Sense behind pensions and share moves

YOU may have read about the huge increase in the liabilities of UK pension funds since the Brexit vote.

This has nothing to do with the fact that they are going to be paying out bigger pensions, but everything to do with what is known as the Dividend Discount Model.

This attempts to forecast future profits and dividends generated by a company and to discount them back to a “net present value” with reference to an appropriate discount rate, such as the yield of a safe government bond.

If one buys a government bond one is guaranteed to receive set interest payments and the return of capital on a specified date. No such guarantees are attached to shares, so they are a “riskier” asset class. But if one can make a reasonable estimate of how much cash a company will generate over, say, the next ten years, and then ascribe an appropriate risk premium to take account of the uncertainty, one can put a value on those cash flows today.

Falling bond yields mean that companies will need more assets to generate the same level of income as before. Fine if your assets and liabilities are already matched, but a disaster if you have a funding deficit. Hence the pensions woe. What has been less reported is the positive effect on shares.

Leaving growth forecasts and the risk premium unchanged, future cash flows are worth more today than they were before.

This, and for UK overseas earners, the falling pound (prior to its recent rebound), has been the biggest factor behind share price rises, and it risks sending out completely the wrong feedback to policy makers. Markets are not rising because they are expecting a resurgence of growth: precisely the opposite. They are saying that growth will remain sluggish, and interest rates and bond yields will remain low. Thus, mathematically, and somewhat counterintuitively, future company cash flows are worth more today. No wonder there are so many conflicting opinions as to whether equities are still good value or about to crash. John Wyn-Evans is head of investment strategy at Investec Wealth & Investment