Everything that Converges Must Diverge?

March 21st, 2013

by Eric Schaefer

A decade or so ago, the world's major investment banks reorganized their equity analyst teams. Hitherto, teams had been organized by country; going forward, they would be constituted by economic sector (viz., consumer staples, health care, etc.).

The impetus was the introduction of the Euro: first as an accounting currency in 1999 and then as a medium of exchange in 2002, when the first bank notes and coins were put into circulation. The logic was, the Euro would truly bind together the Common Market, much in the same way the Dollar aggregates the economies of the fifty states.

A common currency would not only make trade among the member states easier, it would also spur cross-border mergers and acquisitions. To the Euro's boosters, even localized sectors and industries such as utilities, real estate and retail would be transformed as investors from neighboring countries rushed in to buy local players to create transnational champions.

A not-unintended consequence of this development was the compression in the range of equity market returns between Euro member states. In December 2001, the monthly return range for the equity markets of the eleven key Euro members (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal and Spain) averaged 21.6%. Five years later, as of December 2006, the monthly return range averaged just 6.5%. In other words, the return differential between the best and worst national equity markets narrowed dramatically. Why? For a very simple reason: investors started to view companies not under the magnifying glass of their local markets but through a European prism.

But this golden age of convergence proved to be brief. The 2008 financial meltdown, and the ensuing European sovereign debt crisis, caused the spread to widen, albeit not to pre-Euro levels. As of December 2012, the average range of monthly equity market returns (for the year) was 14.9%.

What changed? For one, investors realized that a company may be pan-European in the scope of its sales and operations, even though it is still domiciled in just one of the European Union's member states. So, one day, a company conducting operations in Euros might be forced by government action to revert back to lira or peseta. Second, in the event of bankruptcy, local law trumps European law. While there has been some rationalization — to create a common set of standards and rules — corporate bankruptcy proceedings today still largely reflect local laws and institutions.

FIAT S.p.A. offers an interesting illustration of this trend. Including the output of Chrysler, FIAT is within the ranks of the top ten volume automotive manufacturers. In 2012, global revenues topped € 84 Billion based on sales of 4.2 Million cars and light trucks. Only twenty percent of FIAT's sales originate in Europe, the Middle East and Africa (EMEA); of which, Italian sales account for less than one-half of the EMEA total.

Since the 2008 financial crisis, FIAT has gone from being an acquisition target to become an acquirer itself. By re-structuring its operations — spinning off its industrial operations — it created the wherewithal to acquire a position in Chrysler — a stake which it has steadily increased. Today over one-half of its sales originate in North America with another thirteen percent coming from Latin America. Today FIAT is truly a global car company that just happens to be headquartered in Turin, Italy.

But, to investors, this is a problem. And, the reason why country once again matters. In this FIAT is not alone. BBVA and Telefonica are two Spanish firms which have also outgrown their local markets. But, in today's climate, being nominally Spanish counts for more than being global in scope. We suspect this anomaly cannot persist. Sooner or later, what has diverged may once again provide an opportunity for convergence.

Notes on Sources and Methods:

MSCI publishes a range of single country and regional indices. Each performance index (with dividends reinvested net of withholding taxes) is a free-float adjusted market capitalization weighted index which is widely used to track the performance of the equity market of the specific country as well as the Eurozone region. All returns are expressed in US dollar terms.

The monthly return range is the range of the best and worst performing single country in the Eurozone. Returns for eleven different markets (Austria, Belgium. Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal and Spain) were used. The market capitalization weighted composite index for the entire Eurozone region is also shown for comparative purposes.

You cannot invest in an index. Performance shown includes the re-investment of dividends, net of applicable withholding taxes, and excludes any management fees, expenses and sales charges associated with most investment products.

(Sources: MSCI-BARRA; Lipper; AIFS estimates.)

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