Country factors could be even more important, argues Kevin Coldiron
Statistics published by Eurostat on July 30 showed that both Portugal and Ireland would fail to meet the EMU inflation criteria if June 1998 inflation data were used. This illustrates an economic dynamic that should make investors cautious about treating European equities as a single market too quickly.
Unfortunately caution-and detailed analysis - have increasingly been brushed aside by investor Europhoria. This is clearly evident in the rush by many securities houses and asset managers to reorganise European equity research and investment decisions along industry lines.
Their logic is that EMU will accelerate the integration of the continent's economies and financial markets. In particular, they expect the single currency to reduce transaction costs, promote price transparency and create conditions where companies can exploit continent-wide economies of scale. They also anticipate diminished market segmentation as cultural and regulatory barriers to investment in other EMU countries fall away. In addition, future corporate earnings will be priced off a common discount rate leading to convergence in price-earnings and dividend yields. Going forward, their argument concludes, there will be no reason other than industrial make-up for investors to value stocks differently across countries.
In the long run EMU should reinforce the trend toward equity market integration. In the short-run, however, the single currency may create forces that accentuate differences be-tween markets and make selecting eq-uities based on country factors even more important. In Ireland and Portugal we are beginning to see the im-pact of a single monetary policy being imposed over a range of divergent economies. Econ-omic activity in these two countries has been very strong; both are now operating well above long-term capacity. At the same time their entry into EMU means that short-term in-terest rates are set to fall. This is likely to fuel further growth but also potentially sharp increases in inflation.
The elimination of exchange rates also means that foreign economic shocks must now be absorbed by the real economy. This could lead to more exaggerated and longer-lasting business cycle swings, making country allocation even more important .
A final note of caution relates to the path that any eventual equity market integration may take. Corporate activity in the past few months demonstrates that integration in areas such as automobile manufacturing and telecoms is already underway. However, outside of these two groups (and perhaps energy and utilities) most European 'industries' behave little differently than random collections of stocks. Evidence of this is provided in the chart. This shows the average correlation between stocks the largest European industries. If industries were truly the most meaningful way to group European companies we would expect these correlation numbers to be much higher - reflecting exposures to common economic and financial risks.
So while a few sectors dominated by larger companies could integrate very quickly, others have a long way to go. In particular, smaller companies and those operating in more internationally segmented industries will retain a high exposure to local economic conditions. For these companies country factors will continue to dominate industry factors after EMU.
Taking all this into account we believe European equity asset allocation should remain balanced in favour of country-level influences. Indicators that capture the primary drivers of relative equity market returns - fundamental asset valuations and investor expectations - should continue to drive these decisions. Ultimately there will be a role for industry-based decision making. In some larger sectors this could happen quickly. The key challenge for investors after EMU is to identify the groupings - industry or country - which remain economically meaningful.
Kevin Coldiron is head of European research, Barclays Global Investors Europe in London