Although country allocation still matters within Euroland due to the magnitude and the volatility of government bond yield spreads, its impact on active return and risk is becoming lower because of the general high correlation of interest rate movements. Today the management of country/currency risk is limited primarily to allocations between UK and Europe.
For equities, managers have begun to structure their investment process around the concept of one Euroland region where the sector allocation together with stock selection within sectors has replaced the prevalence of country oriented asset allocation decisions.
Our strategy for Europe follows a structured investment approach that takes these considerations into account. We make separate decisions on the bond and equity part of the portfolio by applying quantitative valuation models to forecast equity and bond returns. Our investment philosophy follows a multi factor approach to exploit different kinds of inefficiencies within and between asset classes. The bond process consists of two parts: we select maturities within Euroland based on the forecast of term structure movements. Fundamental factors in this approach include the change of manufacturing orders, the previous change in US yields, valuation of the stock market measured by the earnings yield and the surprise in inflation. In addition we use technical factors like a three-month momentum and one-month reversal in yields that exploit short term pricing biases in bond markets.
In a second approach we forecast changes in government yield spreads within Euroland. Our research found the relative valuation of equity markets expressed by the change in the earnings yield difference between eg the Italian and German stock market and the current yield spread level between these two countries as the most significant factors. Both sets of forecasts are amalgamated and used monthly in a risk-return optimisation framework to derive optimal maturity and country allocations, taking benchmark weights and transaction costs into account. The graphs show our current Euroland maturity allocation for a bond portfolio benchmarked against the JP Morgan Euro index. Recently low Euro-inflation figures, the reduction in US-yield over the past month together with bad stock market performance are the driving factors for our positive short term bond outlook. We overweight medium and long term maturities and established a slightly higher duration compared to the benchmark. The spread model currently favours Italy at the expense of slightly underweighting Germany and France
Our equity approach recognises the changing environment in Europe and is designed to make specific ‘currency area’, sector and stock specific forecasts which are than added up to give a total stock forecast. While individual country forecasts are derived out of a global context, Euroland is treated as one entity within our European framework. We are therefore focusing on the ‘currency area’ allocation while at the same time we are emphasising the sector component within Euroland in our asset allocation process. We have done extensive research on the relevance of value, growth and sentiment factors for forecasting sector returns across Europe. Our final model includes as factors: the price-to-book ratio, the return-on-equity, the previous US-sector return and a momentum factor. In addition we found the exchange rate and the recent change in commodity prices as valuable factors in forecasting individual sector returns. The final ‘currency area’ and sector allocation is determined implicitly within a stock optimisation framework. Active country, sector and stock positions are individually constrained in this process. Graph 2 shows our sector allocation in a pan-european portfolio. We prefer consumer staples over consumer discretionary. In addition we underweight information technology and telecommunication services mainly due to previously bad US-sector performance. With respect to currency area allocation we are overweighted in Euroland and underweighted in UK.
Andreas Sauer is managing director and CIO at DG PanAgora Asset Management in Frankfurt

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