Gerald Holtham: Careless euro talk costs livelihoods - the US still matters

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The Independent Online

America's 51st state or European superstate? Sometimes the political and economic choice facing the UK is put in that stark way.

Three decades on from our belated EU entry, markets are speculating whether the UK will soon be committing its future to the Continent by holding a referendum on adopting the euro. If Tony and company persuade us to vote yes, the thorny issue of currency volatility will no longer be a problem for our euro-based trading partners, but will probably increase for dollar-based ones. After all, the pound has been relatively stable against the dollar, in stark contrast to the Deutsch- mark/euro roller-coaster. Which relationships are most important to British business? Can the stock market tell us anything about that?

On the face of it, the pro-euro lobby have an open-and-shut case on the over- riding importance of Europe for Britain's trade. The Bank of England's trade-weighted sterling index has a 74 per cent weighting for Europe against only 16.5 per cent for the US. But this index overstates the role played by Europe. In 1999, some 59 per cent of our goods exports went to Europe (55 per cent to the eurozone), compared to 15 per cent to the US. These figures have been fairly stable during the past 10 years, following a steep rise in Europe's trade share after the UK's EU entry in 1972.

However, traded goods are only a part of the picture. The UK is increasingly dependent on the export of services and receipts of investment income to pay its way. If we take these into account, they bring the proportion of current account credits that come from the eurozone down to 43 per cent, against 17 per cent for the US.

While Europe remains a more significant trading partner than the US, that is not reflected in the stock market. International markets tend to move together, and since the 1970s the correlation of movements across the major markets has exceeded 50 per cent. More than half the movement in the FTSE is due to international influences.

If we consider the period since 1987, the correlation is even tighter. Monthly movements in the UK equity market are 70 per cent correlated with those of other major markets. Unlike the situation in terms of trade, there is nothing to choose between the correlations with Wall Street and the European markets – the US co-efficient is 68 per cent, the European 71 per cent.

From a stock market perspective, what matters is profits. Company data show that a little over 50 per cent of the profits of UK-quoted companies are earned overseas. In contrast to the trade data, the largest slice of this comes from the US rather than Europe.

It seems unlikely these correlations would change much, whether the UK is in or out of EMU. All stock markets are more correlated than in the past; the last 12 months have shown the highest ever correlation between US and non-US equities. As capital flows have been liberalised, markets have become more globalised.

While markets knee-jerk together, however, they can move apart in the long run. The performance gap between the best (Latin America) and worst (Europe) performing equity regions this year is 22 per cent. If we look at the performance of markets in the longer term, however, we discover a funny thing. It is the UK that is the odd man out. Since the 1970s, the cumulative rise of the US and main European stock market indices in local currency has been similar. The UK has performed somewhat worse. That history is made up of two distinct periods. Up to 1987, the UK outperformed, reflecting, perhaps, a recovery of company earnings from the 1970s when profits were slammed by high inflation and bad labour relations. Since 1987, the UK has under-performed, reflecting our slower rate of trend productivity growth. The US and European indices are up by about 13 per cent a year; the UK is up by 9 per cent a year.

The truth is that short-run market movements will be correlated whatever the UK does about EMU. The US will remain the main source of mood changes. But longer-run performance will depend on how the underlying economy fares. The stock market tells us little about which relationships are more important to the UK economy.

Gerald Holtham is chief investment officer of Morley Fund Management

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