The European equity strategists at HSBC Global Research have recently expressed a rather grim outlook on the state of the UK stock market, dubbing it as ‘unloved, unsuitable, and undervalued’. This sentiment is driven by a myriad of factors that have contributed to the unattractiveness of UK equities in recent times. According to HSBC, the composition of UK indices and global trends in bond yields have played a role in this market state. However, the strategists at HSBC pinpoint the root cause of this decline to be the unintended consequences of government policy and regulation over the last few decades.
One of the key policy shifts that triggered a series of detrimental effects was the 1997 abolition of the dividend tax credit by the Labour government. This move notably deprived defined benefit (DB) pension schemes of approximately GBP 5 billion annually, placing a significant financial burden on companies to sustain these pensions. The cascading effect of this policy change led to an exacerbation of pension liabilities as bond yields declined, ultimately making DB schemes unsustainable.
The early 2000s saw a significant change with the establishment of a Pension Regulator, marking a momentous shift away from equities. The regulator imposed a legal mandate on DB schemes to align their liabilities in a way that is suitable to the expected future retirement benefits payable. As a result, DB pension schemes have increasingly divested from equities and shifted towards investments in bonds over the past two decades, as highlighted by HSBC.
By 2022, it was observed that the share of UK listed equities held by pension funds and insurance companies had plummeted from 52% in 1990 to a mere 4%, reflecting a substantial GBP 1.9 trillion withdrawal from the domestic stock market, according to the Capital Market Industry Taskforce (CMIT). This dramatic reduction in equity holdings has had a profound impact on the performance of UK equities in comparison to other major markets.
Apart from the pension-related challenges, the UK equity market faces other fundamental obstacles as outlined by HSBC. The diminishing role of the UK market in global benchmarks, with the FTSE UK’s index weight in the FTSE All World index dropping from 10% in 2000 to approximately 4% currently, is a significant concern. Additionally, the heavy reliance of the FTSE 350 index on sectors such as Financials, Energy, and Basic Materials, which are susceptible to commodity price fluctuations and interest rate movements, poses added risks to the market.
Notably, the lack of representation of the Technology sector in the index further exacerbates the market’s vulnerability to external factors. Moreover, the dependence of UK markets on overseas investors, particularly from the US, raises uncertainties about the stability and resilience of the market in the face of global economic fluctuations.
Despite the prevailing challenges, HSBC’s strategists have identified three reasons for optimism regarding the UK market. Firstly, the undervaluation of the UK market presents opportunities for heightened merger and acquisition activity and limits downside risks. Secondly, the exhaustion of sellable assets by UK pension funds could alleviate the market overhang that has persisted for years. Lastly, the current environment characterized by rising bond yields, increasing commodity prices, and a strengthening US dollar, are seen as favorable factors for UK markets.
In terms of sector positioning, HSBC strategists advocate for a balanced approach, incorporating both cyclical and defensive stocks in their overweight allocations. While acknowledging that current market expectations may be overly optimistic, they believe that a positive shift in the global manufacturing landscape and rising commodity prices could bolster specific cyclical sectors in the UK market.
The UK equity market’s current predicament is the result of a confluence of factors, ranging from government policy changes to global market dynamics. While challenges persist, there are glimmers of hope for a resurgence in the UK equity market if the right conditions are met and strategic decisions are made to navigate the evolving landscape of global finance.