UK stocks have been described by European equity strategists at HSBC Global Research as “unloved, unsuitable, and undervalued.” The reasons behind this assessment are multifaceted and include significant factors that have shaped the UK stock market's current state. One of the key aspects highlighted by HSBC is the diminishing appeal of the UK market for both upcoming IPOs and existing issuers. Several broader factors have contributed to this decline, such as the composition of UK indices and global trends in bond yields. However, strategists at HSBC point to government policy and regulation over the past few decades as the root cause of the market's current predicament.
An example cited by HSBC is the 1997 abolition of the dividend tax credit by the Labour government, which had significant repercussions on defined benefit (DB) pension schemes. This change deprived these schemes of approximately GBP 5 billion annually, adding to the financial strain on companies responsible for maintaining such pensions. As bond yields fell over time, the burden on companies increased, making DB schemes unsustainable. The establishment of a Pension Regulator in the early 2000s marked a significant shift, prompting DB schemes to divest from equities and invest more in bonds. This trend has resulted in a dramatic withdrawal of GBP 1.9 trillion from the domestic stock market by pension funds and insurance companies.
As a consequence of these developments, UK equities have underperformed compared to other major markets in recent years. HSBC also highlights the diminished 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 about 4% currently. Additionally, the heavy reliance of the FTSE 350 index on sectors such as Financials, Energy, and Basic Materials poses further risks due to their dependence on commodity prices and interest rate movements. In contrast, the lack of representation of sectors like Technology in the index is noted as a concern for market diversification.
Another critical point raised by HSBC's team is the declining interest of domestic DB pension funds in UK equities, which has made the market increasingly dependent on overseas investors, particularly those from the US. While US funds are significant owners of UK equities, a substantial portion of UK equities do not meet minimum size and liquidity thresholds, posing challenges for foreign investors.
Despite the challenges faced by UK equities, HSBC strategists identify three reasons for optimism regarding the market. Firstly, the undervaluation of the UK market presents opportunities for potential upside and increased merger and acquisition activity. Secondly, the exhaustion of sellable assets by UK pension funds could alleviate the longstanding market overhang. Lastly, current global economic conditions, such as rising bond yields, commodity prices, and a strengthening US dollar, are viewed as favorable factors for UK markets.
In navigating the evolving landscape of UK equities, HSBC strategists emphasize a balanced approach to sector positioning, combining both cyclical and defensive stocks in their allocations. While acknowledging that current market expectations may be overly optimistic, they believe that a positive shift in the global manufacturing environment and the rise in commodity prices could benefit specific cyclical sectors.
The challenges faced by UK equities are complex and multifaceted, but there is room for optimism based on potential opportunities and favorable market conditions. It remains to be seen how the market will evolve and adapt to the changing global economic landscape.