The case against American equity exceptionalism

US equity markets have performed very strongly over the past decade. As multi-asset investors, we believe in diversification¹ not just across asset classes, but also geographically: we want to avoid country and regional concentrations in our portfolios.

In many client meetings, I am asked if this approach still holds given the recent performance of US equities, and what to do going forward. Is the US market ‘special’, and can it continue to outperform?

This leads us to a bigger question: how should we think about regional risks in an investment portfolio?

The risk lens

Risk depends on the investor’s reference point or benchmark. An equity investor with a global equity index may find it natural to hold two-thirds of their investments in the US market.

As a multi-asset investor without such a benchmark and a greater focus on target returns, market cap is just one reference point among many for us. As we want to balance political and economic region-specific risks, we favour a more balanced global exposure.

Can the US continue to outperform?

The outperformance of US equities has been spectacular over recent years. Clearly, the strong US economic performance was a key driver, but advocates of US equities would also emphasise the country’s robust institutions and favourable sector split.

However, to my mind there are good structural reasons to believe that this exceptional performance can’t continue:

1. US outperformance is a relatively recent feature. While North American markets have been the top performer in eight out of the past 12 years (2011 to 2022), they only topped the regional equity market ranking twice in the 20 years before that (1991 to 2010)²
2. Dividend growth and earnings growth only explain part of US returns. The strong outperformance is largely a result of US equities getting more expensive, and valuation gains can only ever be a temporary driver of returns.³ Higher valuations for US equities would suggest lower trend market growth going forward, as equities will struggle to exceed ever-increasing expectations
3. Markets are, for the most part, efficient. Long-term analysis⁴ shows that there tends to be an initial period when disruptive industry or country news is priced in. Thereafter, we believe investors shouldn’t expect to be rewarded for owning such favourable exposure

The fight against recency bias

As is often the case when making investment decisions, it is hard not to be influenced by recent performance. However, the case for diversification – across asset classes and also across regions – remains strong in my mind. It is backed by financial theory and decades of historic data.

This blog is an extract from our latest AA outlook. Read the full Q4 AA outlook.

1. It should be noted that diversification is no guarantee against a loss in a declining market.

2. Source: Bloomberg’s analysis of annual returns between 1987 and 2022.

3. See the analysis of regional equity returns in LGIM Blog – Return of the 'cult of equities”?

4. See, for example, the Credit Suisse Global Investment Returns Yearbook 2015.