(Schroders) - Russia’s invasion of Ukraine has had a devastating impact on the daily lives of the people in Ukraine and sent shock waves across the world. In the past, during periods of market turmoil, investors have sought out the US stock market. So far this has been repeated, but is it set to continue?
Before looking forward, we need to understand what has happened in the past. For most of the last decade, the superior performance of US equities has been in an environment where US economic growth has expanded at a faster pace than other developed markets.
But US dominance has been less about domestic growth and more about the rise of the growth stocks, namely the technology (tech) companies. Both the US and tech have greatly benefitted from lower borrowing costs brought about by record low government bond yields.
This is thanks to the massive injection of monetary stimulus into the financial system triggered by the global financial crisis (GFC).
Before the tragedy in Ukraine, US bond yields, particularly real yields, had started to rise. This hit the US and tech stocks and spurred investors to seek non-US markets with a bias towards the value sectors. But not all markets have benefitted from higher yields and the performance of emerging market (EM) equities has been hindered by the strength of the US dollar.
With the world now turned upside down, the US dollar has rallied and bond yields have retreated. Investors may continue to seek out US equities in these uncertain times.
Has domestic growth mattered to the dominance of US stocks?
Several past studies, such as those undertaken by Elroy Dimson et al, have shown that there is no clear relationship between equity returns and growth in a country’s gross domestic product. But this does not mean that economic activity is irrelevant. Growth has a bearing on corporate revenues and earnings.
Over the past 10 years, the outperformance of the US market has coincided with superior domestic growth. Chart 1 shows that US economic activity, tracked by purchasing managers' indices (PMI), has outpaced the developed world over this period. US earnings (based on the 12-month trailing earnings per share) also grew at a rate of 7.5% per year compared to only 1.7% in the rest of the world.
Looking ahead, we expect activity in the advanced world to expand at a similar pace to the US. But there remains high uncertainty over the unfolding crisis in Ukraine and its economic implications. Although the advanced nature of the US economic cycle means that growth elsewhere could catch-up in the coming years, which suggests a more supportive backdrop for non-US equities.
How has US dollar strength driven performance of non-US equities?
The relationship between the US dollar and the performance of EM versus the world has generally been negative over time (chart 2). Although correlation does not necessary imply causation, EM countries are particularly dependent on foreign inflows, as we have seen by the recent sanctions against Russia.
When investors are faced with an environment characterised by lower interest rates and bond yields, they are incentivised to move up the risk spectrum to seek assets that provide higher returns. This is particularly powerful for EM equities due to the larger share of foreign investors.
As US bond yields rise, this tends to make the dollar more attractive. This reduces foreign inflows to EM and makes it more challenging for these economies to fund their current account deficits and dollar-denominated debt.
By contrast, the UK stock market has generally benefitted from a strengthening US dollar. UK companies get a large share of their revenues from overseas in foreign currency (the FTSE 100 generates over 70% of revenue overseas). So, dollar strength means that the earnings of UK companies rise when it is translated back into pound sterling.
But the relationship between the dollar and US equities is less straightforward. The slightly negative correlation suggests that a weaker dollar is positive for the market via overseas earnings received by multinationals. But US equities are more domestic in nature such that only 40% of their revenue comes from overseas.
Superior performance of the US market over the last decade has also happened during a period when the dollar and domestic growth have been strong.
So, the strength of the dollar seems to be more important to the well-being of non-US equities. The Federal Reserve is further along in terms of policy tightening compared to central banks in the other main developed markets. With the world and market in a spin from the Ukraine-Russia war, the dollar could remain firm. This would likely benefit the equity markets in the developed world at the expense of EM.
Performance of regional equity markets has been driven by sector dynamics
The tech sector has become key to the strength of US equities, which now accounts for 30% of the market (chart 3). This compares to the MSCI UK index, which has less than 2% exposure to tech and a greater weighting towards financial and energy stocks.
This is important as the overall performance of the market is dependent on the sensitivities of the individual equity sectors to higher borrowing costs.
Lower US government bond yields, specifically real yields, benefit sectors such as tech and consumer discretionary, which are more sensitive to the borrowing costs. Chart 4 shows that the tech sector is the most negatively correlated with US real yields (measured using 10-year inflation protected Treasury bonds).
This contrasts with the financial and energy sectors which have outperformed when real yields have increased. In addition, the correlations between the returns of financial and energy companies with real yields have turned even more positive over the last five years.
The significant weighting towards the tech sector has meant that US equities have tended to benefit from the fall in real yields (chart 5). Instead, countries such as the UK and Japan, which have a larger exposure to financials, energy and industrials, have typically struggled in this environment.
That said, the turmoil from the Ukraine situation has resulted in a sharp rise in energy prices, which has boosted the UK market as it has greater exposure to energy stocks.
In conclusion, given the Ukraine crisis and with real bond yields being pulled lower, the heavy tech exposure of US equities means that investors may continue to seek comfort in this market. Meanwhile, a stronger US dollar is likely to have a bigger impact on foreign investors’ holdings of EM equities.
This is because they tend to underperform the global market as the dollar strengthens.
When the world can move on from the devastating tragedy in Ukraine and real yields do rise, investors may need to see a more positive growth outlook compared to the rest of the world to hold onto US equities.
But this could prove to be challenging given the advanced nature of the US cycle and given growth elsewhere is expected to catch up in the coming years.
By Tina Fong
March 9, 2022
