LDI broke the UK stock market
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The writer is chief global equity strategist at Citigroup
Back in the 1990s, I was a UK equity strategist at a storied London stockbroker with roots going back to the 18th century. It was my job to help domestic fund managers navigate macroeconomic themes playing out through the market. I spent much time visiting investors in London, Edinburgh and Glasgow. The rivalry between my clients was fierce, as was the competition from other UK equity strategists.
This reflected a vibrant stock market. Between 1990 and 2000, the FTSE 100 index rose from 2444 to 6930. UK equities rose to account for 11 per cent of the MSCI World benchmark. New companies rushed to list. Old companies raised fresh equity to finance ambitious overseas acquisitions. Three UK stocks ranked in the global top 15 by market capitalisation. Share buybacks were rare, as were leveraged buyouts. The UK “equitised” (the increase in market value not attributable to higher share prices) by 60 per cent over the decade.
Let’s roll those numbers on 23 years. The FTSE 100 trades at 7800, a desultory 12 per cent gain from its late 1990s high. The US S&P benchmark is 186 per cent higher. The UK market is down to 4 per cent of the world equity benchmark. Shell, the biggest stock, ranks only 38th in global market value. Share buybacks have accelerated, along with take-privates. New listings have dried up. The UK has de-equitised.
What went wrong? Some cite burdensome listing requirements, others the UK’s excessive weighting towards older industries and lack of new technology stocks. Brexit also gets the blame. All of these have contributed to the sickly state of the UK equity market, but the biggest drag has been a giant shift in institutional asset allocations. My old clients, domestic pension funds and insurance companies, have dramatically cut their weightings in UK equities. They owned more than half the market in the 1990s. Now they own just 4 per cent.
This selldown partly reflects the impact of the early 2000s bear market. Heavy equity weightings left pension funds horribly exposed. Asset valuations collapsed. Liabilities rose as bond yields fell. Deficits ballooned. The near-death experience pushed trustees towards liability-driven investment strategies, which promised to match portfolios more closely to fund obligations. That meant selling equities and switching into gilts.
The bear market also left deep scars across the UK insurance industry. A shift to more risk-weighted asset allocation strategies, embedded in new accounting standards and regulation, drove a similar move away from equities.
The selling onslaught turned UK equities into a classic value trap, permanently trading at cheap valuations. Alternatively, index-linked gilts, a favourite among LDI investors, rose to high valuation levels. This left them especially vulnerable to last September’s failed UK budget. LDI strategies always made a lot of sense, but there is a price for everything.
The corporate finance implications were significant. Companies raised capital in the bond markets, where UK funds were buying, while reducing reliance on the public equity market, where they were selling. The private equity industry got rich by taking the other side of the institutional switch, issuing bonds at low yields to buy cheap assets off the equity market. Private markets grew as public markets shrank.
How would we position on UK equities now? The market remains underexposed to technology stocks, but that may not be such a bad thing right now given the recent sector sell-off. It was never a big beneficiary of lower interest rates, so should be less vulnerable now they are rising. It is not especially sensitive to a lacklustre domestic economy, given 70 per cent of earnings come from overseas. Valuations are attractive, with UK equities trading on 10 times 2023 earnings per share versus Continental Europe at 14 times and the US at 19 times. From here, we think the market is less of a value trap given the domestic institutions have largely sold out. Hence, we are now overweight the UK in our global equity portfolio.
Low valuations still discourage new companies from listing and leave old ones vulnerable to bids. For many, the economics of share buybacks remain compelling. UK equity supply will probably shrink further given the permanent drop in demand. If legislators really do want to revive the UK equity market, they need to encourage some fresh flows into the asset class. Mind you, they have a lot of gilts to sell, so maybe not.
As for all those UK equity strategists, they are long gone. I switched to a global equity remit many years ago.