds and life insurers.

Equity issuance includes IPOs, secondary offerings and rights issues. Even though issuance has picked up this year, it has been more than offset by actions such as share buy-backs and cash acquisitions that take equity out of the market.

The big sellers of UK equities have been pension funds. They have been selling for more than a decade as they diversify their assets and – under pressure from actuaries – do more to match their assets and liabilities. There has been heavy switching into bonds and increased buying of overseas equities. Morgan Stanley notes that pension funds are still selling UK equities at a rate of £4bn every quarter and it sees little to suggest the trend is starting to ease.

Back in 1996, pension funds had 57.6 per cent of their assets in UK equities, a figure that had shrunk to 33.2 per cent by the end of the second quarter of this year. At this rate, it will not be long before pension funds hold more overseas equities (30.9 per cent of their assets were invested in them at the end of the second quarter) than UK ones.

But pension fund selling has been swamped by share buy-backs as companies have responded to shareholder pressure for the return of capital. This has been a huge trend of the past few years. In 2003, some £7bn was spent on buy-backs. By last year that figure had risen to £25bn. This year, Morgan Stanley predicts, it will reach a staggering £30bn, not least because of huge buy-back programmes from companies such as BP. Add to that dividends and UK plc will return £75bn to its shareholders this year. Much of that cash will find its way back into the stock market.

Demand for UK shares is also coming from overseas institutions and private investors, who are diversifying their portfolios in much the same way as UK pension funds. Overseas investors now own about one third of the UK market, according to the Office for National Statistics.

Merger and acquisition activity – running at its highest level since 2000 this year – is also supporting “equity demand”. There is a particularly strong impact when a company is purchased for cash, as O2, the mobile operator, was by Telefónica of Spain. It’s not just corporate buying, but private equity activity which is driving the market. Morgan Stanley believes this year could be the first time that private equity buyers have exceeded corporate buyers in their purchases of UK listed companies.

All other things being equal, de-equitisation should have helped the UK stock market outperform European stock markets, where the trend has been much less pronounced.

In fact, as Citigroup notes, the UK market has struggled to keep pace with Europe. Since 2004 the UK market has returned 46 per cent (including reinvested dividends) whereas the Dow Jones Stoxx ex-UK index has returned 51 per cent over the same period. Selling by UK pension funds may have helped neutralise the impact of de-equitisation. But without the trend, UK shares would not have performed as well as they have done in the past three years.

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