the McKinsey financial markets report
The McKinsey Global Institute just published a research paper titled: “The emerging equity gap: Growth and stability in the new investor landscape.”
The paper is the product of research by McKinsey consultants, in conjunction with “distinguished experts” from the academic world, government and private financial companies. No actual bond or equity market investors appear to have been asked to help with the work, with the possible exception of the head of index products for a UK insurer.
its conclusion
The study’s conclusion: by the end of this decade there could be a shortfall of $12.3 trillion between the amount of equity capital global firms will need to fund their operations and the amount that global investors will be willing to offer on current terms. To put this figure in perspective, total world financial assets are projected by McKinsey to be $371 trillion.
If this is correct, companies may:
–borrow more, thereby increasing their vulnerability to cyclical economic downturns ( a company always has to service its debt, but can reduce or omit dividends without triggering a default)
–issue equity on less favorable terms to the firms,
–use capital more efficiently, or
–expand more slowly.
I’m going to write about the McKinsey study in two posts. Today’s will outline the McKinsey argument. Tomorrow’s will have my thoughts.
the McKinsey argument
1. qualitative
Throughout its analysis, McKinsey divides world financial markets into those in the developed world (the US, Europe and Japan) and in the emerging.
the developed world
aging
A key starting point for McKinsey is the demographic fact that the US and Europe are old–and aging. This list of median ages (from the CIA) illustrates this point. Starting with Monaco, the Florida of Europe, median ages by country range as follows:
Monaco 49 years old
Germany 45
Japan 45
Italy 44
Sweden 43
UK 40
Spain 40
US 37
China 36
world median 28
Indonesia 28
India 26
Many African and Middle Eastern countries fall in the late teens or early twenties.
Why is this important?
As people become older they gradually shift from wanting to increase their assets to being happy to preserve the wealth they already have. This increasing risk aversion means they are less willing to buy equities.
pension plan shifts intensify this trend
In the US, corporations have pretty much completed the process of transferring the risk of paying for retirement from themselves to their employees. They’ve done this by substituting defined contribution pension plans for defined benefit ones This shift is now under way in Europe. Individuals tend to put a smaller proportion of their retirement assets into equities than the defined benefit mangers would have. In addition, corporations tend to shift the assets in their residual defined benefit plans into bonds to limit their risk exposure.
the emerging world
Although emerging economies will provide most of the growth in the world over the next decade, and have relatively young populations, they are unlikely to generate widespread–and increasing–domestic interest in equities. Two reasons McKinsey thinks so:
–most citizens are too poor to want to take the risk of holding equities, and
–most emerging markets have low standards of financial disclosure, are badly regulated and exclude foreigners. So they’re not places you’d really want to put your money.
2. quantitative
In the report, McKinsey attempts to estimate, on a country by country basis:
–how much equity money corporations will need through 2020, and
–the amount that investors are likely to allocate to equities over that period.
equity needs
McKinsey addresses the first task by trying to project what the total market capitalization would be for each country, based on the assumption that each can obtain all the equity funding it requires to fuel growth.
It assumes that aggregate assets and earnings will grow in line with nominal GDP. It applies a valuation multiple to them that’s derived from a two-stage present value model. McKinsey then adds the results of IPO stock issuance, which it extrapolates from past relationships between IPOs and GDP.
investor allocations
This is a complex process that McKinsey only describes in outline, even it the appendix to the report.
Basically, the consulting firm projects, country by country, future disposable income. It assumes that in the emerging world that individuals continue to put the same fraction of their disposable income into investments and that their allocation between stocks and fixed income remains constant. For the US and Europe, on the other hand, it shrinks the equity portion progressively–citing age as the rationale.
the results?
McKinsey estimates that investor demand for equities will grow by $25.1 trillion between now and 2020. However, worldwide corporate demand for equity financing will rise by $37.4 trillion, creating a $12.3 trillion “equity gap.”
According to the analysis, the US will have a slight funding surplus, despite a gradually waning interest in equities by Americans. Europe will face a funding deficit of $3.1 trillion.
The real potential problem is in emerging markets. China is in the worst shape, facing a potential financing deficit of $3.2 trillion. Other emerging markets face a total funding deficit of $7.0 trillion.
That’s it for today. My thoughts tomorrow.