Prometheus has highlighted some encouraging forecasts for world markets in recent weeks. Clearly there are downside risks as well as upside ones and here he focuses on a particular concern in the UK.

Schizophrenia in the UK Bond Market

What are the implications of Bond Market distortions on the wider economy?

The ongoing strength of institutional pressures in the bond market has left the UK asset markets pricing in what looks like a bizarrely schizophrenic outlook for the economy. The ultra-low levels of real yields apparently point to deepening gloom while the equity market continues to rise ever higher. This dichotomy could presumably remain in place for some time, but the risks must now be weighted towards a pick-up in bond yields, at least at the longer end of the curve, and possibly an associated fall in the stock market. 

The money markets have begun to price in a further fall in UK base rates now that inflation is back below its target and the consumer recovery seems to be faltering. Lower rates should firm up as inflation falls further and growth remains weak.

In the bond market, institutional pressures have continued to weigh down on the longer end of the yield curve. Any easing in such pressures, particularly if combined with a further fall in short rates, could see the curve re-steepen markedly. 

Equities have received a strong boost from the fall in bond yields and are therefore at risk from any back-up in yields. At the same time, it is possible that the recent strength of corporate earnings growth may not be sustained in the face of weak GDP and productivity growth in the economy. 

Healthy returns on commercial property continue to be driven by rapidly falling yields. The boom is set to continue in 2006, as property remains self-financing for debt-backed investors. However, in 2007, modest rental growth and rising yields should cause capital values to stagnate. 

The sterling exchange rate has so far defied the narrowing of the interest rate gap between the UK and the US and €urozone. But a further such narrowing and continued concerns over the external position are likely to put downward pressure on the pound.  

The Bond Market has become distorted largely because of demand created by……… 

Pension Fund Deficits – what is their likely impact on corporate activity? 

The large and depressing hole in corporate pension funds has been exacerbated recently by the drop in UK long bond yields, which are used to discount the value of future pension liabilities. In order to eliminate their pension fund deficits, firms are likely to have to divert a significant proportion of their resources into pension fund contributions over the next ten years or so. This could have a potentially devastating effect on business investment and the prospects for a re-balancing of the UK economy. 

The aggregate pension fund deficit is estimated at between £100bn and £160bn on a FRS 17 basis for the corporate sector as a whole. And if calculated on the more expensive buy-out basis, the deficit is estimated to be up to three times bigger than this. Of course, different firms might choose to plug this over different periods. But even spreading the burden evenly over the next ten years would mean an annual aggregate contribution of between £10bn and £40bn a year, the equivalent of 2% to 6% of companies’ total revenues. 

Clearly this is not good news as it could put a severe dent in the money companies have to spend on other things. One option for firms faced with a squeeze on their resources would be to reduce dividend payments. But some firms do not pay a dividend, while others are under heavy pressure from investors to maintain such payments. In such cases investment would be more likely to come under threat at most firms. An extra pension fund contribution of £10bn to £40bn a year is the equivalent of some 9% to 38% of the amount firms spent on investment last year. And in a worst case scenario, wherein the deficit is at the upper end of estimates and is plugged over five years, investment could be more than halved. 

Bottom line: Pension fund deficits present a whole new threat to investment, making previous models of corporate behaviour potentially completely redundant. As such, there is a real danger that both the Treasury and Bank of England’s expectations of a recovery in business investment over the next couple of years could be disappointed. What is more the black hole in corporate pension funds could continue to drag down investment for many years after that. 

And finally…………… to find out why women live longer than men click here 

HAVE A GREAT WEEKEND!

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.