British Stock Market Triggers Concerns

The British stock market has become a desolate landscape, raising concerns about the future of pension funds. This underreported phenomenon has seen the U.K. stock market transform into a barren wasteland, prompting comparisons to its global counterparts.

Recent data from Citigroup reveals that U.K. stocks trade at a significantly lower price-to-earnings ratio for 2023, standing at 10.6 compared to 20.7 in the United States and 17.2 globally. Even if high-performing tech stocks are excluded from the equation, the U.S. ratio still stands at 18.4, leaving the U.K. numbers unaffected. The bleak conditions have led SoftBank to make the decision to list U.K. microchip designer ARM in the U.S., bypassing its home country altogether.

Many attribute this gradual decline to an accounting rule change that took place in the 1990s. The rule dictated that pension fund liabilities must be reported as corporate liabilities, a response to the scandal involving Robert Maxwell, who misappropriated his company’s pension fund. Consequently, pension funds in the U.K. shifted toward a liability-driven investment approach that significantly reduced their reliance on equities. Goldman Sachs reports that the weightings of equities in U.K. corporate pension funds have plummeted from two-thirds to negligible figures, despite the substantial growth of assets over the past 25 years.

This predicament raises concerns about the potential withdrawal of U.S. funds as well. J.P. Morgan strategist Nikolaos Panigirtzoglou analyzes the flow of U.S. defined benefit pension funds and notes that these funds typically rebalance their portfolios based on the performance of equities and bonds. Panigirtzoglou references Federal Reserve data to highlight that whenever the gap between positive returns for equities and negative returns for bonds exceeds 10%, there is an average equity selling of $80 billion. Similarly, when the gap falls between 5% and 10%, equity selling averages around $40 billion. Based on the current quarter-to-date return gap, this suggests an estimated equity selling of approximately $55 billion.

Although U.S. private pension funds generally boast strong funding, recent revisions indicate a downward adjustment of $150 billion due to unexpected investment losses on private assets. This revision provides an incentive for these funds to further reduce risk and secure improvements in their funding ratios. Despite a bond market sell-off in 2022 that resulted in a nearly -15% return for the U.S. Aggregate index in the first three quarters, the bond allocation of private U.S. defined-benefit pension funds actually increased from 38% to 40% during that period.

While state and local pension funds are notorious for being inadequately funded, they still maintain high equity allocations and near-record-low bond allocations, just under 20%. Panigirtzoglou suggests that these funds may have an asset-liability mismatch and could benefit from purchasing bonds, especially considering the attractive yields of around 4.7% relative to the past 10-15 years. Moreover, as a growing number of beneficiaries near or enter retirement, the allocation of bonds in defined benefit pension funds is expected to gradually increase. Notably, bond allocations in the United States are significantly lower compared to those in Europe and Japan, indicating potential room for growth in this asset class.