The importance of investment diversification took on more prominence in recent weeks, as sovereign debt concerns in Greece and other European Union (EU) countries played a role in increasing volatility in the equity and currency markets.

Putnam Europe Equity Fund is focused on achieving diversification by investing in the securities of established large and midsize companies that are themselves diverse, across a range of sectors and geographies.

Concern over the sustainability of sovereign debt in the eurozone has created turmoil in global markets, with some observers speculating that the future of the monetary union is at stake and with the euro selling off sharply against other currencies. The euro, introduced in 1998, is now used across 16 countries where some 320 million people live.

Certainly there are some significant indicators to be concerned about. While Greece has been the poster child for poor fiscal management, Spain and Portugal also experienced credit-rating downgrades from Standard & Poor’s Ratings Service, and have been forced to establish harsh austerity plans to reduce fiscal imbalances.

Market volatility reached new heights in the United States and Europe in recent weeks as the EU grappled with the details of a bailout for Greece. Spreads on EU government credit default swaps (CDS) — a financial instrument used to insure against default — widened, which is a sign of heightened perceived sovereign risk. The euro dropped to a 14-month low on May 6, while the Dow plunged 998.5 points in its largest intraday drop since 1987.

 

European governments were pressured to join with the International Monetary Fund (IMF) on May 10 to craft a US$955 billion bailout for debt-laden Greece and other struggling EU countries, but there remain considerable doubts about the plan’s effectiveness in restoring stability.

The latest aid package helped the euro rebound temporarily, but the currency still remained down 9.4% from the start of 2010 and has lost further ground as investors digested details of the rescue plan.

While the common currency was created to bring nations together, the global recession has highlighted some of the flaws in the structure of the EU. Not least, it is a monetary union with a common central bank setting monetary policy for the entire region, but it has limited control over fiscal policy, and members have pursued divergent strategies over the last decade that were often inconsistent with European Central Bank (ECB) monetary settings. The debt crisis that has emerged in Portugal, Ireland, Italy, Greece, and Spain has created divisions that could further undermine the euro going forward.

While Greece’s bailout package may have a positive effect in the short term, long-term structural issues remain, such as the ability of the troubled countries to maintain fiscal discipline in the face of inevitable social unrest while also boosting employment and productivity.

However, don’t rule the euro out yet.

The rescue package removed the specter of immediate systemic risk. Following its announcement, European stocks rebounded and CDS spreads tightened significantly, including a 3.5% drop on the CDS spread for Greece. The euro is now trading near US$1.20, which is in line with consensus estimates of its fair value. The fall in the euro should increase the relative competitiveness of eurozone exporters, giving a boost to economic growth, especially in Germany with its large manufacturing/export base. While various members of the eurozone face significant fiscal problems, in aggregate the fiscal situation of the EU is stronger than, for example, that of the United States. This may provide support for the euro versus the dollar as markets move, in time, to focus on this issue.

The positioning of Putnam Europe Equity Fund takes account of the ongoing vulnerability of various economies within the EU that have the potential to cause broader ripple effects. We have preferred to invest in countries with relatively stronger fiscal situations, especially for our investments in financial sector companies whose funding costs are tied to the borrowing costs of the government. We are also seeking to exploit opportunities among companies benefiting from the weakness in the euro. As of March 31, 2010, the UK, which does not use the euro, made up the largest percentage of the portfolio’s holdings, followed by Germany, France, and Switzerland, which also has a separate currency. While there are holdings from other nations that use the euro, the allocations are relatively small.

We are monitoring closely the issue of sovereign debt and the status of the euro as the impact of the bailout package unfolds.

Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Additional risks may be associated with emerging-market securities, including illiquidity and volatility. The fund invests some or all of its assets in small and/or midsize companies. Such investments increase the risk of greater price fluctuations. The fund invests in fewer issuers or concentrates its investments by region or sector, and involves more risk than a fund that invests more broadly. The use of derivatives involves special risks and may result in losses.

The views and opinions expressed are those of the fund manager above, are subject to change with market conditions, and are not meant as investment advice.