"The greatest winners of EMU will be global capital markets." Donaldson, Lufkin & Jenrette, 1997

Against all "euro Skepticism," the most significant event of 1999 affecting global capital markets was the introduction of the euro and the creation of the European Monetary Union (EMU). Despite its fluctuations, the new currency, which is now used in all financial transactions between the 11 member countries of the euro zone, has had a tremendous impact on capital markets. This impact will grow in magnitude over the next few years.

By extension, global institutional investors, particularly pension plans, will have to seriously reconsider their asset allocation and the appropriate benchmarks for international portfolios. Not undertaking this task could result in lost opportunities and a lack of risk control.

Had he possessed access to the economic figures and political facts available to us, Nostradamus could easily have predicted that Europe would one day become a large, independent financial bloc with its own currency. Consider the facts: The 15 countries within the European Economic Community (EEC) have a population of more than 380 million and a combined GDP of $10 trillion, exceeding the U.S. population by over 100 million and U.S. GDP by over $2 trillion. EEC countries have increasingly depended on exports, especially to one another, ranging from 25% of GDP in Germany to 75% in Belgium. As a result, currency fluctuations have had a larger impact on inflation, corporate earnings and competitiveness in Europe than in the U.S. (where exports represent only 10% of GDP), making European exchange-rate stability a necessity. A control system, the Exchange Rate Mechanism (ERM), has been in place since 1979 but due to the growth of inter-European trade and exchange needs, the system is no longer able to fix exchange rate issues. Add to this the fact that European countries must maintain huge foreign reserves in U.S. dollars to pay their commodity bills (oil, gas and strategic minerals) and it becomes understandable why Europeans had to further consolidate their economies and exchange rate mechanisms. The solution was obvious: the creation of a European currency. This idea was not new; there has always been a common political will to establish a monetary union with a European currency. This was explicitly outlined in the Treaty of Rome in 1957 and later reinforced by the Maastricht Treaty in 1992.

The euro's decline: So what!
Despite the positive aspects of EMU, it could be argued that the euro's earlier downward fluctuation puts its credibility into question. Indeed, the euro has been sliding since issue to below parity against the U.S. dollar, from US$1.18 in January to below US$0.89 in April. (Note that at the end of June the euro rallied to US$0.97.) Should we be alarmed about its long-term impact? No. First, let us not forget that the euro was arguably overvalued by 12% at its launch to offset any expected devaluation the market could bring, given its lack of history. And the euro devaluation has been more than good for European exports. The depreciation enhanced the competitive position of European exports, which stimulated manufacturing in the core economies of EMU (source: Murray Johnstone International). As well, the decline has nothing to do with the strength of the euro's underlying economies, which are robust and poised to grow further:

"There is strong economic growth and all the economies in the euro zone are better than before the introduction of the euro 15 months ago. I calmly say and agree with the President of the ECB and other finance ministers that eventually the markets will realize this."
-Hans Eichel, Germany's Finance Minister, April 2000.

Furthermore, the decline does not represent a lack of confidence in the currency by Europeans. Rather, it is the direct result of a few factors. Firstly, since growth in the U.S. has been stronger than in the euro zone and interest rates rose faster than in Europe, the resulting interest rate differential did not help to boost the new currency. Secondly, between January and November 1999, the euro was undermined by net outflows of capital ($180 billion for direct investment abroad and $40 billion in portfolio investment, representing an amount larger than the euro zone current surplus of $60 billion). Finally, fluctuation and volatility are quite natural for a new currency, as money managers and currency traders have for any new product a tendency to either "wait and see," or to boost their stock and credit focus and currency positions. Eventually, the euro will climb up again, then stabilize. Remember, it is here to stay!

Equity Markets
In the context of equity stocks, the euro will be a major catalyst for change. Figure 1 shows the amount of euro-denominated IPOs (expressed in $Cdn) by EMU for the first three quarters of both 1998 and 1999. With a rise of 55% in new stock issuance for EMU in less than a year, one may foresee exponential growth of new issues denominated in euros.

The stock market effect is already measurable: In Germany, for example, the number of quoted firms on the Neuer Market (a market for new small cap and technologies stocks established in 1998), climbed from 60 in January to 110 in September 1999. Today, it is over 200. Reasons for the growth are relatively simple.

First, by forcing members to keep their debt to GDP ratio below 3%, an EMU criterion, the euro contributes to a uniform economic stability within EMU, thus encouraging cross-border investments. Secondly, in order to establish a unified market, the common currency justifies the abolition of many trade rules, business regulations and legal constraints with regard to commercial transactions within EMU. This in turn facilitates the creation of public firms, financial transactions and thereby new equity issues. Finally, the euro establishes transparency and exchange stability with all commercial transactions.

Since EEC countries are largely dependent on intra-European trade for growth, regional stability is of utmost importance. For this reason, among others, the various national central banks within EMU will not have much interest in "immobilizing" capital by keeping large amounts of foreign reserves in US$. The US$ in these foreign reserves will gradually be replaced with euros.

By extension, financial uniformity increases liquidity within Europe. Until now, European banks dominated capital markets in the issuance and distribution of fixed income and derivative products. With the exception of large firms, new companies did not have the luxury of raising equity on capital markets and had no other choice but to turn to banks for capital borrowing.

With EMU, everything is changing: Banks are losing their monopoly in security issuance and distribution, and thus a major slice of their currency exchange and capital-raising business is being transferred to global capital markets, where the cost of raising capital for firms is much lower as well as less stringent in terms of legal and administrative constraints.

These new developments encourage firms to finance their expansion through equity issuance on capital markets and no longer through bank loans. In addition, they open the door for them to use industrial consolidation at both the domestic and intra-EMU levels. For example, Mergers and Acquisitions (M&A) activity, estimated at $50 billion in 1993, rose to over $250 billion in 1998 in anticipation of EMU implementation. The math is easy: the more M&A, the more equity activity. In short, pan-European development and industry fundamentals, not national economic conditions, will be the major force behind expected returns for European equity stocks.

What's in it for investors?
This new environment will create huge opportunities for global investors. EMU will offer a substantial pool of stocks while eliminating multi-currency risks. And, with a unique currency for 11 (soon to be 15) countries, the requirements for pension plans' currency overlays are becoming much less obvious. Institutional investors will rebalance their international portfolios accordingly. Thus, the euro will allow for substantial capital transfers between traditional markets, which will further increase liquidity and facilitate stock trading.

Finally, buoyant stock activity will exert pressure for a better equity infrastructure. This is currently happening. Dow Jones has formed associations with German, French and Swiss stock exchanges to launch new indices for large and mid caps such as the euro Stoxx (50, 100, etc.). Other associations are being established, notably in the areas of large caps and technology, using S&P and Nasdaq principles. The introduction of these new stock indices will incite pension plans and mutual funds to review their asset allocations, which will increase demand for European stocks and thereby liquidity on global capital markets. Figure 2 indicates the expected demand for European stocks by international institutional investors.

Bond Markets
The euro will profoundly change the nature of bond markets. Figure 3 shows growth of 92% in bond issuance (both government and corporate) for the first three quarters of 1999 as compared to the same period in 1998, from $360 to $690 billion. This impressive growth does not include the gradual conversion of over $6 trillion of EMU 11 government bonds from national currencies into euros over the next few years. The sovereign debt of EMU issuers will thus become one under the euro. This convergence will equalize the spreads between the rates offered by EMU sovereign bonds and the credit ratings on related individual sovereign issuers. Such an environment should significantly reduce currency risk for bond investors.

Another impact the euro will have on bond markets is directly linked to the size of the European government debt market. This market is already greater than the American treasuries market by over $1 trillion. It will not be, however, as homogenous as its American counterpart, due to regional differences concerning the issuance and distribution of new bonds. Rather, the European bond market will be similar to the Canadian bond market for provincial and municipal issues.

Even more interesting is the change in the nature of "national" bonds. As individual governments within EMU no longer have the privilege of issuing their own currencies on global capital markets, they no longer can monetize their debt either. Currently, there are no sovereign debt instruments issued in Europe. In a way, government debt becomes a mere credit instrument and the European Central Bank is the only government entity that can issue sovereign bonds! By contrast, as it facilitates bond issuance and distribution, this new situation should increase liquidity for these "credit instruments."

Where can opportunities be found?
If national debt is no longer offered on capital markets, one may wonder where bond opportunities reside for foreign investors. Let us be reassured: Sovereign bonds are not disappearing; they are simply transformed into credit instruments which are more easily available on financial markets. Moreover, these "instruments" retain superior liquidity and represent the only European indices with which other bond sectors can be compared. But, as implied, there will be a shrinkage of sovereign bonds.

So where are the true fixed income opportunities? They are with European corporate bonds. This will be the euro's major impact on global bond markets over the next few years.

For quite a few years, the German Pfandbriefe sector (mortgage-backed type of security, issued by regional mortgage banks and fully guaranteed by "Landsbanke," provincial banks legislatively supported by provincial governments) has conquered the German bond market with over $1.5 trillion in circulation. This sector has been so successful that France (Obligations Foncires), Spain (Cedurias Hypotecarias) and Luxembourg (Lettres de Gage) have started to issue the same type of securities in euros. For example, last October three of France's regional/local mortgage banks issued five AAA Obligations Foncires worth around $10 billion, so far the largest issue of Pfandbriefe-type securities outside of Germany. One may expect rapid growth in this sector which, due to superior credit quality (i.e. fully guaranteed) will represent an explicit no-default risk and a highly liquid market for foreign investors.

Despite this growing bond investment opportunity, however, and due to the credit quality, the yield may not be much higher than sovereign bonds. So, where can more aggressive foreign investors find a higher yield? As discussed earlier, the M&A activity within EMU and the euro convergence will radically change the face of the European bond market with the arrival of many high-yield corporate bonds denominated in euros.

Extraordinary growth potential
Potential for growth for the high-yield corporate bond market is quite large, as it currently represents only half of its American equivalent. By year-end 1999, the high-yield market in Europe amounted to $900 billion; in the U.S. it amounted to around $2 trillion.

Those numbers may change rapidly. For instance, during the first two months of 1999, $20 billion was issued in Western Europe, compared to $5 billion during the same period in 1998 (source: Euromoney). The introduction of the euro was the main cause of that growth. As the euro takes ground, the opportunities for foreign investors in the areas of currency exchange and interest rate differentials among the EEC sovereign bonds are disappearing fast. If foreign investors want to maintain higher returns in their bond portfolios, they should seriously consider investing further in euro-denominated high-yield corporates, which are also credit instruments.

In addition, if one considers that around 50% of new high yield securities issued in the world will be denominated in euros (source: Euromoney) and as both issuers and investors look increasingly at deals in a global context, one of the dominant themes in this sector in the very near future will probably be the blurring of the line between the European and American markets. For foreign investors, this will also offer a great fixed income investment opportunity: a bond portfolio including high-yield corporates in two major currencies more or less at parity, lower currency risk, with truly global and diversified characteristics.

The Time to Act is Now
The euro will modify in depth the nature of global investments in terms of demand and supply patterns for both equity and bonds. This financial transformation will be reinforced by the inevitable requirement for EMU members to rely more heavily on private pension provisions rather than government pension schemes. For institutional investors across the globe, this combination will translate into radical changes in asset allocation and the demand for the available asset classes. Such changes will be positive as long as they allow for the establishment of truly global and diversified investment portfolios, including a wider choice of products. Above all, the changes initiated by the euro will allow institutional investors to maximize the expected returns of their foreign portfolios.

If one considers the U.S. situation, we see that the market is overvalued, the economy is overheating, the spending/income ratio is negative, wage pressure is awakening the ghost of inflation, and that the stock market could be subjected to a correction (remember Nasdaq in April!). By comparison, the EMU bloc does not show these alarming figures and offers a relatively undervalued new market with tremendous growth opportunities. It might be judicious to consider a re-allocation of global assets with a bias towards EMU and the euro today.

Franck Perrin is a pension consultant with Royal Trust in Toronto