U.K. Over U.S. Stocks: A Generational Relative Value Play
Summary
- Prior to Covid-19, U.K. stocks offered a considerably higher dividend yield than U.S. stocks, while the long-term growth outlook for dividend growth was only marginal, suggesting strong long-term outperformance.
- The MSCI U.K. now has an even higher yield relative to the S&P 500, while the growth outlook is much stronger as dividends are set to recover following the Covid crash.
- Even if the current record valuation divergence remains intact over the next decade, U.K. stocks should outperform by a few percentage points a year.
- If valuations were to mean revert so that required rates of return in both markets were similar, the U.K. could easily outperform by double digits for a full decade.
U.K. large cap stocks are priced to outperform the U.S. considerably over the coming years after valuations have fallen to new record lows on a relative basis while the growth outlook for U.K. dividends is stronger following the crash seen over the past year or so. Even if the current record valuation divergence remains intact over the next decade, U.K. stocks should outperform by a few percentage points a year. If valuations were to mean revert so that required rates of return in both markets were similar, the U.K. could easily outperform by double-digits for a full decade.
From A Good Opportunity To A Real Gift
Long-term equity returns are driven by a combination of the dividend yield, the growth rate of dividends, and the price investors are willing to pay for any given level of dividends (valuations). Prior to the onset of the Covid-19 the MSCI U.K. offered a considerably higher dividend yield than the S&P 500, while its long-term growth outlook for dividend growth was only marginally weaker. At the time, I estimated that the U.K. would outperform the U.S. by around 4% per year over the next decade. My expectation was that the U.K.’s higher dividend yield would more than offset the impact of slightly weaker dividend growth, and the U.K.’s valuation discount, reflected in the higher dividend yield, would narrow.
Ratio Of MSCI U.K. Vs S&P 500 Rebased To 1995
Source: Bloomberg
However, the impact of Covid-19 and the associated oil price crash caused U.K. stocks to be hit particularly hard due to the combination of financials and energy sector exposure, in contrast with the tech-heavy U.S. market. Even as U.K. dividends have fallen significantly from pre-Covid levels, equity prices have fallen by even more, causing the dividend yield to rise. Meanwhile, U.S. equity prices have surged despite dividends remaining flat, causing the dividend yield to decline. What this means is that the MSCI U.K. now has an even higher yield relative to the S&P 500 than before Covid, while the growth outlook is much stronger as dividends are set to grow faster following their recent large decline. As a result, I now estimate U.K. stocks to outperform the U.S. by over 9% per year for a full decade.
Anyone looking at the long-term underperformance of U.K. stocks relative to the U.S. may find this forecast hard to believe. The MSCI U.K. has lost almost two-thirds relative to the S&P 500 in total return terms since the ratio peaked in 1995, leading many to extrapolate this underperformance into the future. However, it is exactly because the U.K. has underperformed to such a degree, despite the long-term dividend growth outlooks for both markets being similarly weak, that suggests the U.K. will outperform in the future.
MSCI U.K Vs. S&P 500 Total Return Rebased To 1995
Source: Bloomberg
Long-Term Dividend Growth Outlook Is Similar In Both Markets
From the mid-1990s to 2019, U.K. dividends per share underperformed the U.S. by around 1% per year, which largely reflected the outperformance of the U.S. economy over this period. The onset of Covid caused U.K. dividend per share to crater while U.S. payouts remained near all-time highs. This was largely due to the idiosyncratic factors such as the collapse in oil prices causing U.K. oil majors to slash dividends, and a government mandated pause in dividends by the country’s banks. However, the long-term outlook for U.K. dividends is not materially weaker than for the U.S. Over the long term, both are likely to track the pace of nominal GDP growth as has been the case for decades, which is likely to be only marginally stronger in the U.S. The MSCI U.K.’s higher commodity exposure will undoubtedly mean that dividend growth is more volatile relative to the tech-heavy S&P 500, but the long-term growth outlooks are relatively similar.
Source: Bloomberg
Breaking Down The U.K.'s Future Outperformance
The below table shows the source of future U.K. equity outperformance relative to the U.S., broken down into the dividend yield, dividend growth, and valuation changes. The figures are explained in the text below.
Annual 10-Year Return Forecast For MSCI U.K. And S&P 500
MSCI U.K. | S&P 500 | Difference | |
Dividend Yield | 3.5 | 1.3 | 2.2 |
Real Dividend Growth | 2.0 | 0.0 | 2.0 |
Change In Dividend Yield | -2.0 | -7.0 | 5.0 |
Real Total Return | 3.6 | -5.7 | 9.2 |
Source: Author's calculations
Dividend Yield: The U.K.'s dividend yield is currently 2.2pp higher than the U.S. which should result in 2.2pp annual outperformance in U.K. stocks all else equal.
Real Dividend Growth: U.K. real dividend growth should outperform by around 2pp per year over the next decade as they recover from the impact of Covid, while U.S. dividends stagnate for reasons explained in 'VOO: Don't Expect A Dividend Recovery'. Even in the context of the U.K.'s long-term relative dividend decline, a recovery back to the long-term trend would be enough to see strong multi-year dividend growth outperformance.
Valuations: I expect the MSCI U.K. dividend yield to head slightly higher over the coming years while the S&P 500 dividend yield rises much more aggressively from its current low level back towards historical norms. The impact of this valuation mean reversion should add around 5pp to the U.K.’s annual outperformance over the next decade.
Don’t Underestimate The Impact Of Valuation Changes
The majority of U.K. outperformance over the next decade should come as a result of valuation changes, specifically a sharp rise in the S&P 500 dividend yield. I expect this factor alone to undermine U.S. stocks by around 7% per year. This may seem ambitious to some readers, but it is actually pretty conservative when considering long-term required rates of return.
To see why, consider that even with a 7% annual increase in the dividend yield over the next decade, the yield would still only double to 2.6% by 2031. If we assume the long-term real growth outlook for real dividends is likely to be around 0.5%, the S&P 500 would be priced to deliver real annual returns of just 3.1%, which compares to a post-War average annual real return of 7.4%. In contrast, by 2031 the MSCI U.K. dividend yield would be 4.3% based on a 2% annual rise in the dividend yield from current levels. Assuming a similar real long-term dividend growth outlook, U.K. stocks would be priced to deliver annual returns of 4.8%. If over the next decade the S&P 500 dividend yield were to rise to the level where expected long-term returns were equal to the MSCI U.K., it would have to rise to 4.5%, which would act as a 13% annual drag on U.S. stocks.
Summary
The long-term underperformance in U.K. stocks relative to the U.S. has created an incredible opportunity for future outperformance. The combination of a significantly higher dividend yield and a relative recovery in dividend payments should be enough to see the MSCI U.K. outperform the SPX by over 4% per year. When we add in the impact of dividend yield mean reversion, this outperformance is likely to be significantly greater.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of EWU either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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