Benchmarks' soft dictatorship
Throughout Euroland, equity markets started the year on a high, as the new trading currency inspired a flurry of activity. Institutional investors have been shifting their investment bases in line with the new regime, rebalancing markets throughout Europe.
The market has enjoyed a liquidity-driven rally in the first days of 1999," says Bernard Coupez of BNP Asset Management in Paris. "It was a short-term answer to the predominant 'euro-phoria' combined with the portfolios' asset allocation rebalancing process towards the new benchmarks, as well as the more classical 'January' effect." The new euro benchmarks look set to exert a major influence throughout the first half of this year, according to market experts throughout Europe. The major institutions are benchmarking themselves against the Dow Jones Euro STOXX 50 and other similar indices, all of which have a strong large-cap bias. The new retail products that are being launched are also aiming at the benchmarks.
"Everyone is paralysed by the benchmark," says Guy Lerminiaux, director of institutional asset management at Petercam in Brussels. "They do not want to underperform the benchmark, so they just buy the benchmark." Coupez calls this effect the benchmarks' "soft dictatorship". The effect of this was noticeable throughout the second half of 1998, and the trend accelerated in the early days of trading in 1999. "It became a self-fulfiling prophesy," says Mike Young, director of European investment strategy at Goldman Sachs in London. "The large investors were getting in early to capitalise on the projection. There was a presumption that being early was a benefit."
It is true that large caps have been outperforming small to mid caps for the past two to three years.
There are several reasons for this, including the introduction of the euro.
Another reason is that trends towards globalisation and greater technology have increased the optimum size of a firm, and this has benefited large caps more. But this market movement overall does have major implications for mid-caps. What is a mid-cap on a pan-European basis may be a large cap on some national markets, such as Belgium. "What has happened in Belgium has happened in other countries," says Lerminiaux. "In 1998, there were important corporate takeovers inspired by the euro. Companies want to grow and Belgian companies were too small to compete." Lerminiaux has noted that investment in Belgian companies that are part of larger groups is on the up, while the smaller companies have been left alone. "It will be some time before the difference in valuation between mid-caps and blue chips catches the attention of the big investors," points out Uwe Ziedler, head of European equities at WestKA in Dusseldorf. "The gap is not big enough yet - perhaps some time towards the end of the year," he says. However, if the market remains focused on large caps for too long, the differential in the cost of capital between larger and small-er companies may be-come an issue. So far there has only been a slight shift in the margin, rather than a major im-pact.
There is agreement that the market will find its own equilibrium toward the end of the year. In general, it depends on how long it takes big institutions to shift their mandates to the new euro basis.
Some early birds are halfway through the process, while others are only beginning. Young points out that asset-liability restraints have changed more dramatically for some nationals than for others. Dutch institutional investors, for example, have been up against an 80% limit on assets in the currency of their liabilities, so they tend not to be well-diversified.
That it is a short-term effect is not doubted. "Following the benchmarks this closely is too mechanical to be justified in the long term," says Lerminiaux. "If valuation is only a matter of being in the index or not, then there is something wrong with valuation." In the meantime, Cou-pez notes that investment in equities will continue to increase as "private savings continue to shift towards equities and there is further development of funded pension schemes within the EU". There are also some major opportunities out there. As has been noted, some blue chips are currently over-valued while small and mid-caps are overlooked, and often better valued. Less prominent national markets that are now part of the euro-zone, such as Belgium, will also be attracting more attention. "There are a lot of people who have never invested in Belgium, particularly the Italians, Germans and Spanish," says Lerminiaux. Coupez estimates that other "potential winners" include Italy and Spain. Sectors viewed favourably at the moment include telecoms, pharmaceuticals and life sciences and banking."