Style is already proving its value in analysing Euro-zone performance, writes Robert Schwob
The euro has been with us for only seven months, but it is already possible to recognise some of the early implications regarding Euro-zone sectors and, equally significantly, Euro-zone styles.
There is clear evidence that style patterns are coherent and relevant across and within the Euro-zone, that they apply within the principal Euro-zone economic sectors, and that they are intelligently interpretable against economic and market fundamentals. However, just like the economies, political environments and markets to which they are related, Euro-zone style factors will require sophisticated, flexible and adaptable forecasting methodologies.
Looking into the euro environment from the perspective of late 1998, the economic foundation for style looked solid and compelling. Across the Euro-Zone:
q Inflation was to stay subdued: so high growth, high capital investing companies would not be disadvantaged; and consequently,
q Interest rates would remain low: so investors could afford to take a longer view and benefit from securities’ growth potential;
q Economic growth would be stable: so the profitability cycle would favour companies with apparent profitability and growth potential;
q Currencies would be fixed regionally: so the larger, more export-oriented, typically growth, companies would enjoy further predictability; and,
q Increased foreign interest: focusing, naturally, on internationally traded brands, which are also, generally, the more growth-oriented companies.
And, sure enough, the expectation of this environment resulted in a very significant and strongly cohesive style reward pattern over the months immediately approaching the introduction of the euro – and for one month into its existence. Large growth stocks performed strongly and uniformly, while small value stocks performed uniformly weakly (see Table 1).
As expected, larger growth companies performed strongly in the buoyant market and, similarly, smaller value companies underperformed very dramatically. And, perhaps even more importantly, the style reward patterns displayed striking similarities within the major euro markets over the five-month period.
But the situation was quickly to change.
Very soon after the New Year and the implementation of the euro regime of preparatory fixed exchange rates, the economic foundation started to shake. Political and military concerns from the Kosovo crisis rebounded across the Euro-zone, highlighting disparate political perspectives and resolve, and souring international attitudes towards the new currency. The suspicions of budgetary crises in Italy, and possibly also France and Germany, and evidence of corruption within the central European administration did not help. And the occasional hint of upward interest rate pressure from across the Atlantic also contributed to change the economic perception, virtually over a month end.
As the euro declined relative to the US dollar and sterling, the European equity markets experienced a bout of unnerving uncertainty, increased volatility, and sporadic weakness. But there was also growing speculation that economic growth could be significantly stronger.
Just as it was the large growth stocks that led the way higher, in anticipation of the creation of the euro, with small value trailing furthest behind, the change of tone brought about a complete reversal in the prevailing reward patterns (see Table 2). Just one month into the new regime, small value stocks were dramatically outperforming (with only one exception) as large growth stocks lagged consistently behind.
But just because the style turning points may be dependent upon changing economic, political and market conditions and may be difficult to predict, it doesn’t mean that style is any less relevant. Striking evidence of Euro-zone styles is available at a deeper level.
Current questions surrounding convergence and the feasibility of managing Euro-zone equity portfolios across broad market sectors, lead towards a more detailed, sector specific analysis of the recent pattern of returns (see Table 3).
The principle observations are immediate:
q There are strong patterns of sector performance across the region:
l In all markets except the UK and Spain, the performance of the financials sector softened consistently from the end of January onwards;
l In a manner which would be consistent with the expectation of a strong economic resurgence and a broad recovery among cyclical stocks, consumers and services stocks softened uniformly across the region. And, with the exception of Spain and possibly Italy, all industrial sectors across the region rebounded very strongly from the end of January.
q There are also strong patterns of style performance across the region:
l Large growth stocks softened from January onwards across most sectors in all European markets. This occurred in 20 of 25 possible situations – reviewing five sectors in the UK, and four each in France, Germany, the Netherlands, Italy and Spain; style data within Ireland are sparse);
l Small value stocks strengthened dramatically within the major Euro-zone markets from January onwards. And, across all markets and sectors, post January performance exceeded pre January performance in 22 of 25 possible situations.
The preliminary conclusions from the first six months of life of the euro strongly favour euro convergence and the relevance of style within and across the Euro-zone.
There appears to be significant convergence affecting equity market sector performance and style reward patterns across the major markets of the Euro-zone. These patterns of performance are interpretable (and therefore possibly predictable) in terms of the market and economic fundamentals. And, clearly, style patterns are coherent across the Euro-zone and within Euro-zone sectors, as well as within the structure of the constituent markets themselves.
It is always advisable to recognise the caveats:
q this has been a period of very dramatic historic change marked by a pronounced reversal in market sentiment and style trends – perhaps less demanding times would give less clear-cut results, and,
q the analysis principally applies to only the two most distinct style clusters – research should also address the detail of the reward patterns of other key factors.
Nevertheless, it is clear that style is rapidly becoming a very rewarding management instrument for European equity portfolios.
Robert Schwob is director of Style Investment Research Associates in London.