Forced sellers cast shadow over equity markets

A stock quotation board in Tokyo is shown in this file photo.

LONDON (Reuters) - Investors looking for the next shoe to drop in Europe's stock bear market are watching the region's pension funds and insurers uneasily.

The reasons for their discomfort: the prospect of forced selling by European insurers, which prompted the last stock market collapse in 2003; and fears pension funds could worsen the situation by extending their move out of equities.

But while these threats loom over an edgy market, analysts say prices would have to fall by up to 15 to 20 percent more before the two groups dump stock, and the effect of any selling will be less pronounced than in the past.

European markets are extremely vulnerable: shares have fallen 30 percent from a 6-1/2 year peak hit a year ago, driven by a credit market crisis, an economic slowdown, and big losses at the region's top banks.

Among those hit have been UK blue-chip company pension funds, which slipped into the red in June, hurt by falling shares and higher inflation expectations.

"It is a further risk out there -- if you see material falls from these levels, it could drag potential forced sellers into the market and exacerbate the situation, causing stock prices to overshoot fundamentals," said Royal Bank of Scotland strategist Ian Richards.

"If the market were to trade 10 percent lower than where we are now, a lot more attention will be paid and a lot more questions will be asked about when the forced sellers are brought into this process."

Insurance companies could be forced into selling stocks because they hold a lot of equities as capital and as prices fall they need reduce stock holdings to protect the solvency margin set by industry regulators.

Big selling by the insurers and by pension funds, which have been selling equities throughout the four-year bull run that ended last year, could rule out any chance of a turnaround for stocks and make a bear market more pronounced.

"UK pension funds have lowered their equity positions to 57 percent from around 80 percent in the mid-1990s, and the fact that equities outperformed over the past five years has helped maintain that weighting," said HSBC strategist Robert Parkes.

"Further falls in the equity weighting cannot be ruled out and the level may move down to as low as 50 percent over the next five years," he said.

Investment consultancy Redington Partners estimates that in aggregate FTSE 100 pension funds have 170-200 billion pounds invested in equities, up to 70 percent of which is in domestic shares, giving an idea of how powerful an influence the funds could be.

"As potential forced sellers are still reasonably comfortable, I'd expect selling only when we go 15-20 percent lower, when the VIX is 35 or 40 and indexes drop 5-6 percent on a given day," said Philippe Gijsels, strategist at Fortis Bank.

The VIX index of volatility -- Wall Street's fear gauge -- last traded at 40 in late 2002. It hit 37 in January and is now around 31.

"In the short term pension funds are likely to offer some stability to the market, rather than being the ones who will destabilise it further by rushing out," said Daniel Peters, an investment consultant at pensions advisory firm Aon Consulting.

INSURERS STILL VULNERABLE

Insurers have slashed their exposure to equities since some were forced to the verge of oblivion when the value of their large stock portfolios crumbled back in the early 2000s. But they remain vulnerable to downward lurches in stock markets.

Companies such as Allianz, Munich Re, AXA and Zurich Financial ServicesVX have hedged some of their equity exposure, but they may be forced to sell shares if markets fall further.

But regulators are likely to take a more flexible line than they did in the previous crisis, when their solvency rules forced insurers to sell shares at rock-bottom prices, but which only had the effect of destabilising markets further.

ABN's Richards said that the insurance sector was better placed this time round as it had run more conservative asset allocation strategies through the cycle.

"If the market falls far enough they may have to re-allocate further away from equities, but they would be reluctant to go down that road just yet, not least because they are aware of the impact of their actions on the market," he said.

As for pension funds, according to UK government data, in 2006 there was a net outflow of 9.6 billion pounds from equities, confirming the trend that schemes have been moving out of equities over the past decade.

In contrast, there was a net inflow into gilts and fixed interest securities of 23.8 billion pounds in 2006, and net investment in alternative assets of 13.5 billion pounds.

Aon's Peters said: "I think the key thing is to differentiate between the long term and the short term. In the long term pension schemes will move away from equities, mainly because as they mature they will hold fewer and fewer equities."

In other words as pension scheme members get older, and the point at which they start to receive payments grows nearer, schemes move out of equities and into less volatile investments such as bonds.

A 140-percent surge in European equities between 2003 and 2007 and a rise in bond yields has enabled many pension funds to plug their deficits.

Under FRS 17 rules, yields of AA-rated sterling bonds are used to calculate pension fund liabilities. When yields -- which move in an opposite direction to prices -- rise, deficits shrink.

European and British 10-year bond yields have risen this year, suggesting that bonds could help offset equity declines.

But inflation expectations have been rising along with surging crude prices, reducing the allure of bond investments. In June, for example, higher inflation expectations added 18 billion pounds to pension liabilities in the UK, according to pension consulting firm Watson Wyatt.