Grim reaper stalks the City

The London stock market is bracing itself, in the words of one fund manager, for a "tidal wave" of selling by pension funds as they rejig their portfolios to reflect the abolition of their ACT tax-exempt status in the Budget.

The removal of the benefit means that British pension funds, which have an average of 55 per cent of their portfolios invested in UK stocks, are reassessing whether they should move some of their capital into gilts and property, which now offer yields up to 30 per cent better than equities after the tax-credit removal.

"The net yield on UK equities versus gilts is more unattractive now than at any time since September 1987," said one leading fund manager. "And we all know what happened then."

British pension funds have historically held a much higher proportion of their capital in UK stocks because of their vastly superior long-run performance to similar institutions in continental Europe. In addition, they hold around 25 per cent of their capital in overseas equities, bringing the average total equity portion of a UK-based fund to 80 per cent of its value, versus 20 per cent devoted to cash, bonds and property investments.

In light of the removal of the ACT credit and the drop in yield associated with equities, actuaries and equity strategists believe that a typical fund with 40 per cent of its members retired and claiming their pension will have to raise the proportion of the fund devoted to fixed-income instruments like gilts and overseas bonds so that it more or less matches its current liabilities.

This would mean dumping about a quarter of the fund's equities by value, the majority of which are UK stocks.

A more pessimistic scenario, involving a more mature pension fund with 60 per cent of its members retired, would require a typical fund to swap half its equities for bonds and property investments. This would mean 30 per cent of the pounds 580bn currently in pension funds - around pounds 120bn - flowing out of the UK equity market, which would, in theory at least, cause the FT-All Share index to fall by 15 per cent.

"Funds have been moving more towards a more conventional asset-allocation profile over the last year, and the change in ACT is bound to speed up this shift," said Feargus Mitchell, an actuary working for accountants Deloitte & Touche.

"The upshot of this will be to push more money towards gilts and overseas investments, and will mean a flight from UK equities."

Alistair Ross Goobey, head of Hermes, the pounds 30bn Post Office and BT pension fund, said: "It is tautological that UK equities are less attractive to pension funds now than they were on Wednesday morning." In April Mr Ross Goobey warned that scrapping the ACT tax credit would lead to a sell-off in the UK markets.

Andrew Black of Standard Life said: "The traditional statement that equities offer the best return after five years is now more marginal. People will be rebalancing their portfolios, and the change will be noticeable."

Equity strategists said on Friday that there would be a trend away from UK stocks among pension funds, but the unwinding would happen slowly. "Fixed-income stock is looking much more attractive, but it is not like flicking a switch. Any shift away from equities will take time," said Richard Kersley, equity strategist at BZW.

More volatility is expected to be added to the market next week by the distinct prospect that the Bank of England will raise interest rates by half a percentage point. A rate rise of this magnitude is seen by the City as the only way to damp down the high levels of consumer demand in the economy, which the Chancellor estimated in his Budget speech to be growing by 4.5 per cent this year and 4 per cent next year. It will comfort some economists who are concerned about inflation, but is likely to depress the markets, with manufacturing companies and exporters hardest hit.