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Take note of the euro

On January 1 next year about 14.5bn of euro notes and about 50bn of coins will come into circulation. For now, the UK is a bystander and will have the luxury of watching the eurozone payment system coping with this historic occasion. But in terms of domestic politics, there is no longer the option of being an agnostic.

The election of Iain Duncan Smith to lead the Tory Party and his selection of Euro sceptics to the Shadow Cabinet, must surely sharpen the issue and is likely to polarise the debate.

The tragic events of September 11 and the desire of the EU to offer a concerted response will be seen by opponents of the so-called European super state as a further transfer of sover-eignty to Brussels.

From an investor&#39s perspective, the issues are quite complex.

When should we start to worry about a referendum?

How will markets react?

Are you going to be a beneficiary or a bystander?

First, what view should we take on the timetable? For now I am making the sweeping assumption that Gordon Brown&#39s five tests have been met. It seems to me the tests themselves are sufficiently elastic to allow the case to be argued either way – after all, that was the point in the first place.

But, bear in mind it is not just up to the UK Govern-ment or electorate. The European Commission and European Central Bank must receive an application from the UK for an assessment as to whether the UK has achieved a sustainable level of convergence.

The criteria are broad but look for:

Price stability in relation to euroland.

Bond yield convergence.

Fiscal stability.

Exchange rate stability with the euro.

It would be hard to argue that we have currently failed on the first three but the last point will be entirely subjective. It is also not clear whether we need to be a member of the ERM prior to joining or not.

The Government says it is committed to assessing the five tests within two years of the new Parliament. A referendum would probably then follow within four months.

What is to stop Labour going early and exploit the Tory disarray? However, the events of September 11 have introduced unpredictability and must have put off the day that Tony Blair was going to launch the great euro debate.

With the potential for comic coverage in the tabloid press of the introduction of notes and coins before the end of February when the legacy coinage disappears, the temptation to procrastinate will be great.

Nonetheless, if Tony Blair wants to join and get the currency introduction out of the way and leave breathing space for calling the next election, he will have to schedule the referendum in the middle of Golden Jubilee year.

One assumes he would not call the referendum without thinking it winnable but current polls indicate that success is not assured. Bear in mind that while a majority are currently against entry, most think it is inevitable in the long term.

What rate will sterling enter at? To some extent, the convergence trade has already happened. This is in contrast to 1997 when EMU speculation drove a sharp fall in long rates and a consequent narrowing in the spread over bunds. The prospect of lower rates took sterling lower while boosting equities.

Today, the world looks quite different. Ten-year yields are very close to one another whereas at the long end technical demand in the UK has pushed rates far below those of Germany, posing a real risk to holders of UK paper.

Currently, short rates are 1 per cent apart, adding greater piquancy to the debate over the rate at which sterling might enter. The rate at which Gordon Brown would prefer to enter is likely to be quite different to that sought by existing members. I think it reasonable to assume it would be somewhere below the current Dm3.11.

For equity markets, the emergence of a genuine single European currency has the potential to unleash huge cross-border institutional fund flows – mostly from the UK to the rest of Europe.

The reasons are relatively simple but estimating the impact is more difficult. It is all to do with the relative size of the UK equity market compared with the eurozone and the predominance of equities (especially UK) in the assets held by UK institutions.

If the UK and eurozone markets were combined today, the UK would make up nearly 40 per cent of the index. Yet, on average, UK institutions have perhaps 80 per cent of their UK and eurozone allocation in UK equities.

On the face of it, this would prompt a significant movement of assets for those funds to move to a benchmark weight. But is it reasonable to assume that institutions would imm-ediately give a full weight to eurozone assets before establishing how durable was our membership of the euro?

The answer is probably not. At the same time, eurozone investors will be increasing their weight in equities and would have to come up to the 40 per cent UK weight.

The timeframe is just too long to seek out the usual suspects of sterling weakness beneficiaries and anyway such an approach would be simplistic. The retail fund investor needs to make his own decisions about how to get exposure to the eurozone and the rising cult of the equity there.

Most will already have a UK equity fund, which for this bear market has been quite a defensive investment. But European equities have suffered much more this year than almost any other major developed region.

While UK equities have fared better in the downturn, European equities are likely to outperform next year in the recovery and investors should also benefit from weak sterling versus the euro. The region is now certainly worth a look.

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