The All-Share index has fallen to its lowest level relative to the S&P 500 since 1976. This poses the question: is there any hope that this long underperformance will soon cease?
To answer this we need to know what, if anything, is associated with the relative performance of the two indices and, better still, whether there are any factors that can help predict it.
Luckily, there are a few. Taken together, these can explain around half of the substantial variation in annual returns on UK equities relative to US ones since 1990. These factors are:
- US industrial production. The faster the US economy grows – and by implication the faster the global economy grows – the more the US market outperforms the UK.
- The US dollar. When sterling rises against the dollar, the All-Share index tends to underperform the S&P 500 in local currency terms. One reason for this is that a weaker dollar reduces the sterling value of UK companies’ overseas earnings. This implies that the variation in relative equity returns in the two countries is smaller in common currency terms than it is in local terms.
- Valuations. A high dividend yield on the All-Share index relative to that on the S&P 500 predicts that the UK will outperform the US, as you might expect.
- Yield curves. A steep US yield curve (with five-year yields well above the Fed funds rate) points to the S&P 500 underperforming the All-Share. And a steep UK yield predicts that the All-Share will underperform. This is perhaps because the yield curve is a measure of economic optimism – an expectation that economic growth will be strong enough to raise interest rates. If such optimism is embedded in bond prices, it is also likely to be embedded in share prices too. But this means good news is already in the price and so there’s a strong chance that investors will be disappointed.
- Volatility. A high Vix index predicts that the S&P 500 will outperform the All-Share index. This is because (over a 12-month period) volatility tends to mean-revert so that high volatility leads to falling volatility. US shares benefit more than UK ones from falling volatility.
- Commodity prices. The All-Share index does relatively well if non-oil commodity prices rise relative to oil prices. This perhaps reflects the high weighting in the All-Share of commodity producers.
There is something else, though. Even controlling for these factors, the UK has underperformed the US by around 3 per cent a year since 1990. This implies that US shares have been consistently underpriced relative to UK ones.
This might be in part for the same reason that Warren Buffett has done so well. A lot of his success has come because he looks for companies with strong 'economic moats' – sources of monopoly power that allow companies to fend off competition and so translate a growing market into rising profits. Because investors have historically under-appreciated the importance of such moats, companies that have them have been underpriced. And because the US has more such companies than the UK, so US shares have outperformed the UK. This has been strengthened by the fact that the monopoly power of US companies has increased over time.
These factors help explain why the UK has underperformed the US in the past 12 months. It’s because sterling has risen against the dollar; because the US economy has grown nicely; and because, well, the UK usually does underperform.
Herein, though, lies some good news for the more parochial UK investor. All this gives us reasons to suspect that the All-Share might recover relative to the US.
One is simply that UK shares are cheap. The dividend yield on the All-Share index is now above its post-1990 average, while the dividend yield on the S&P 500 is below its average. The UK, then, is relatively cheap. In the past, this has mattered.
Secondly, the US yield curve is quite steep, which suggests a lot of economic optimism is in the price. Unless we see very strong growth in the US economy to validate such optimism, there is therefore a risk of US shares suffering a disappointment.
We might, however, have a third reason to suspect the UK might outperform. It lies in that tendency for the US to outperform the UK even controlling for other factors. If that does tell us that US shares have been systematically underpriced – whether because of an underestimation of monopoly power or anything else – it poses the question: might investors by now have wised up? We could interpret the US’s recent outperformance as a sign that investors have learned from Mr Buffett about the importance of monopoly power and so re-rated US shares to a level from which they are no longer underpriced.
Behavioural risk – the risk that investors have corrected their past errors – is ever-present. Perhaps it applies here. The possibility that it might materialise gives us another reason to favour the UK.
Now, all this is necessarily tentative. There are a couple of big unknowns: the paths of commodity prices and the US dollar. And of course, all these factors explain only half the variation in the UK’s relative returns (although they seem to do a reasonable job of capturing turning points in relative returns). Nevertheless, it is possible that the All-Share will recover a little of the ground it’s lost in recent years. We should not write off the UK entirely.
