The UK stock market: coming in from the cold?

In his upcoming Mansion House speech, Chancellor Jeremy Hunt is expected to provide details on how he wants to “unlock productive investment from defined-contribution pension funds and other sources”.  However, this hasn’t been without pushback from the industry.

According to the article the UK economy has no capital as “a rush into safer assets has left the UK listing market moribund and is driving companies overseas”. But when we look at the data for pensions and insurers (given the ongoing pension risk transfer shift, whereby insurers are buying out fully-funded pension schemes, we need to look at them together), we see a rather more balanced picture.

Indeed, it’s not about a wholesale shift to fixed income. Instead, we’ve seen significant increases in allocations to mutual funds: equity and mutual funds have gone from 50% of assets in 1987 to 49% in the most recent data. Data on the holdings of these mutual funds are not available so we can’t be sure of the equity total, but we believe that a significant proportion of their holdings is likely to be in equities.  

We have chosen to use the flow of funds data as our source here as it covers a much broader institutional sector than the Pension Protection Fund's Purple book data. However, it’s important to acknowledge that the latter has equities dropping from 61% of the weighted average DB pension in 2006 to 19% today. That said, the PPF data doesn’t include a mutual funds category, although they do show a 5% allocation to hedge funds. In addition the Purple Book doesn’t include insurers, the Local Government Pension Scheme or all pension funds. It therefore covers a much smaller pool of assets.

Home bias: not what it used to be

While it does appear from the flow of funds data that UK-based pension companies and insurers haven’t reduced equity risk as much as suggested, it’s true that the home bias of UK investors is nothing like it used to be. Indeed, the FT recently reported that since 1996 UK DB pension funds have significantly reduced their home bias from 71% of equities to just 13% invested in UK equities today.

Yet with UK equities representing only just over 4% of the global market index,[1] investors do still clearly have a home bias. In doing so, they risk foregoing some diversification but there can be good reasons to do this.

Besides the benefit for the common good (e.g. when UK productivity rises we all benefit) a UK-based investor with liabilities in the UK may want to hold sterling assets for matching purposes. But when it’s about listed equities, it is important to recognise that 80% of FTSE 100 revenue comes from overseas, so currency fluctuations still matter.

Part of our diversification strategy in the Asset Allocation team includes holding a smaller weight in the most concentrated part of the equity market (the US) which frees up room to hold a strategic weight in the UK greater than that of the market. The aim is to receive some of the potential benefits while still being properly diversified.

Remaining tactically neutral for now

On a more tactical basis, we believe that the UK stock market looks increasingly interesting. Sentiment around the UK stock market is extremely downbeat, with the FTSE forward p/e (price-to-earnings) ratio standing at around 10x compared with the MSCI World at 16x.

 Certainly last year the FTSE 100 was the pick of the major developed markets. And what’s more, cheap relative valuations and a high weight to consumer non-cyclical stocks both point to the potential for relatively good performance again this year, if our view of a broader global economic downturn is right.

However, this positive backdrop for UK equities is balanced by the fact that two of the more unique features of the UK market’s outperformance, relative to other defensive markets, are fading.

Firstly, commodities were the focus in 2022 as Russia’s invasion of the Ukraine led to large price increases but prices have fallen from the peak and the most likely macro scenarios do not point to a repeat in our view. Similarly, sterling depreciation has helped boost foreign earnings in pound terms but we now see currency risks as being skewed to a stronger sterling.  

With this backdrop in mind, and given other preferred defensive trades in our portfolio, we are staying neutral on UK equities for now.

[1] Source, FTSE All-World Index, as at 31 March 2023