The phrase "fog in channel, Europe cut off" encapsulates the UK's isolationist view of its position ...
The phrase "fog in channel, Europe cut off" encapsulates the UK's isolationist view of its position in Europe. Nearly 30 years after joining the EU, the debate on its suitability rolls on and the progress towards possible membership of the single European currency divides the country if opinion polls are to be believed. Some people even feel we should join Nafta rather than the euro.
Until recently, one would also have added micro and macroeconomic management to the differences between the UK and Continental Europe. At the same time as Mrs Thatcher was carrying out her supply side revolution, Mitterand was carrying out Keynesianism and nationalising the economy. However, the past 10 years have seen major changes in both these areas. The disciplines of Maastricht, exhorting governments to reduce budget deficits, government debt and inflation as a prelude to membership of the euro, put in place a Thatcherite framework policy, whether on purpose or not.
Privatisation, sometimes referred to as the UK's greatest export, has been firmly embraced on the Continent. Coming at the same time as the opening up of the Eastern bloc, with its reservoir of cheap labour, these developments have meant that the European corporate sector, traditionally run on stakeholder lines, has also moved to a model closer to that of its American and UK counterparts. This means profitability and shareholder interests are now promoted more significantly than before.
In equity investment, these factors have led to the prevailing tradition of UK investors accessing Europe via free-standing Continental funds set alongside their existing UK equity funds. The Continent has been considered as a diversification away from the UK, in the same manner as investment in the US or Japan.
There has been extremely limited use of Pan-European vehicles to effect this and, given the historical differences between the economic models (not to mention exchange rate volatility), there have been strong reasons for this. The question now is whether this is still valid, given the greater degree of economic and corporate convergence referred to above.
What is certainly clear, if possibly unsurprising, is that these more recent developments have brought about a large degree of convergence in the investment arithmetic governing equity and bond markets.
Our forecasts at Rothschild suggest Europe ex-UK is selling on a prospective price-earnings ratio of 20.3x compared with one of 19.3x for the UK. On earnings growth, we forecast 11% from the Continent and 8% from the UK for this year. In bond markets a similar trend has been discernible. The UK, traditionally an inflation and currency sinner, has, even without the disciplines of Maastricht, moved to a position where its 10-year bonds yield a mere 9 basis points more than Germany, where the currency has never been devalued since the Second World War.
There are still clear differences in the structure of the respective equity markets. While European equity markets have deepened to some extent over the last few years via the onrush of IPOs, there remain vast tracts of the economy in the unquoted sector.
When one considers sector breakdowns, the UK has higher weightings than the Continent in such areas as pharmaceuticals or retailing, and lower weightings in areas such as telecoms, financials and, notably, in IT hardware. Thus the purchase of separate UK and Continental funds might lead one to pursue different themes, other things being equal.
The UK has a greater tradition of being a more defensive market, as shown by its high weighting in retail banks, oil, and pharmaceutical stocks, and its proportionally lower weighting in the technology arena.
Obviously, these issues can be circumvented: the purchase of separate UK and European funds, carefully monitored for the sector exposures within each fund, can presumably get the investor the sector exposure, and indeed the required asset allocation between the UK and Europe. Such a policy might also allow the investor to access strong performance in each area by using different investment houses for the two products, an approach that some investors might prefer.
This method of gaining exposure to UK and Continental markets is in no way invalid: by using this route, investors are gaining Pan-European exposure after all.
What is important for investors is that, having presumably made the decision to diversify from a UK base, this method means that they will still have to make the asset allocation decision of how much UK and how much Europe for themselves. Such an approach will also entail more monitoring, especially if different houses are used to ensure the portfolios remain well diversified by sector.
This is especially relevant in a world where there is strong evidence that all equity markets, and indeed cross border sectors, are becoming more closely correlated with each other. As a result, the investor will need to check that the implied sector weights within the different funds are as required.
One possible advantage, depending on the investor's viewpoint, of accessing UK and European investments by a single Pan-European vehicle, is that those latter decisions on asset allocation and sector mix have already been taken for the investor by the portfolio manager.
Assuming the fund is being managed in a well-diversified manner, the risk of exposures doubling up between different portfolios is removed and sector and country exposures are easier to monitor.
While Rothschild firmly believes that sector correlations in many sectors will continue to rise, there are still several sectors retail, utilities and even banks where domestic country factors can have a strong influence on share price performance and close monitoring is necessary.
So, European investment need not always be Pan-European and there are pros and cons in both the methods we have outlined above for diversifying into Europe.
Different investors will have their own preferences for the method they choose, but there are some other wider issues. A very significant body of investors, including the vast majority of those in the US and Japan, have always looked at Europe from a Pan-European point of view. As a result, it is equally vital that any UK investment house has the capability to monitor Pan-European and also global comparisons of stocks.
At Rothschild, we have made recent additions to our investment team in London to put us in an even stronger position to carry out such work.
Moreover, such factors mean that UK investment houses will need to develop such capabilities to protect their existing book of UK and European business. In addition, they need to grow their client base for UK and European funds outside of the UK, even if UK clients continue to feel more comfortable with what one might call the traditional model.
In the short term this issue might be of greater importance in the institutional rather than the retail market.
However, as European investors diversify away from their traditional large weightings in cash and bonds into greater equity holdings and, within that, into more international equities, they will represent another significant group of investors viewing Europe from a Pan-European perspective.
One final point probably needs to be made.We have referred above to the greater correlation of the UK and European markets, but it goes without saying that this is largely because of both markets' greater correlation with the US market. Pan-European investing is merely a subset of global investing after all.
With the market economy now accepted across the Western world, and sector correlations rising on a global basis, investors will no doubt soon be debating the merits of investing in global sectors, in which Pan-European investing is but a part, albeit a significant one.
David Ballance is head of asset allocation at Rothschild Asset Management
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