Many of you are underweight in US stocks for fear that the market, which is dominated by big tech firms, is over priced. You might be right. A recent paper by a team of economists led by the University of Chicago’s Amir Sufi shows that low and falling interest rates “disproportionately benefit” superstar companies. This suggests that these will do badly when US interest rates rise, which could drag down the whole market.
This poses the question: would UK stocks be a safe haven in the face of a deflation of US valuations?
Theory is ambiguous. On the one hand, the UK is a very different market from the US. It is dominated not by large growth stocks but rather by mature ones such as Unilever (ULVR), Royal Dutch Shell (RDSA) and HSBC (HSBA). These are not at all like Apple (US:AAPL), Amazon (US:AMZN) or Microsoft (US:MSFT) and so they should behave differently – as indeed they have done in recent years, by underperforming them.
On the other hand, though, a falling US market would be both a cause and effect of global investors becoming less willing to take risk. That would be bad for equities everywhere. So too would be the brute fact that people buy fewer shares generally when they become poorer.
With theory ambiguous we need evidence. My chart provides some. Each point on both lines shows the correlation between the UK and US markets over the previous five years.
It shows that if we take monthly returns the two markets have been highly correlated since the mid-1980s. A correlation coefficient of 0.69 over the past five years implies that if the US market falls significantly then the All-Share is highly likely to do so as well. This isn’t necessarily because the UK market will be dragged down by the US. It’s because the same things are bad for both. Both markets, for example, fell a lot when the pandemic struck last March – and this would have been the case even if there were no direct link at all between the two markets.
What’s more, there have been no periods in recent years when the two markets were not highly correlated with each other. Which suggests there’s little chance of the UK escaping the influence of the US or of the common factors that drive both markets.
If we look at longer-horizon returns, however, we see a different picture. Recently, the two markets have become decoupled, with the correlation between them being less than zero. This is thanks to US stocks doing so much better than the UK. Which is not unprecedented. The two markets diverged in the early 1980s, although the boot then was on the other foot as the UK outperformed the US.
There is, actually, a clear message here. International diversification among developed markets doesn’t work if we look only at short-term returns, because these are often similar: if the US falls by (say) 10 per cent next month it is overwhelmingly likely that the UK will fall too. Over longer periods, however, returns can diverge a lot, which means that international diversification can work for the longer-term investor.
Which isn’t to say it is always necessary. Between 1999 and 2013 the UK and US markets performed similarly. It’s just that diversification protects us on those few occasions when returns do diverge.
So far, I’ve only discussed returns in local currency terms. Which leads to a complication. If sterling falls when US stocks do, it would cushion us from those losses. And recent history suggests this is what happens: sterling has tended to rise when the US outperforms the UK, and to fall when the UK outperforms the US, so sterling returns on the two markets have been less divergent than local currency returns.
Personally, I’m not sure this is reliable as a guide to the future. When stock markets are rising (albeit with the US doing better than the UK) it’s a sign that investors are taking on more risk – and that bids up the price of risky assets such as sterling. But there’s another possible mechanism. A significant fall in US equities could drag down the dollar. That’s partly because demand for dollar-based assets would (by definition!) be falling in such a scenario, but also because a US bear market would change the narrative and pose questions about the general health of the US economy. If this were to happen, UK investors in US shares would suffer a double loss, on both equities and the currency. In which case the safe haven merits of the UK would be even greater.
We have, therefore, reason to suspect that UK stocks could hold up well in the face of falling US valuations.
We cannot, though, be wholly confident of this. Markets are driven by many things other than valuations, several of which would cause losses on UK as well as US stocks – such as a deterioration in the global economy. Being fully invested in UK stocks while US shares are falling would therefore be risky. If you are worried about the US market, therefore, you need decent holdings of safe assets as well – not least of which is cash.
