Bear market likely to be less severe on Irish stocks than British counterparts

Investment managers of Irish pension funds have diversified equity portfolios very aggressively over the past decade

Investment managers of Irish pension funds have diversified equity portfolios very aggressively over the past decade

The prospect of imminent war with Iraq is having a predictable impact on an already fragile investment environment. If, as seems increasingly likely, America goes to war against Iraq, with or without UN backing, a military victory for the US is all but guaranteed.

While there is uncertainty about how that may be achieved, the greater unknown lies in the reverberations that will be created in the aftermath of war. The possibility that other regimes in the Middle East may be destabilised is a real concern.

A war against Iraq could also lead to more terrorist attacks in the US and Europe. A further cause for concern is that if the US unilaterally attacks Iraq it could lead to a rift in relations between Europe and America.

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The recent sharp decline in equity prices across the globe clearly reflects this intensification of geopolitical tensions. Year-to-date virtually all stock market indices are now firmly in negative territory. The UK market has been particularly hard hit and is now down an alarming 11 per cent since end-December. From the perspective of Irish investors the decline is even greater given that sterling has depreciated against the euro by over 2 per cent so far this year. A particularly worrying feature of the UK's under-performance is that it may be due to further forced selling by UK insurance companies in an effort to preserve their solvency ratios.

Unfortunately this is creating a self-feeding process of selling pressure. As the market falls it strains even further the already weakened balance sheets of many insurance companies. This then results in further selling of equities particularly from companies that still have a high exposure to the market.

Another source of selling pressure on UK equities may come from company pension funds. The majority of UK pension funds have been investing over 50 per cent of their cash flow into the UK equity market over the past two decades. On average, the value of UK pension funds declined by over 18 per cent last year and they are now showing a negative return of -0.7 per cent per annum for the past five years.

Many company defined benefit schemes, where the company guarantees the value of employee pension benefits, are now seriously under-funded. This has led many UK companies to close their defined benefit schemes to new entrants.

Defined contribution schemes are now replacing defined benefit schemes across a swathe of corporate UK. The key feature of these schemes is that the value of an employee's pension benefits is determined by the value of the assets that have been accumulated. Therefore, the company is not under any obligation to make good any shortfall that may occur.

Whilst companies can reduce their potential future liabilities arising from defined benefit pension schemes by closing the door to new entrants, there is little that they can do to limit their obligations to existing members.

Therefore, in order to limit their exposures many UK pension funds may decide to reduce their investments in equities. Given the size of the assets controlled by UK pension funds such a shift has the potential to create further sustained selling pressure on the UK equity market.

The trustees and investment managers of Irish pension funds are faced with a similar situation. Just like their UK counterparts, the asset mix of Irish pension funds is heavily skewed towards equity investments and the cumulative impact of the bear market has undoubtedly seriously eroded the asset base of many pension funds.

However, the implications for the Irish equity market are not as severe as seems to be the case in the UK market. This is because the investment managers of Irish pension funds have diversified their equity portfolios very aggressively over the past decade and the portion of their portfolios committed to the Irish equity market is now quite modest. Therefore, if Irish funds decide to reduce their equity exposures they can achieve this by selling assets across the highly liquid international equity markets.

This technical selling pressure from insurance companies and pension funds could well be a feature of the UK equity market for a significant period of time. The only source of relief would be a sustained improvement in equity values, and such a positive swing in investor sentiment does not seem likely in the near future.

The Irish equity market may suffer from some of the same selling pressure, but to a much more modest extent due to the internationally diversified nature of Irish institutional portfolios.