A McKinsey report called The Emerging Equity Gap is sketching out an important change to the global capital markets whose consequences will be profound. In 2010 global financial assets were valued at $198 trillion, with only 21% in emerging economies. $85 trillion are held by households. Only 15% of emerging market household portfolios are invested in equities, compared with 42% in US households. McKinsey forecasts that by 2020 there will be $371 trillion in financial assets, 30% of which will be held by emerging economies. The share of financial assets will have fallen from 28% in 2010 to 22% in 2020. That adds up to a $12.3 trillion “equity gap” by 2020.
I am not entirely sure what they mean by “gap” here, but it does point to an important shift in global capital formation. There will be a dearth of equity capital:
That will create a growing “equity gap” over the next decade between the amount of equities that investors will desire and what companies will need to fund growth. This gap will amount to approximately $12.3 trillion in the 18 countries we model, and will appear almost entirely in emerging markets, although Europe will also face a gap. As a result, companies could see the cost of equity rise over the next decade and may respond by using more debt to finance growth. Only a tripling of equity allocations by emerging market investors could head off this drop in demand for equities—which will be difficult to accomplish in this time- frame, given the remaining institutional barriers. The probable outcome is a world in which the balance between debt and equity has shifted.
The implications of this shift are potentially wide ranging for investors, businesses, and the economy. Companies that need to raise equity, particularly banks that must meet new capital requirements, may find equity is more costly and less available. Reaching financial goals may be more difficult for investors who choose lower allocations of equities in their portfolios. And, with more leverage in the economy, volatility may increase as recessions bring larger waves of financial distress and bankruptcy. At a time when the global economy needs to deleverage in a controlled and safe way, declining investor appetite for equities is an unwelcome development.
As the report points out, equity capital is a different type of transaction to debt. Debt has different economic and systemic effects:
As a result, companies could see the cost of equity rise over the next decade and may respond by using more debt to finance growth. Only a tripling of equity allocations by emerging market investors could head off this drop in demand for equities—which will be difficult to accomplish in this time- frame, given the remaining institutional barriers. The probable outcome is a world in which the balance between debt and equity has shifted.
The implications of this shift are potentially wide ranging for investors, businesses, and the economy. Companies that need to raise equity, particularly banks that must meet new capital requirements, may find equity is more costly and less available. Reaching financial goals may be more difficult for investors who choose lower allocations of equities in their portfolios. And, with more leverage in the economy, volatility may increase as recessions bring larger waves of financial distress and bankruptcy. At a time when the global economy needs to deleverage in a controlled and safe way, declining investor appetite for equities is an unwelcome development.
From an investor point of view, it may imply that those who are willing to provide equity will be in a good bargaining position. From an anthropological point of view it spells the waning of the Anglo-style of capitalism. Big stock markets are an English speaking phenomenon, despite its being invented in France. The reason seems to be connected with non-conformist groups in the North of England who used equity to underpin the industrialisation rather than debt (it worked in tandem with the creation of mutual funds such as Manchester Unity). Those non-conformist groups of course also went to the United States. It is perhaps the biggest reason why Marx turned out to be wrong about English industrialisation: equity capital is a very different type of ownership to bank or bond ownership because the risk resides with the owner. Consequently, it is a much more benign form of capitalism, and for a long time it proved a much more effective form as well. It is a big reason why the English style of capitalism tended to be very strong. Much has been made of the more “laissez-faire”, individualistic style of English speaking capitalism, but it is rarely noticed how deep equity markets are based on ideas of mutual interest, which is the opposite of brute individualism. European capital markets are much more biased towards debt and the banks have much greater control. Japan had a big stock market because of the American influence, but has been shrinking for about two decades. Asian stock markets are extremely thin (China’s is big by market capitalisation but there are only about 800 stocks and the companies are mostly majority government owned).
Equity capital has many systemic advantages. Most important is that it can be repriced without creating damaging effects. A repricing of debt, as we are now seeing in the European crisis, threatens to bring down the whole system because banks are not able to handle much defaulting. The picture is a little different with corporate bonds, where individual investors are more likely to lose out, but in general debt is inflexible. Equity markets, on the other hand, have repricing built in. Volatility is accepted and because the risk lies with the investor, any collateral effects tend to be less harmful. Investors may feel poorer, but the system is not imperilled.
Equity capital is also important because it is a third force: it refines the government-private dialectic. A publicly listed company is neither government nor private and its flexibility is important to solving debt crises. One remembers how the Latin American debt crisis was alleviated by debt for equity swaps, which changed all the risk equations such that the problems were eventually dealt with.
Equity capital is currently under attack from high frequency trading, which is removing the underlying logic of equity — the provision of capital for businesses to grow in the medium to long term — and turning it into just another asset to be manipulated in high tech market games. The same thing is happening, on a massive scale, with debt markets. And of course there is also the various forms of “meta-debt”, including $700 trillion of derivatives.
But what it most indicates is that the rise of the developing world will also be a relative rise of debt capital. That spells more systemic risk.