Chris Nowakowski gives his views on what lies ahead
The arrival of the euro will be the catalyst for a financial 'Big Bang' across the 11 founding 'euro' countries. It will cause serious structural changes, specifically in the financial sector: the weak and the small will, even more than expected, be devoured by the strong and the large.
In the process, the euro will cause both structural and portfolio rationalisation across the euro-leaders, most immediately in their capital markets. The role of banks will diminish and so will their numbers. Foreign asset managers will begin to pay attention to euro portfolio investment flows, at first on the debt side, but increasingly on the equity side, as the euro-leaders equitise their assets.
A single euro monetary policy will inevitably have unequal economic effects on the 11 euro-leaders (called 'asymmetric effects'). These impacts will be cushioned by regional fiscal and/or financial support policies, such as tax-induced labour mobility. Overall, euro-leaders will move to fiscal convergence at a national level, but fiscal divergence at the local level to increase corporate and personal mobility, strengthening the euro.
We will see massive privatisation and institutionalisation of the savings process, accompanied by increased financial sophistication of both providers of asset management services and their clients, institutional and retail. Small asset management firms will fill niches that surviving behemoths are unwilling, or unable, to fill. Overall the major winners in the near term will be financial intermediaries, domestic and/or foreign. And, as transaction volumes explode, important winners will be purveyors of trading facilities, especially electronic ones.
Movement towards a single capital market will, of course, bring with it reduced cost of capital and improved allocation of capital. However, cultural, regulatory and tax differences amongst the euro-leaders make the actual arrival date of a truly single euro capital market impossible to predict.
In each of the euro-leaders, the owners and the managers of capital will need to re-evaluate their stock-versus-bond-versus-cash allocations. They need to do this domestically, vis-à-vis other euro countries, and versus the rest of the world. Likewise, the rest of the world needs to re-evaluate its euro holdings.
Driven partly by new euro-indices, there will be significant portfolio rebalancing by industry sectors. For example, German portfolios will reduce their overexposure to heavy industries while Spanish portfolios will reduce theirs to utilities.
One currency, one central bank, and one set of 'lower' interest rates will lead to a level playing field for all of the euro-leaders' capital accumulation processes. In turn, this will result in sustained new investment in equities.
There will be a rapid and massive rollout of new products by the euro-leaders, largely equity related, this leading to sustained new investment in equities. A handful of financial service organisations will end up dominating each marketplace. Foreign investment constraints within the euro-leaders, now often expressed in domestic currency terms, will remain in place. However, they will effectively apply only to investment outside the euro-leaders. So we will see a significant increase in international diversification, specifically in equities, both for euro-leaders and others.
Euro-leaders' asset liability modeling and optimisation will be denominated in the euro not in the domestic currency. Again this will lead to increased international diversification, specifically in equities, both within and outside the euro.
The most important effect on euro-leaders' asset management business will be a major reallocation away from domestic fixed income and towards non-domestic equities. Finally, the long awaited equitisation and internationalisation of the continental investment process will come of age.
Many foreign asset managers are now preparing major programmes to capture market share in the euro-leaders' retail and institutional home markets. I believe they will succeed, for the first time, primarily through cross-selling agreements, joint-ventures and acquisitions.
Euro-leaders will change their investment style. On the bond side, as issuers proliferate, credit risk analysis will obviously become a new factor. In both bond and equity investments, longer duration will prevail, in other words, an extension of the investment horizon. In equities, there will probably be more emphasis on future growth and less on current value. There is a 'common wisdom' that euro-equity analysis will become primarily bottom-up: essentially industry/stock selection driven, no longer macroeconomic/country driven.
But some words of caution. Increased industry analysis could result in increased country significance! For exaple, if the euro-leaders fall in love with consumer distribution, guess which country's index goes up? After 50 years, will the country factor in euro-equities disappear overnight? Could this occur simply because of a reduction in currency risk from something already 'small' to 'zero' and interest rate convergence.
Will the correlation of the Portuguese and Austrian stock markets move to one overnight? Or indeed, ever? Does Los Angeles real estate, or even mortgage rates, move in lock step with New York? Some recent historical correlation sensitivity analysis by the University of Liege and Goldman Sachs suggest that the disappearance of country factors in the euro-leaders' equity market analysis is not obvious. Indeed asymmetric impact on monetary policy could increase country risk, and hence drive up the importance of the country factor from today's levels.
If euro-leaders' mandates are defined by the euro, what will they do about the euro-laggard equivalent market cap in the UK, Switzerland, Sweden and Denmark? In any event, it is unlikely that, 'foreigners' will view the euro-leaders as an asset class anytime soon, thereby requiring a specific asset allocation.
As things stand, portfolio accounting systems, valuation practices, client reporting, peer group creation, benchmark choice and, indeed, performance measurement calculations themselves, all present serious problems.
Not surprisingly, the Anglo Saxon investment management mind-set will become the norm, to include the dreaded consultant. Indeed, Henry Kaufman has forecast a new colonisation by Anglo-American financial markets". I am not quite so bearish for the euro-leaders. But complexity, competition and costs will rise dramatically. Services will be unbundled. Margins will be under pressure for money managers.
Chris Nowakowski is president and founder of InterSec Research Corp"