A US vs UK asset allocation model

Over the long term, there is no reason why the UK stock market should offer a higher-or lower-return than the US market in dollar terms if the two countries operate in an open system and are similarly (badly) managed. Equally, there is no reason for the US bond market to outperform or underperform the UK bond market since-in an open system-the risk-free rates must be the same. If one market has outperformed the other for a considerable period, capital will begin to flow out of the first into the second, eventually returning the system to equilibrium. So, in the long run the returns of the two stock and bond markets must be the same.

For shares, there are two decision contradict each other:

1) If the US current account is improving as a proportion of GDP, buy US shares, because an improving US current account balance is a sign that returns on invested capital in the US are rising and that international liquidity is shrinking, which is always an ominous signal for assets outside the US. During periods in which the US current account is improving, US shares outperform UK shares. However, the reverse is not always true. UK shares can underperform even if the US current

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can account balance is deteriorating.

2) If the US market is one standard deviation or more undervalued in terms of relative performance versus the UK, buy US shares, and vice versa.

At present, can run into a contradiction between the two decision rules. The US current account is still improving, but the UK stock market is undervalued against the US. However, the relative market momentum is still very much in favour of the US, so the UK’s undervaluation could widen towards two standard deviations, as it did in the mid-1970s and at the beginning of the 2000s. When it comes to bonds, there is just one decision rule, based on the relative valuation between the two markets. Here the reading is much simpler. Since 2005, one should have been in the US bond market most of the time, the exceptions being in 2009 and 2012.

So, in a world with only these four assets (US stocks and bonds, UK stocks and bonds), over the last four years it would have been sensible to have had a portfolio concentrated in US shares and US bonds. The interesting point is that US bonds are probably at the beginning of a long period of outperformance relative to UK bonds, while US shares are fast approaching the end of a spell of outperformance which has lasted more than five years. If the US current account were to deteriorate because of a significant rise in the US dollar, then we recommend selling US shares and buying the UK stock market.

On the other hand, one should continue to run a massively overweight position in US bonds compared with European bonds, since the US bond market is not only attractive on a relative basis, but also offers reasonable value in absolute terms. That is no longer the case for the UK, French or German bond markets.