A convergence between equity and bond portfolio management is anticipated by Ernst-Ludwig Drayss and Bettina Nuerk of Deutsche Asset Management
The introduction of the euro will trigger dramatic changes on the national bond and equity markets and in investor behaviour. Euroland will replace the national markets in EMU. Exchange rate risks will disappear, so country-specific features will lose much of their significance. Investor decisions will increasingly be dominated by other factors. This development will be flanked by structural changes in the markets - not only for investors but also for issuers.
Euroland will become the domestic market
Investors' domestic currencies will be replaced by the euro. As a result, the portfolios of institutional investors, which have for the most part been dominated so far by investments in their national currencies, will focus more on Euroland. One reason for this bias towards national investments is that - in most cases - institutional investors know most about their respective domestic market. For institutional investors, this development is an opportunity and a challenge at the same time. The ability to provide the necessary know-how about Euroland as a single market will be a major key to successful asset management.
But there is another reason for institutional investors' propensity to invest primarily in national markets. Certain institutional investors, for example German insurances and pension funds, are subject to statutory regulations designed to prevent currency mismatching between assets and liabilities. As a result, at least 80% of the investments of an insurance or pension fund in Germany must be invested in the same currency as its liabilities.
Although this regulation never prevented German insurances or pension funds from selecting the countries of the EU - or to be more exact the European Economic Area - as investment universe, they were extensively restricted to investments in deutschemarks. On the introduction of the euro, the 80% matching principle will become obsolete, as will other investment restrictions relating to deutschemarks or other national EMU currencies within Euroland. All liabilities currently denominated in deutschemarks will in future be denominated in euro. Institutional portfolios will become more European, and the differences between institutional investors in various countries of Europe will gradually disappear: The investment universe as well as investment restrictions and benchmarks will become increasingly identical.
EMU will also eliminate a second hurdle which had - at least until recently - confronted insurances or pension funds wishing to invest outside their national financial markets. The currency risks will disappear for ever in Euroland from January 1, 1999. In future, investors will have a broader market for equities and bonds which are all denominated in the same currency.
What does all this mean for the German equity market?
There will be a dramatic increase in the weighting of European equities in the portfolios of German institutional investors. The same holds true for institutional investors in the rest of Euroland. So far portfolios have been dominated primarily by investments in German equities, but in future there will be no reason to limit equity portfolios only to Germany. Quite the contrary: In so doing, investors would for no compelling reason - ie without being forced by supervisory provisions - be robbing themselves of the possibilities offered by Europe. In recent years, the Euro STOXX 50 would have been the more efficient alternative to the DAX based on return/risk considerations. This statement will undoubtedly retain its basic validity even factoring in the changed parameters - above all the introduction of the single currency.
It will, however, result not only in a more European bias for portfolios so far geared to national markets. It is also expected that we will observe a stronger trend towards equity investments outside Europe, since in the future international diversification of portfolios will mainly be achieved by adding investments outside Europe.
For institutional investors the convergence of the national equity markets to a single market will bring trenchant changes - in terms of not only research but also the investment approach. When the euro equity markets becomes the domestic market for institutional investors in Euroland, within this framework it will then no longer make any sense to differentiate investments by country and currency. In the future, country analyses and country-specific sector analyses will, therefore, bring only limited added-value for asset management. They will increasingly be replaced with sectoral and individual stock analysis geared to Europe.
Within the European sectors, investors will have more opportunities to concentrate on stocks in sectors they think have special growth prospects in the future and which were not available in their domestic market - for example Germany. Currency is no longer an issue. Only regulatory differences in the individual countries could still play a role. Equally, investors can focus on companies with higher earning potential than a comparable company from the same sector in their domestic market without being prevented from doing so by currency risks, mismatching regulations etc. For asset management this will bring a process of change, at the end of which research and investment decisions will focus on individual stocks. Country and sectoral analysis will have a support function in such stock picking and will help to monitor risks.
Ramifications for the bond market
Similar to equity investments, the weighting of European bonds in investment portfolios will also increase. But bonds reflect much more than equities the ramifications of the fixing of exchange rates and the introduction of the euro. With the harmonisation of monetary policy and the convergence of interest rates in Euroland, the possibility to generate above-average yields because of different interest rate and inflation developments in the individual countries will disappear. The process of interest rate convergence is basically already completed with respect to the fixing of exchange rates on January 1 1999.
The irrevocable fixing of exchange rates will result in their disappearance as factors determining yield spreads. In future, yield spreads will solely be the result of the varying liquidity of individual bonds and rating differences. Analysis will, therefore, concentrate on the quality of the respective bonds. Active bond portfolio management will no longer be possible without relative value analyses and credit research. To this extent, bonds will also see a shift to a bottom-up approach to complement the top-down analysis of macroeconomic and political parameters which has been the norm so far.
The investment universe for bond investors will expand not only as a result of the fusion of the national markets to form a single euro bond market. There will also be additional paper from the regional and local authorities and from the non-state segment. Compared to the USA ($Ý2,133bn in June 1997), the corporate bond sector in Europe is still very underdeveloped ($242bn in EMU 11 in June 1997). With currently only approximately DM6bn in outstanding industrial bonds, Germany basically does not yet have a corporate bond sector. There is, therefore, enormous development potential here. At the same time, central governments' efforts to consolidate their finances will result in a decline in the supply of government bonds from Euroland.
As for equity portfolios, bond portfolios will be more international in future. While diversification based on return and risk considerations can in some cases take the form of investment in bonds of various issuers in Euroland, they cannot replace the addition of bonds from outside Euroland - from the US or the emerging markets in eastern Europe with the probable future EMU-Ins Poland, Hungary or the Czech Republic.
Major potential in the European financial markets
With EMU, Euroland will become the world's second largest equity and bond market. The gap compared to the US is in both cases still huge. At the end of 1997, the equity market capitalisation in the US was almost $11,000bn. The market capitalisation of the 11 member countries of EMU totalled roughly $2,700bn, that of Japan roughly $2,000bn. The volume of outstanding bonds denominated in the currencies of the 11 EMU countries or in ECU is today almost half that of the dollar bond market.
This indicates that the potential of the bond and equity markets in Euroland is enormous. The markets will grow closer together as a result of the euro and their structure will change on both the investor and the issuer side. Overall, it is expected that the integration effects of EMU will initially be reflected only indirectly in the equity field. Despite the standardisation of the macroeconomic parameters, separating factors such as differing national tax and accounting regulations which will be relevant for the assessment of individual companies will remain for the time being. It is, however, expected that as the national equity markets grow together there will be mounting pressure on the governments of the member states to harmonise the legal parameters for companies and investors at the European level. In contrast, the national bond markets will come much closer together as a result of the harmonisation of monetary and interest rate policy and extensively merge to form a single market. In this single market, German Bunds and French government bonds are vying for the benchmark function.
The demands on asset management will change considerably for both equities and bonds. The focus in equity asset management will be a bottom-up approach focusing on analysis of the individual company and targeted stock picking. Professional asset managers will have to provide the necessary know-how and the requisite resources.
In the bond segment, the restructuring of the investment universe in favour of semi-state or non-state issuers will also trigger a reorientation in the investment approach. The top-down approach - country and interest rate analysis - will in future be complemented by a bottom-up element - credit analysis. To this extent, the transition to Euroland will trigger a certain convergence between bond and equity portfolio management. Cooperation between these segments will intensify, and results of the bottom-up analysis from the equity field will become a factor in the investment decisions of bond asset managers.
The challenges of the future will probably be reflected even more strongly in institutional asset management than in the retail segment, since cultural barriers which could still prevent a European or international focus will be maginalised.
The still underdeveloped market for pension funds in Germany offers major opportunities for asset management in Germany. For the most part, German pensions are based on a state-run pay-as-you-go system. German politicians have recognised the signs of the times. All major political parties support the introduction of company pension funds. One major step would be the introduction of deferred taxation meaning to exempt contributions to pension funds from tax and to tax pension benefits when they are received and available for consumption. That would bring Germany into line with the tax law practices common in most European countries.
Ernst-Ludwig Drayss is managing director and Bettina Nuerk is senior associate director/marketing at Deutsche Asset Management in Frankfurt