An interesting but difficult question for long-term investors is whether the United States equity markets will continue to perform better than the rest of the world. Based on four scenarios following current trends, a decade of U.S. underperformance seems more likely than we may be prepared to admit.
Based on the premise that the US stock market has outperformed the rest of the world throughout most of the 19th and 20th centuries, the average investor allocates most of their capital to the US. As a result, the US now makes up around 60% of global equity markets.
However, the historical record of US outperformance is not as strong as it seems. In a 2019 research paper, Edward F. McQuarrie shows that the historical record of US outperformance is based on incomplete data from Jeremy J. Siegel, published in 1994. McQuarrie found, for example, that Siegel’s data of US equity markets in the 19th century omitted the largest single stock (the 2nd Bank of the United States - BUS). This stock accounted for 30% of the market capitalization of the US before it failed spectacularly. It is worthwhile to quote McQuarrie in length here:
“To duplicate this omission in the contemporary stock market, it would be necessary to drop Microsoft, Apple, Amazon, Alphabet/Google, and Facebook from the S&P 500; and even these five would not account for as high a percentage of S&P 500 capitalization as did the 2nd BUS at its peak. Omission of the BUS is the single most glaring error I found in Siegel’s stock market sources.”
The bottom line is that while many people believe the US has been the best place for investors for more than a century, in reality, US outperformance is highly concentrated in the period of 1980 to the present. See the graph below:
However, US outperformance from 1980 to the present also deserves some scrutiny. In a 2023 research paper, Michael Smolyansky argues that “lower interest expenses and corporate tax rates mechanically explain over 40% of the real growth in corporate profits from 1989 to 2019”. Put simply, the higher level of interest rates in the US since 2022 is another reason to be very careful about extrapolating the outperformance of US equities into the future.
To assess the likelihood of US underperformance in the coming years, we draw inspiration from a 1999 research paper by Philippe Jorion and William Goetzmann entitled Global Stock Markets in the Twentieth Century. The authors sought to explain US outperformance in the 20th century and identified various scenarios that led to underperformance in other countries: “financial crises, wars, expropriations, or political upheaval”. Based on history, we would add the possibility of a bubble in another country. This results in four scenarios that could trigger the end of US outperformance (in order of probability, from lowest to highest): a bubble in another country, a war, political upheaval, and a financial crisis.
The first scenario is a bubble in another country. This would be similar to what happened in the 1980s with the bubble of Japan (see the graph below), leading to several years of U.S. underperformance. This scenario, however, is the least likely of all because China, the best candidate for such a bubble, is increasingly seen as ‘uninvestable’ due to the unpredictable policies of the Chinese Communist Party and the escalating conflict between China and the US. Meanwhile, India is even less likely to become as attractive for investors as Japan was in the 1980s, as we have explained before.
The second scenario of a war (directly involving the United States) is becoming more likely. However, for a war to have a significant impact on a country’s financial markets, it must affect its territory or infrastructure. This is unlikely in the case of the US because of its geographical distance from its adversaries. Indeed, the US continued to outperform the rest of the world during the World Wars because its territory and infrastructure were relatively safe and unaffected (see the graph below). Nevertheless, the digitalization of warfare could change all of this, as infrastructure can now be attacked from a great distance (in the case of the electric grid, for example).
The third scenario of political upheaval in the US is higher than at any time since the American Civil War, as we witnessed on January 6 in 2021. With the 2024 elections approaching, a similar scenario of political violence is possible. This is what destabilized the financial markets of Spain and Greece in the 20th century. Such a crisis could lead to a more general belief that the US is no longer a “safe haven” for global investors. Another scenario, however, is even more likely and therefore more important.
A financial crisis is the fourth and most likely scenario. In the period from 2000 to 2010, two financial crises triggered a decade of US underperformance (the dot-com crash and the housing market crash). Today, we see several potential triggers for such a crisis. Since 2021-22, the higher levels of inflation and interest rates (which remain unpredictable) have increased the likelihood of a financial crisis in the US. We have already seen significant stress in regional banks in early 2023.
In the coming months, investors will be looking closely at the valuations of illiquid assets such as commercial real estate (mainly offices) and private equity. These valuations will also be important for US pension funds, which on average allocate 34% of their capital to real estate and private equity. In the United Kingdom, some pension funds are expecting losses of more than 60% on the sales of their private equity holdings. Meanwhile, the historically high level of US government debt could lead to an unpredictable crisis, as we have shown before. Taken together, these examples point to an increased likelihood of a financial crisis in the US. Similar to the period from 2000 to 2010, such a financial crisis could trigger a decade of US underperformance.
The growing likelihood of war, political upheaval or financial crisis in the US shows that the world order is changing. Because of this, investors should critically evaluate their most cherished beliefs, such as the consistent outperformance of US equity markets. Above all, beyond the more extreme scenarios like war and political upheaval, investors would be wise to remember that a financial crisis in the US, as a result of higher interest rates, is also a scenario that can lead to a decade of US underperformance against the rest of the world.
