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BLOG: Watch corporate behaviour, not pension deficits

Written by: David Stubbs
As stock markets hover near multi-year highs, investors are rightly considering what drivers could take the market higher in coming years, and what risks may be lurking under the surface.

One broadly positioned force that tends to grab headlines in mature bull markets is merger and acquisition activity (M&A). If executed correctly then M&A should add to shareholder value by allowing cost reductions and efficiency gains to boost margins and allow more revenue to fall to the bottom line.

M&A activity has certainly been brisk of late. According to Bloomberg, more than 40,000 deals were completed globally in both 2015 and 2016, exceeding the previous peak of around 36,000 in 2007. This activity reflects a decent economic environment, affordable and ample financing to fund deals and buoyant confidence among business management about the economic outlook.

Of course, there are many examples for corporate activity which destroy value, and those deals often occur near market peaks. So while investors can welcome increasing levels of M&A for now, any signs of irresponsible and overvalued deals would be a warning sign.

As investors look for risks, the topic of pension liabilities is front and centre. Longer lifespans and lower contributions than were necessary have now created significant deficits in defined benefit pension plans.

According to the Pension Protection Fund, the 5,794 UK schemes they monitor have a combined £186.2bn deficit at the end of June this year (of course, not all these firms are listed and hence not all are of concern to equity investors). On the surface, these deficits create a significant future drag on earnings, or at least the amount of cash available to be returned to shareholders through dividends and buy backs.

Yet right now, this problem is exaggerated. Many companies use government bonds yields to discount their liabilities and the current depressed levels of yields are exaggerating the scale of those future commitments. In the short-term, that is forcing firms to allocate more money to their funds, but if multi-asset portfolios produce returns higher than current bond yields, and those yields trend higher in coming years, then sooner rather than later, and the shortfalls will be greatly reduced.

When investing today, future pension liabilities that exist are well known to investors. The data is regularly and transparently presented to investors, and the scale of the shortfall (with the exception of the discount rate) is clear and stable. Hence it is unlikely to be a source of material new information which moves the share price around. In other words, if the pension deficits matter, they are in the price already.

David Stubbs is global market strategist at JPMorgan Asset Management

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