The imminent advent of the euro changes the rules. Its principle implication for country asset allocation is that many continental pension funds, previously confined to laid-down proportions in their domestic markets, will now have the totality of the euro markets within which to address investment opportunity. There is no doubt that the past parochial nationalist approach has constrained international investment flows.
It can therefore be confidently ex-pected that the advent of the euro, which removes the risk premium attached to variable rates of exchange, can be counted upon to produce a flood of cross-border investment. Pension funds will balance their portfolios on a European-wide basis rather than on traditional lines. To this extent we are seeing in Europe the creation of a massive pool of free investment capital.
As happened following the abandonment of exchange control in the UK, we may be sure that a greater proportion of pension fund portfolios will be committed to equities. The argument here is that the diversification of equities by currency, by political risk, when combined with a greater range of opportunity, makes for a higher allocation to equities. This trend can be confidently predicted to affect the continental markets in a positive manner, not forgetting Ireland.
In response to this development, research houses and strategists at in-vestment management houses are giving their attention to a European sector allocation rather than by reference to the past country-based allocation discipline. There is no doubt that sector allocation has become progressively more important over recent years reflecting the integration of economies - both financial and commercial. Yet the trend of the local national stock exchanges remains a powerful influence. One reason for this is that liquidity is not spread evenly throughout Euroland and this differentiation can cause diversity in stock market performance.
A further issue is coming to the fore. If governments are unable to adopt their own exchange rate policy and are forced by the European Central Bank to adopt a common interest rate policy, the only adjustment option left to them is fiscal. This means that countries, instead of conforming to one another in terms of their fiscal re-gimes, as the Eurocrats wish, may actually diverge.
It is nonetheless true that to this point, convergence has proceeded to a greater extent than most predicted. Equities have already anticipated some of the benefits of a larger euro market. Continental management have suddenly found 'religion' in the form of recognising that shareholders' expectations have to be respected if they are to attract risk capital. European managements who had been neglectful of dividends to shareholders have recently declared generous dividends. No doubt the past dependence on banks for provision of capital is seen as being less dependable in the future. It is also perhaps no coincidence that it is the pension funds to whom dividends are particularly im-portant.
Collaboration between the ex-changes in Frankfurt, London and Paris will make a particular contribution to eliminating geographical barriers, and this is compounded by the advances in information technology and electronic trading. Nonetheless it is too early to dispense with the concept of national markets. The lack of full mobility in relation to both labour and capital is one of the factors impeding the development of a unitary European economy that is necessary to support a truly unified stock market.
Bond markets are a different case. The convergence of continental bond markets has been one of the features of the emerging euro scenario. Conformity is assured by the imposition of a Central European bank and a common exchange rate policy. In the past one of the most significant added value contributions in bond management used to be the currency component. Without currency entering into the equation, bond yields conform.
The case of equities is very different. There are wide investment opportunities across national boundaries. There are well-managed and less well-managed companies from which to select a portfolio. The exposure to exchange rates outside the Euro varies from company to company and from country to country. I believe, therefore, that for equities the national basis of quotation will continue to have significance despite the advance of sector allocation. Country allocation will remain an important factor for some time to come.
It is interesting to note that the US, so long a proponent of specialist management for pension funds, has chosen not to go down the industrial sector route, preferring to focus on the more academic divisions of growth, value, big cap, small cap subdivisions. One wonders why the continent of Europe appears to be taking a different path. This may simply reflect the academic bias in the US by contrast to European pragmatism.
What does this mean for the UK? In my view it is positive. Most wise investors include the UK and Switzerland in their mandates and in their benchmarks. They are too important to do otherwise. While the UK may not benefit to the full extent of the euro club members, nonetheless the UK market is the largest and arguably the most efficient in Europe - and will be able to maintain, for the present, interest rates appropriate to its circumstances. Swiss banks and pharmaceutical companies command a world-wide following. If the euro strengthens against sterling as seems possible, British competitiveness in Europe will be enhanced, just as the continental market-place expands.
In conclusion, European markets are likely to be strong in the wake of the dismantling of controls linked to European integration of which the establishment of the euro is a key part. Nonetheless for the time being strategic allocation by national market will continue to play an important, if diminishing role.
John Morrell is head of consultants John Morrell & Associates in London