When the former Chinese premier Zhou En-lai was asked about the effect of the French Revolution on the world, he is famously said to have quipped that it was too early to tell. His words come to mind when we think about the effect of the euro on equity markets. The last six years have not exactly been typical. To pass judgement on the euro, we need more time in a more normal environment – one devoid of bubbles and their after-effects. If compelled to respond, we would argue that, beyond some local effects, the euro hasn’t made much of an impression on markets in aggregate. Given the nature of equity markets, perhaps we should not even expect it to.
The last six years have been remarkable and hardly an ideal testing ground. When the euro first appeared, we were living through the closing stages of the biggest equity bubble we are likely to witness in our lifetime. Tulip mania it wasn’t, but it was not far off. Since then, we have been navigating through the bursting of the bubble and the global lowering of interest rates that followed. Normal equity markets may be an oxymoron, but even in the context of the volatile, fat-tailed distributions that equity markets represent, the last few years have been exceptional.
One major reason for downplaying the effect of the euro is that today’s global markets act as one. The euro has not changed that: just compare the MSCI Europe with the S&P 500 and the MSCI World over the last 35 or so years.
This degree of correspondence is hardly surprising given the globalisation of capital and the increasing concentration of markets. Stock markets exist because companies need to attract capital to grow. This capital is allocated by investors whose opportunity set is increasingly global and across asset classes. Fear and greed infect these investors at the same time, altering their preferences. All companies – no matter where they are quoted – tend to be affected by these preferences at the same time.
On the same theme, it is worth also looking bottom-up at the companies that drive national indices. A quarter of the market capitalisation of the MSCI Europe is made up by just 5% of its constituents. These companies have had one mantra over the last 35 years: scale. You need to be big to compete – or, more cynically, company executives need to rule over a bigger empire. The days when BMW simply exported BMWs from Germany, and therefore could be crippled by high exchange rates, are gone. Nowadays the company dances to a more brand- and market-diversified, currency-hedged tune. This tune is one that the euro - even given more time - could only ever change around the edges.
You may be tempted to highlight that the euro served to lower interest rates in the more marginal countries; surely this had an effect on valuations? In fact, we don’t see much evidence of this in aggregate. Looking at the market valuations of Portugal, Italy, Greece, Spain and Ireland and taking the dividend yield as our yardstick, it’s only in Spain that yields are lower today than 10 years ago (ie markets are more highly valued). It’s not supposed to be like that: popular perception has it that when nominal rates drop, markets tend to rise. We say popular because in theory markets should be left unchanged: nominal rates drop in response to lower inflation, which in turn slows earnings growth; the lower growth in theory cancels out the lower rates,
The reality is that markets tend to rise when rates drop either because investors disregard the effect of inflation or because when nominal rates drop, so do real ones. For example, in Italy take inflation away from the 10-year bond yield in the mid-1980s and you will see a real rate of somewhere between 4 and 6%. In the late 1990s this dropped to between 2 and 4%. The euro boosted the Italian economy’s credibility. Markets should have gone up. They didn’t, which means that either the euro has not driven markets, or that investors are missing a trick. Time will tell.
If, in aggregate, the lower euro rates have made little or no difference, they have had an influence on some sectors. Lower nominal rates boost people’s propensity to borrow, either because real rates are lower or because people don’t fully realise that the lower inflation that brought rates lower will make repayments no less onerous than they were before. Accordingly, the euro’s lower rates led consumers to borrow and spend more, which was a boon to the domestic sector, especially banks. This played itself out - and is ongoing - in the quintet of countries mentioned above. Conversely, the same euro rates were too high for a Germany that was coming to terms with reunification. The domestic sectors there suffered and, as we write, still seem only to be bumping along the bottom.
These local effects cause strategists and economists to declare that the euro heralded the return of country correlations and accentuated relative differences in competitiveness between countries. We find such analysis either loosely connected to the euro or irrelevant to investment thinking. At the time of the bubble, TMT was driven up at the expense of defensive sectors, an effect which then reversed. Around that time, it was all about sectors. Now this trend seems to have partly reversed. Was it actually the euro that made country factors more important or the unwinding of the bubble? Furthermore, in this debate we should not lose sight of the variation between markets in terms of sector composition which further complicates the interpretation of any country data. As for talk of relative competitiveness, we’ve already argued that business is much more of a global affair for those companies that drive equity markets. Besides, it’s the output of companies that makes a country more or less competitive, not the other way around. Knowing about country competitiveness is an interesting big-picture fact for economists, but it doesn’t really help investors pick stocks.
So we doubt that the euro has made much of an impact so far. Given time, we might change our minds. The currency’s lack of impact partly has to do with the structure of markets and indices, a key feature of equity investing today (a structure that investors would do well to ignore). And when we say we might change our view over time, it is because, to our mind, equity investing is all about the long term, over which the noise dies down and fundamentals prevail. To judge the effect of the euro on equities we do not quite need Zhou En-lai’s timeframe, but we do need a longer time horizon in conditions that are more ‘normal’ than those we have witnessed over the last six extraordinary years.