A US vs UK as­set al­lo­ca­tion model

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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



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.

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