The shift from country to sector trends in Europe is one of the most important features of the equity market since the introduction of the euro. In an environment where fund managers are diversifying away from the traditional domestic equity benchmarks and seeking to invest in either Euroland or pan-European portfolios it is a vital consideration.
Clearly, portfolios can be diversified on either a country or a sector basis. However, it is only appropriate to fo-cus on country weights relative to a benchmark if country returns are in fact the dominant feature of overall portfolio returns. The management of active sector exposure becomes in-creasingly important as equity returns become more sector-oriented. Longer term, this has significant im-plications for the creation of sector derivative products versus the current range of country indices and products.
To analyse how this has developed it is possible to examine market and sector returns and determine the degree of returns derived from either Europe as a market or the pan-European sector as an influence.
The best starting point is perhaps to look at how country returns have changed over the past few years and consider how this affects asset allocation. The main point here is really to examine the proportion of a market’s return that can be accounted for by the rest of Europe’s market movement. In the simplest sense, we are testing for how ‘European’ a particular country is. (To do this we look at r squared, which is the degree of movement accounted for by, in this case, the European market; see table 1)
It is hardly surprising in this age of highly integrated equity markets with substantial cross-border investing that equity markets around Europe are highly correlated and tend to have a significant amount of their market movement explained by other markets in Europe. More specifically we can see that France has the highest degree of European influence, followed by the Netherlands and Switzerland. The markets that have the lowest level of European influence are the smaller ones.
However, to achieve a better understanding of how the European landscape has emerged it is probably more informative to consider how the degree of ‘Europeanisation’ has changed over the last three years. This gives a better idea of the dynamics of the market and as to how Europe has emerged as a driving force for local equity markets. It is clear that some markets have become more stable than others but the clear message is that all markets have become increasingly pan-European.
Looking at the individual countries we find that it is the smaller ones that have typically experienced the largest increases in influence by the larger pan-European equity market (see table 2). Interestingly over the past three years the UK, Norway and the Netherlands have seen the smallest change in their level of influence by Europe. The strongest shift in terms of equity market harmonisation has been in Finland, Italy, Spain and Switzerland. In the cases of Italy and Spain it is clear that the euro has been a strong factor in bringing Europe into the equity market equation, whilst the dramatic change in Switzerland show that Swiss equities have become truly pan-European.
It is possible to extend this market comparison and consider not only whether Europe is a single equity block but more importantly whether a separate and distinct Euroland equity block exists. If one looks back six months it was clear that in fact Europe was a more important factor in determining equity market trends within markets in Euroland and there was no clear ‘euro’ effect. Thus just prior to the advent and implementation of the euro it was clear that equity markets were focused on the broader European issue rather than the narrower euro/Europe distinction.
In six months the situation has changed and it is now clear that 56% of Euroland equity markets by value have a stronger relationship to Euroland than Europe. There is the clear emergence of a euro equity block and this is especially important in the context of simply going back one year prior to the actual implementation of the euro when 80% of markets by capitalisation had a higher correlation to Europe than to Euroland.
This year has seen not only the formal implementation of the euro but also the development of Euroland equities as a separate equity class, distinct from pan-European equities. This also means that Euroland equities need to be considered as a clear group requiring a specific asset allocation decision (see table 3).
While we have been able to ascertain that Euroland equities have formed a single block it is worth considering where this leaves the countries outside the euro block. Again an analysis of the relative influence of market and regional returns (in this case we use an ex-Emu benchmark) shows the ex-Emu countries do not form a single equity block in the way that we have seen occur in Euroland. All the ex-Emu countries have a higher relationship to the pan-European equity market rather than as an ex-Emu equity block.
Logically one can assess this on the basis that markets are anticipating a shift with these countries that will occur in the long term. The market has discounted the ex-Emu block and has ultimately taken the view that these countries are not likely to remain permanently outside Euro-land. Therefore, if one asks where the ex-Emu countries are, the answer is that they are part of the broader European equity landscape and not an asset class on their own (see table 4).
Given that it is possible to see that countries are being driven by the larger European/Euroland equity effect, the next issue is whether individual sector returns within countries are also being driven by the larger pan-European sector picture or whether there remains a strong domestic country bias. Again, the best way to analyse this is to consider returns in individual markets and sectors on an adjusted basis, whereby one strips out the contribution from the market/ sector under analysis. Thus for any given sector it is possible to determine the degree to which it is influenced by the movement in its local market, excluding its own contribution to local market returns. Similarly it is possible to determine the influence of the corresponding pan-European sector excluding, for any sector, the influence of its own returns on the analysis.
In simple terms we find that only a relatively small proportion of Europe by value is truly pan-European on a sector basis. In fact only 17% of Europe by market capitalisation has a higher correlation to its pan-European sector than to its local market. As one might expect this is typically concentrated in the sectors that are more naturally non-domestic such as the oil sector, utilities, forestry and paper products and more interestingly banks and in some countries insurance.
Whilst in absolute terms the pure sector effect is at a relatively low level and the country effect is still dominant it is fair to say that this static picture is misleading. The more important trend to capture is the dynamic relationship between countries and sectors. By examining how this has been changing over the last three years, a period during which Emu has shifted from being a mere possibility to a reality, it is possible to observe the underlying relationship between countries and sectors.
Indeed on the basis of observing the change in correlations over time one gets a better picture. Approximately 84% of Europe by market capitalisation has a correlation to their pan-European sector which is increasing at a faster rate than the change it the correlation to the local market. More significantly we can further refine the analysis and establish that 18% of the market has both an increasing pan-European sector correlation combined with a decreasing local market correlation. It is the latter segment of the market that in the medium term is likely to offer the scope for the most change in the coming period of market development as it has already established a breakaway from being purely domestic in focus.
Interesting examples of sectors that are becoming increasingly pan-European and less domestic include the following:
q the banking sector in Spain, France, Belgium and Austria;
q the chemicals sector in Belgium, Italy, France and the UK;
q the construction sector in France, UK, Sweden, Belgium and Italy;
q the utilities sector in France, Spain, Belgium, Austria and Sweden;
q the oil sector in Belgium, France and Austria.
One might assume, following on from the earlier results of a specific Euroland effect that is stronger than the pan-European effect within the euro countries that this should also be the case on a sector basis. In a similar way to the analysis on a pan-European basis we can estimate the results using a Euroland benchmark for both the region and the sectors.
In terms of the absolute level of correlation the result is not particularly exciting, with only 16% of Emu having a higher Euroland sector correlation compared to the local market (it was 18% on a pan-European basis). Looking at the dynamics of this relationship over the past three years shows that only 81% of Emu has a correlation to its Euroland sector increasing at a faster rate than the correlation to the local market. The more significant result is that 28% of Euroland has critical relationship of the increasing euro sector correlation and the decreasing local market correlation, this was only 18% on a pan-European basis. In fact this is probably the key source of the euro-specific effect in terms of becoming a defined asset class.
In a similar way to the Euroland comparison it is possible to analyse whether the ex-Emu block sectors are also changing and to what degree this is happening. As suggested from the earlier results at a country level and market level the effect is small. Looking at the absolute levels of correlation only 2.2% of the ex-Emu block by market capitalisation has a higher correlation to its ex-EMU sector than its local market. So there is little evidence of pure ex-Emu sectors as a group. An analysis of the sectors which have an increasing ex-Emu sector correlation and a decreasing local market correlation shows that only 8% of those in ex-Emu follow this trend. This compares poorly with both the Euroland effect where 28% of sectors are shifting significantly and with the pan-European analysis whereby 18% of sectors are changing on this basis. Overall, this confirms the lack of a definitive ex-Emu block effect at either level.
The broad result from the analysis is that the pan-European effect is not as strong as the pure ‘Euroland’ effect which has become dominant. This represents a significant change over the past year, with the single currency block having a greater impact on sectors and countries than was previously expected. It is interesting to note for the ex-Emu block that the real driving force is the shift to Europe, rather than the creation of a specific ex-Emu block. This shift, coupled with the substantial decline in the importance of the local markets suggests that the market is effectively discounting the likelihood of a long-term block that will remain outside Emu and the focus is pan-European in this case.
It is certainly too early to completely dismiss the level of country impact relative to pan-European sector impact as in general it is clear that the absolute correlations still favour a high level of country impact on returns.
This is based on a talk to the sixth Annual Institutional Asset Management Conference in Frankfurt. Nizam Hamid is director, derivatives and portfolio trading at Deutsche Bank in London