European equity strategists at HSBC Global Research said UK stocks are “unloved, unsuitable and undervalued,” citing several key factors that led to this market state.
The UK stock market has become less appealing both as a platform for upcoming IPOs and as a viable market for current issuers, according to HSBC. Per their analysis, multiple broader factors have contributed to this outcome, including the composition of UK indices and global trends in bond yields, “but the unintended consequences of government policy and regulation over the last few decades are the root cause in our opinion,” strategists at HSBC wrote.
The 1997 abolition of the dividend tax credit by the Labour government notably deprived defined benefit (DB) pension schemes of approximately GBP 5 billion annually, exacerbating the financial burden on companies to maintain these pensions.
This initial policy shift sparked a series of detrimental effects, including the exacerbation of pension liabilities as bond yields fell, ultimately rendering DB schemes unsustainable.
In the early 2000s, the creation of a Pension Regulator marked a significant shift, intensifying the move away from equities. The regulator imposed a legal mandate on DB schemes to align their liabilities "in a way that is appropriate to the nature, timing and duration of the expected future retirement benefits payable," as stated on its website.
The directive has led DB pension schemes to consistently divest from equities and invest in bonds over the past two decades, HSBC noted.
By 2022, the share of UK listed equities held by pension funds and insurance companies plummeted from 52% in 1990 to just 4%, reflecting a staggering GBP 1.9 trillion withdrawal from the domestic stock market, according to the Capital Market Industry Taskforce (CMIT).
“Against this overhang, it is little wonder that UK equities have underperformed other major markets over many years,” strategists commented.
The UK equity market faces other fundamental challenges, HSBC pointed out, including its diminished role in global benchmarks, with the FTSE UK's index weight in the FTSE All World index dropping from 10% in 2000 to about 4% currently.
Furthermore, the FTSE 350 index's heavy reliance on sectors like Financials, Energy, and Basic Materials, which are dependent on commodity prices and interest rate movements, poses additional risks. In contrast, Technology represents just 1.3% of the index.
“Finally, given that domestic DB pension funds are no longer interested in UK equities in any
meaningful way, UK markets are to a large extent dependent on the views of overseas
investors, especially from the US,” HSBC’s team noted.
“US funds are the largest owners after UK-based ones. The trouble is that a significant proportion of UK equities do not meet minimum size and liquidity thresholds,” they added.
Looking ahead, strategists identified three reasons for optimism regarding the UK market.
Firstly, by any metric, the UK market is undervalued, which not only limits downside risks but could also spur heightened merger and acquisition activity. Secondly, UK pension funds have exhausted their sellable assets, effectively clearing the longstanding market overhang. Lastly, the current environment of rising bond yields, increasing commodity prices, and a strengthening US dollar “are all favourable factors for UK markets currently,” strategists said.
In terms of sector positioning, HSBC strategists maintain a balanced approach, incorporating both cyclical and defensive stocks in their overweight allocations. They recognize that current market expectations might be overly optimistic; however, a positive shift in the global manufacturing landscape along with rising commodity prices could benefit specific cyclical sectors.
“We retain a preference for the FTSE 250 over the FTSE 100 index, but the decision is very finely balanced as most of the risks to this view have played out in recent months,” strategists added.