Equity boom, equity retreat

Equity boom, equity retreat

While equity indices power ahead, the global supply of equities is shrinking. The disappearance of equity through share buybacks and leveraged buyouts exceeds new public listings. In the past listing on a public exchange offered the principal route to new funds for larger businesses. Today there are a host of alternatives. Private equity, sovereign wealth funds, infrastructure funds, family offices and late-stage venture capital all compete with public markets. The equity market is no longer the default route to scale for growing businesses. An increasing proportion of the corporate sector is privately owned. A number of major tech companies, including SpaceX, Stripe and Open AI, remain private.

• What is driving de-equitisation, the shrinking of public equity markets?

• The cost of finance is one factor. Between 2009 and 2022, US short rates averaged just 0.6%, one-sixth the rate prevailing in the previous 20 years. Low interest rates mean that financing a business with debt is cheaper than with equity. That created an incentive for businesses to switch from public equity markets to debt-financed private markets.

• The costs and burdens involved in listing – which include listing fees, quarterly earnings calls and mandatory disclosures – add to the attraction of the private route. For technology start-ups seeking to safeguard intellectual property, private investors offer patience and a willingness to burn cash. Start-ups now commonly receive multiple funding rounds, providing pre-IPO liquidity for employees and founders.

• Nowhere is the shrinkage of public equity markets more apparent than in the UK. Schroders estimates that the number of companies listed on the main market of the London Stock Exchange fell by about 75% between the 1960s and 2022. Research by New Financial shows that since 2012 an average of 125 companies have left the UK stock market every year, mainly as a result of companies going private or acquisitions by overseas firms.

• The UK market has been affected by the switch to private markets seen elsewhere. But other factors are also at work. Demand for UK equities from domestic institutional investors has flagged in recent decades. UK pension funds and insurance companies, once the main holders of UK equities, have diversified into overseas equities and alternative assets, such as hedge funds, real estate and infrastructure since the 1990s. Then, from the early 2000s, regulations designed to better match the assets of defined benefit (DB) schemes to their future pension payments, led to DB schemes significantly increasing their holdings of government bonds.

• Heavier weightings in overseas equities, alternative assets and necessary government bonds squeezed DB schemes’ holdings of UK equities. The average allocation by DB schemes to UK equities collapsed from over 50% in the 1990s to just 2% in 2022.

• But this process of diversification is a two-way street. Diversification by overseas investors from their own markets has led to a significant increase in foreign holdings of UK equities. Roughly 60% of all UK equities are now owned by overseas institutions and individuals, up from 33% in 2000 and just 8% in 1963. The UK equity market has a more geographically dispersed and global customer base than ever. Overseas institutions have replaced UK pension and insurance companies as the major owners of UK equities.

• DB schemes are shrinking in importance and currently have fewer than 1m active private sector members. But defined contribution (DC) pension schemes have 18m active members, and, as a result of pension auto-enrolment, their numbers are growing. Annual contributions to DC schemes are twice those going into DB schemes. DC represents the future of UK pension provision. Crucially, DC schemes make significantly higher allocations to equities than DB schemes.

• Will the growth of DC schemes create a new, natural buyer of UK equities? That depends on the perceived attractiveness of UK equities to these schemes.

• Today the US is the most popular major developed equity market. In the last 30 years returns from US equities have been more than twice as high as those from euro area or UK equities. Part of this relates to the strong performance of tech shares, which account for perhaps one-third of the US equity market, a far greater share than in the UK or the euro area. Europe has tech companies, including ASML and STMicroelectronics, but nothing that matches the scale of the likes of Meta, Apple or Alphabet. Investors’ love affair with technology has a distinctly US flavour, with US tech stocks significantly outperforming their European and Asian peers in the last decade. After a multi-year bull market US equities account for a remarkable 70% of the MSCI global developed market equity index. You can understand why investors around the world want exposure to US equities. 

• The UK equity market, with its reliance on energy, mining, financial services, telcos and utilities, lacks the tech component that has powered the US market. Even outside tech, US stocks command higher valuations than their UK or euro area peers. This helps explain why some London-listed UK businesses, including biotech firm Abcam and packaging firm Smurfit Kappa, have moved to the US market. Investors are simply more optimistic about prospects for future growth and returns from US-listed companies than their European peers.

• This has left UK equities looking cheap relative to US equities and, indeed, euro area equities. The discount on UK equities relative to their US peers has rarely been so large. But just because something appears to be cheap doesn’t mean it will make money. Financial history is littered with examples of apparently ‘cheap’ assets that keep getting cheaper.

• Markets can and do change direction. Witness the stellar performance of Japanese equities in the last two years after decades in the doldrums or the fall from grace of Chinese equities since 2021. The UK macro picture, with growth returning and inflation in retreat, looks better than it has for some time.

• I will leave the prognosticating on equity markets to others. What is clear is that the shrinkage of public equity markets and the growth of private capital have transformed corporate ownership. That looks here to stay.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 0.4% at 8,245.

Economics

• The European Central Bank cut its benchmark deposit rate for the first time since 2019, from 4% to 3.75%, but cautioned that further cuts would “depend on the data”
• The Bank of Canada cut its interest rate from 5% to 4.75% as the economy softens
• The US economy added 272,000 jobs in May, significantly ahead of expectations and up from a revised 165,000 in April, lowering expectations of rate cuts later in the year
• The UK’s Local Government Association warned that English local authorities face a budget shortfall of £6.2bn over the next two years
• UK house prices unexpectedly fell by 0.1% in May compared with the previous month, according to estimates from Halifax
• UK rental inflation for new tenancies fell to a 30-month low of 6.6% in the year to May as affordability constraints bite many renters
• Chinese exports grew by 7.6% in May compared with the same period a year earlier while imports only grew by 1.8%, adding to concerns over weak domestic consumption
• UN agency UNICEF said that 27% of children under five years of age suffered food poverty in 2022 with conflict, climate change and economic crises intensifying the problem

 Business

• Chipmaker Nvidia overtook Apple as the world’s second-most valuable public company as extraordinary demand for its AI chips continues
• Former chief executive of Autonomy, Mike Lynch, was acquitted of fraud by a court in San Francisco
• A number of private equity bosses have cautioned that their sector faces the possibility of years of lower returns amid a backlog of unsold companies and higher interest costs, the FT reports
• Lord John Browne, former chief executive of BP, endorsed the UK Labour Party’s policy to end new licences for drilling in the North Sea saying that remaining resources would not make a significant contribution to energy security or lower fuel prices
• Saudi Arabia is to raise over $11bn by selling shares in state oil company Aramco
• United Nations secretary general Antonio Guterres called for a ban on advertising by fossil fuel companies, calling them “godfathers of climate chaos”
• Operations were suspended at several NHS hospitals in London following a ransomware attack. A Russian group is thought to be behind the attack
• A group of investors is planning to open a new stock exchange in Texas aiming to provide a less regulated alternative to the New York Stock Exchange and Nasdaq

 Global and political developments

• Far-right parties have made significant advances in the EU elections with exit polls suggesting major gains for the right in France, Austria and Germany
• The FT commented that the gains are likely to tilt the European Parliament to “a more anti-immigration, anti-green stance”
• President Emmanuel Macron dissolved the French Parliament and called snap elections in the wake of Sunday’s European election results. The French parliamentary elections will be held on 30 June and 7 July
• The European Commission is pushing for Ukraine to start EU membership talks ahead of Hungary taking over the rotating EU presidency, the FT reports
• Russian president Vladimir Putin warned he may provide weapons to enemies of the West to strike western targets in response to NATO allowing Ukraine to use western arms to strike targets inside Russia
• The FT reported that Labour has dropped plans to bring back the pension lifetime allowance on the grounds of complexity and uncertainty for savers
• Veteran Brexit campaigner Nigel Farage announced that he would stand for election in Clacton, UK and assume leadership of the right-leaning Reform UK party
• An average of eight polls published after Mr Farage’s announcement put Reform UK on 15%, up from an average of 11% in eight polls that preceded the announcement
• Israeli war cabinet minister Benny Gantz quit the emergency government in a sign of deepening divisions over prime minister Benjamin Netanyahu's post-conflict plans for Gaza
• Indian prime minister Narendra Modi formed a coalition government after his Bharatiya Janata Party unexpectedly failed to win a majority

And finally… officials in China have been forced to apologise after a hiker found that what claimed to be China’s highest uninterrupted waterfall was actually fed by a pipe – fall from grace