LDI broke the UK stock market

The author is Chief Global Equity Strategist at Citigroup

In the 1990s I was a UK equity strategist with a traditional London stockbroker whose roots go back to the 18th century. My job was to help domestic fund managers navigate macroeconomic issues playing out in the market. I spent a lot of time visiting investors in London, Edinburgh and Glasgow. The rivalry between my clients was fierce, as was competition from other UK equity strategists.

This reflected a buoyant stock market. Between 1990 and 2000, the FTSE 100 index rose from 2444 to 6930. UK stocks rose to 11 percent of the MSCI World benchmark. New companies rushed to the list. Legacy companies raised fresh equity to finance ambitious takeovers abroad. Three UK stocks among the global top 15 by market cap. Stock buybacks have been rare, as have leveraged buyouts. The UK equitized (the increase in market value not attributable to higher share prices) by 60 per cent over the decade.

Let’s roll those numbers to 23 years. The FTSE 100 is trading at 7800, a haphazard rise of 12 percent from its late 1990s high. The US benchmark S&P is 186 percent higher. The UK market has fallen to 4 percent of the global equity benchmark. Shell, the largest stock, ranks only 38th in global market value. Share buybacks have accelerated, along with privatizations. New offers have dried up. The UK has lifted equity.

What went wrong? Some cite onerous listing requirements, others the UK’s overweight to older industries and lack of new technology stocks. Brexit is also to blame. All of this has contributed to the ailing state of the UK equity market, but the biggest drag has been a huge shift in institutional asset allocation. My old clients, domestic pension funds and insurance companies, have drastically reduced their weighting in UK equities. They owned more than half of the market in the 1990s. Now they only own 4 percent.

This sell-off partly reflects the impact of the bear market in the early 2000s. Large stock weightings have left pension funds terribly exposed. Asset valuations plummeted. Liabilities rose while bond yields fell. Deficits exploded. The near-death experience pushed trustees toward liability-oriented investment strategies that promised to more closely align portfolios with fund obligations. That meant selling stocks and switching to government bonds.

The bear market has also left deep scars in the UK insurance industry. A shift towards more risk-weighted asset allocation strategies, embedded in new accounting standards and regulations, led to a similar move away from equities.

The selling rush made UK equities a classic value trap, permanently trading at cheap valuations. Alternatively, index-linked gilts, a favorite among LDI investors, rose to elevated valuation levels. This made them particularly vulnerable to last September’s failed UK budget. LDI strategies have always made a lot of sense, but everything comes at a price.

The impact on corporate finance was significant. Companies raised capital in the bond markets, where UK funds bought, while reducing their reliance on the public stock market, where they sold. The private equity industry got rich by taking the other side of institutional change, issuing low-yielding bonds to buy cheap assets from the stock market. Private markets grew while public markets shrank.

How would we position UK equities now? The market remains underweight technology stocks, but given the sector’s recent sell-off, that might not be such a bad thing. It’s never been a big beneficiary of lower interest rates, so it should be less vulnerable now that they’re rising. It’s not particularly vulnerable to a weak domestic economy, as 70 percent of revenue comes from abroad. Valuations are attractive, with UK stocks trading at 10x 2023 earnings per share, versus 14x continental Europe and 19x the US. From here, we believe the market is less of a value trap as domestic institutions are largely sold off. As a result, we are now overweight the UK in our global equity portfolio.

Low valuations continue to discourage new companies from listing and leave old ones vulnerable to bids. For many, the economics of stock buybacks remain compelling. UK equity supply is likely to shrink further given the persistently falling demand. If lawmakers really want to revitalize the UK stock market, they need to encourage some new inflows into the asset class. Mind you, they have a lot of gilts for sale, so maybe not.

All those UK equity strategists are long gone. I switched to global equity many years ago.