"Integration of bond and equity markets in Europe: The end of the portfolio investment bias?"
Second ECB Central Banking Conference, 24 and 25 October 2002, Frankfurt am Main
The transformation of the European financial system
Press summary - Third session
Jean-Pierre Danthine (Université de Lausanne) and
Kpate Adjaouté (HSBC Republic Bank)
Kpate Adjaouté and Jean-Pierre Danthine challenge the view that the introduction of the euro had only a minor impact on European equity markets. In fact, around the start of Stage Three of EMU the asset management industry underwent a paradigm change, moving from top-down country-based equity allocation strategies to top-down global sector-based equity allocation strategies. Drawing on a battery of new econometric techniques and portfolio optimisation models, the authors show that the euro has made a significant contribution to this development. As it has led to more uniform fundamental economic variables across the euro area, such as a single "risk-free" interest rate (constituted by benchmark government bond yields), commonly low inflation and greater synchronisation of business cycles, the single currency rendered country-specific factors in equity returns less important. This means that portfolio managers can make more money now by diversifying across global industry sectors; diversification across euro area countries has become quasi-obsolete.
This fact is illustrated in the diagram from the paper shown below. It traces the evolution of the dispersion of euro area equity returns over time. The higher a point on any of the lines in the figure, the greater the dispersion and the diversification benefits for equity portfolio managers. The blue line shows the dispersion of country index returns and the red line the dispersion of sector index returns. From the fact that the blue line is above the red line for most of the time between 1973 and 1998, one can infer that significant diversification benefits existed from investing across countries. However, this is no longer true for the recent period of the euro. In 1999 the red line moved above the blue line, indicating that it had become more attractive for portfolio managers to diversify across sectors. The superiority of sector diversification for this period is also confirmed by mean-variance portfolio optimisations. Although this phenomenon has now persisted for more than three years, the authors of the paper also caution that there is no guarantee yet that all these changes will be permanent, since the figure also illustrates the highly time-varying character of equity return dispersions.
However, an even more striking finding by Adjaouté and Danthine is that the pink line in the figure remains well above the other lines for the whole sample, i.e. from 1973 to 2002. This third line describes the dispersion of equity returns across sectors and countries. In other words, whereas euro area asset managers increasingly diversify across industry sectors, they could make significantly higher profits by following a more disaggregated approach, diversifying simultaneously across countries and sectors. Since these results are also confirmed by portfolio optimisation models, the authors discovered an important "puzzle", namely that asset managers seem to forgo these profits.
Another important finding reported in the paper is that the introduction of the euro made benchmark government bond yields significantly less volatile and therefore constituted a "watershed" for public debt securities markets. However, the authors also point to the fact that from a microstructure perspective the establishment of a single public debt market is still not complete and that this fragmentation is costly to treasuries and taxpayers. Moreover, on a more positive note, the euro area seems to fulfil an important condition for further progress in the integration of equity markets, leading to a lower cost of capital for euro area firms and therefore stimulating economic growth.
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