Historically, the UK equity market has outperformed the US, but after 30 years where the States has dominated the global economy, a return to the old world seems rather far-fetched. Yet economic conditions could be lining up for this reversal to take place, according to Gervais Williams, head of equities at Premier Miton Investors.
He says governments that have had an “easy ride” for years, “largely unconstrained in their ability to spend”, will have to be far more frugal now they are under more pressing economic strains. Interest rates could stay at higher and more unstable levels than investors have grown used to, which would be bad news for the growth companies that account for most of the US market – but perfect for the defensive income stocks that populate the UK stockmarket.
“There’s been a virtuous cycle where growth companies like Tesla have generated absurdly strong returns and as their index weightings have become larger, passive funds have been buying loads of them, too. That is great when cash is near unlimited, but there are so many more issues now that will put inflationary pressures into the system and constrain market liquidity,” Williams adds.
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Growth companies excel when rates are low and are able to raise large sums of money to expand but struggle when capital is less readily available. Dividend-paying companies, on the other hand, often have a surplus of cash to fall back on. This could put them in a much sturdier position than growth companies, whose share prices are based more on their expected future earnings rather than their current balance sheets, according to Williams.
“The UK market is dominated by capital intensive businesses that don’t just produce a return in terms of capital growth, but produce a stream of income too. When you have tough economic conditions, interest rates are high, inflation is going up, margins are being compressed and you’re generating surplus cash, then you’re not likely to go bust in a hurry.”
And this change in the economic landscape may already be underway despite a lack of action from investors, says Williams. “There’s an assumption we are just going back to normal, and the normal has been where we’ve been for the past 30 years. But actually, that’s the exception.”
The power of currency
The US’s lead against the UK began in the early 1990s when its historically volatile inflation rates that had held it back became comparatively stable, but it has not been plain sailing since. US shares outperformed sharply in the 1990s and 2010s, but were beaten by the UK for much of the 2000s, namely due to currency, according to Polar Capital UK Value Opportunities manager George Godber.
And like Williams, he anticipates the US government will be under heightened monetary pressures over the years to come. “The US had $35trn (£26.6trn) of debt and it adds another trillion of debt every 100 days at the moment. You almost can’t get your brain around that. But if you’re printing that amount of money, it tends to devalue the currency,” Godber adds. “And whoever gets in – Democrat or Republican – they’re both going to keep spending like crazy, and I think that will come at the cost of a weaker dollar.”
Self-help
The prospect of the UK outperforming the US again may excite some investors, but it will take a long time for the cycle to play out, says Williams. However, he explains there are ways domestic investors can start boosting the UK stockmarket today.
Investors have been withdrawing money from their home market for the past few years, with £25.6bn exiting UK equity funds in 2022 and 2023 alone. One might assume this mass selloff would lead to negative returns, but the FTSE 100 has still made a 31.3% return over the past three years – not far off the S&P 500’s 34.9% increase.
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“But what’s more important is that because UK companies have been buying back shares so aggressively, the FTSE 100 has actually broken out on the upside despite local investors selling hand over fist. Now that’s a very unstable – but very exciting – equilibrium, because if the UK stockmarket is growing despite all this selling, then all it takes is for people to start selling less for it to grow even faster. Imagine if they stopped selling altogether.”
More optimism from UK investors themselves could be enough to improve the market’s performance. That could be exacerbated even further if some of the wealth that has been hoarded in the US is released into the global stockmarket.
Williams says: “If the US gets less hot, the amount of capital coming out of the US and into international markets, particularly the UK, would be phenomenal. Even tiny amounts will make a crazy amount of difference in terms of share price returns.”
This article originally appeared in the September issue of Portfolio Adviser magazine
