Personal finance: European futures
The Jonathan Davis column
Saturday 24 January 1998
Both assumptions are no longer so easily made. It is now widely accepted that monetary union will go ahead on 1 January next year.Whatever your views about the wisdom of the undertaking, or the probability of its success, there is no longer any practical reason for pretending that it won't happen.
And while the Government has at last set out its formal position on the issue, saying it won't join before the next election, do not be misled into thinking that the UK will not be affected. It is clear that economic policy is going to be shaped in a way that leaves Britain in a position to become a member relatively soon after launch - and to a large extent that means behaving as if we were already in it. Interest rates, taxes and the exchange rate are all going to be treated with more than half an eye on what is happening in the rest of Europe.
There is a whole series of possible effects for investors, some more easily predictable than others. I am grateful to Mark Howdle, a market strategist at UBS, the Swiss-owned broker and investment bank, for a lucid guide through the thickets. In the currency and bond markets, the impact of EMU has already been largely anticipated. Bond yields in all the main European countries have moved progressively closer together. Once monetary union is complete, not only will currency risks within Europe be eliminated but one can safely expect bond yields to remain clustered in a fairly narrow range.
When it comes to stock markets, it is helpful to distinguish between the effect (1) on company profitability; and (2) on investor behaviour and preferences. Mark Howdle's view, with which I agree, is that monetary union is likely to be a powerful further catalyst in changing the way that European companies are run and financed. There will be more focus on delivering shareholder value, greater accountability and a loosening of the cosy ties between managers and the banks (and governments) which have provided the bulk of their capital over the years. Tax rates are also likely to converge. There will also be a procession of new companies raising capital from the equity markets, either as privatisations or new issues.
The trend towards industry consolidation in several sectors will continue. UBS believes banks, defence, engineering, food retailing, paper and telecoms are the sectors with the greatest activity potential.
All of these moves are broadly positive for most European stock markets. They imply higher rates of return on assets, more investor-focused managements, lower tax rates and better use of balance sheets to leverage returns. This is not a new trend, in the sense that European stock markets have been an attractive source of returns for some time. The average unit trust invested in Europe has outperformed all but one other sector over both three and five years, despite indifferent European economic growth. Falling interest rates have been one big factor in driving up stock market valuations in Europe. But while that effect may now be coming to an end, the one-off gain from structural change within companies and industries is set to continue. It is logical to expect it to accelerate once monetary union occurs.
At the moment, most investment institutions across Europe invest predominantly in their own local markets. European portfolios tend to be both parochial and bond- rather than equity-dominated. The shares they own reflect the balance of their country's industry: disproportionate numbers of engineering companies in Germany, lots of energy companies in Holland and so on. Will that too change once monetary union takes place? Yes, for sure.
The obvious result will be for investors across Europe to start building portfolios that are more diversified geographically, have a larger equity component and more closely mirror the industrial character of Europe, rather than their own national markets. That is positive for shares as a class. How quickly will change happen? It could take years. For UK institutions, the pressure to diversify will also be there, but the equity component of the average pension fund may fall rather than rise. The big drug, oil and financial companies which dominate the UK market are likely to be much in demand.
The bottom line is that the impact of monetary union on both European companies and markets could be profound. As my chart shows, returns from European stock markets have started to converge in recent years. But the returns within sectors, viewed from an all-Europe perspective, are as wide as ever. It means, suggests Mark Howdle, that whereas in the past the big decisions to get right about investing in Europe have been which country to buy, in future the biggest returns will come from finding the most attractive companies within each industry sector in Europe.
That feels right to me. Provided that monetary union works as hoped (and that does remain a big if), the prospect of further structural change should mean Europe remains an attractive place to go looking for value.
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