Lower demand to cause equities shortfall

However, the MGI report suggests that this trend will be amplified at the global level by the underlying shifts that are taking place in the global economy: emerging markets taking on a more prominent role and developed markets becoming less influential contributors to growth. Investors in emerging markets traditionally hold a much lower proportion of their portfolios in equities; as they come to account for a larger slice of global financial assets, this will also exert a shift toward debt, and fixed-income assets generally, and away from equities.

For example, MGI’s research estimates that as of 2010, there was $198 trillion of global financial assets (all numbers in U.S. dollars), with about 21% of that in emerging economies. By 2020, the MGI report projects that the total value of global financial assets will have grown to $371 trillion, with more than 30% of that in emerging economies. And given that households in emerging markets have only about 15% of their portfolios in equities (vs more than 40% for U.S. households), the report predicts that the share of financial assets in public equities will drop to less than 22% in 2020 from about 28% today.

The result of this shift in asset allocation, the MGI report suggests, will be the emergence of a large gap between investors’ demand for equities and the amounts of equity that companies will need to fund their growth. The report says that this gap will exceed $12 trillion and will be concentrated in emerging markets but will also be evident in Europe.

Inevitably, the danger of such forward-looking macro projections is that they could be undone by changes in any of the factors underlying the predictions. Although population trends are well established and take a long time to change, investor behaviour could be more pliable; households in emerging markets could start putting a larger share of their portfolios in equities, for example.

Indeed, the MGI report suggests, this has happened in other markets. As countries grow richer, investors in those countries become willing to put a larger share of their assets at risk in equities. However, in this case, the change in behaviour would have to be dramatic to alter the forecast fundamentally.

In fact, the report suggests that emerging-markets households would have to triple their historical equities allocations to avoid the appearance of the anticipated equities gap — a huge shift that, while not impossible, is certainly unlikely over the next few years. Moreover, the report notes, the preconditions for such a shift don’t exist in many emerging markets today — namely, diverse, liquid stock exchanges that are backed by credible regulation, reliable financial reporting and adequate enforcement.

Even in the developed economies that do boast deep, liquid stock markets and modern regulatory frameworks, there are pressures driving investors away from equities. Aging populations in those countries is one factor, although, the MGI report says, the scale of that shift should be fairly modest — at least, over the next few years. The report projects that if the portfolios of retiring baby boomers mirror the asset mix of the current generation of retirees, the effect should be to trim the share of U.S. household financial assets in equities to 40% in 2020 (and to 38% by 2030) from 42% in 2010.

Other factors also are driving investors in developed economy away from equities, including: the shift to defined-contribution pension plans from defined-benefit pension plans; the rise in the popularity of “alternative” assets (such as hedge funds, real estate and infrastructure) at the expense of public equities; and changes to the capital adequacy requirements facing global banks and insurance companies, which may drive these large institutional investors to shed riskier assets (while also boosting their own equity funding needs).

Assuming that the combination of factors driving developed economy investors away from equities, and preventing emerging-economy households from taking up the slack, takes place, a shortage of demand for equities of some magnitude is likely to develop in the coming years. This could have a variety of negative implications for the global economy.

“At a time when the global economy needs to deleverage in a controlled and safe way,” the MGI report says, “declining investor appetite for equities is an unwelcome development.”

For one, the cost of equity funding for firms is likely to rise. And this shift in the relative cost of equity vs debt will probably push firms to turn more readily to debt financing. This greater reliance on debt could, in turn, dampen growth rates and increase economic volatility.

The MGI report notes that economies with well-developed capital markets typically grow faster than those in which companies have to rely solely on bank financing. Furthermore, equity is often a key source of funding for startups and other young, fast-growing companies, which are a critical source of economic growth. Companies that do continue to rely on equity funding when investor demand for equities is withering will probably face a higher cost of capital that will translate into lower returns for these firms.

In addition, the greater use of debt funding will make companies (and, therefore, economies) more vulnerable to economic downturns, the MGI report suggests, as highly leveraged companies may have to cut jobs more readily in the face of an economic downturn in order to avoid defaulting on their debt. In turn, such companies may face a greater risk of bankruptcy. So, recessions and other slumps could be exacerbated in economies that are funded more heavily with debt.

Financial services firms may be acutely affected as a result. Banks, particularly in the U.S. and Europe, are likely to see their earnings come under pressure in the years ahead as various regulatory reforms that are being introduced in response to the 2008-09 global financial crisis aim to curb some of their recent excesses.

At the heart of these reforms is a demand for financial services firms to increase both the quantity and quality of the capital they hold, leading to increased pressure to raise equity at a time when investor demand is expected to dim.

Moreover, reduced return expectations for some of these firms could curb their appeal to inves-tors even more.

Although it’s expected that banks will be able to fulfil their equity needs, securities markets will feel the effects of these trends, too. The MGI report states that banks accounted for 32% of the book value of listed equities in developed markets in 2010 (up from 27% in 2000). And the report predicts that this could rise to 39% by 2020. “Such an increase,” the MGI report notes, “would affect risk and return characteristics of major equities indices and the wealth of investors who use index mutual funds.”

Indeed, this forecasted shift in global asset mix would have its share of implications for the money-management business, and for investors, as well. The MGI report suggests that the projected fast growth rates in emerging markets mean that these markets could become particularly rich sources of growth for asset managers. The report predicts that by 2020, investors in developing economies will hold $114 trillion or more in financial assets, including almost $50 trillion in household financial assets.

“Today, only a very small slice of household financial assets in developing economies is entrusted to professional managers,” the MGI report says, “both because of the habits of individual investors and because, in most emerging markets, the asset-management industry is still very small.”

Although this may represent a large opportunity for asset-management companies, it won’t necessarily be an easy one to seize. The report notes that while household income in emerging markets is rising, it is still small relative to the levels in developed economies. And these markets may be tough to crack with the products and distribution strategies that have worked in developed markets.

“It may take long-range marketing and educational strategies to cultivate these new customers,” the MGI report says. “Products will need to be simple and low-cost, but the potential to build a trusted brand is wide open.”

Ironically, much the same can be said about developed markets, in which, the MGI report says: “The industry can also do a better job educating investors about the financial implications of longer lifespans, including the need to get higher returns over a longer period.”

In the years ahead, investors of all stripes will probably need to look farther afield to find the type of growth they need to meet their investing goals.

Ultimately, investors will need to adjust their approaches to investing, too, the report suggests: “Rather than thinking about equities and fixed-income investments as two completely different asset classes with distinct selection criteria, it may be more useful to view investing more ‘holistically’ — buying both the equity and the debt of companies with the best performance potential, for example.”

Finally, the MGI report also recommends that policy-makers try to dampen this looming shift away from equities. In developed markets, the report suggests that policy-makers look for ways to boost savings rates, which would also increase flows into equities; ensure that corporate tax biases don’t favour debt over equity funding; and look at ways to revive initial public offering markets as a way of fostering a vibrant equities culture.

In emerging markets, the MGI report calls for tougher securities regulation, including stronger listings requirements, which would help instil investor confidence, encourage local investors to utilize equities and attract more foreign capital. The report also suggests global measures to encourage greater foreign diversification by removing any statutory limits on overseas investing (such as the foreign-content limit that used to apply to RRSPs in Canada). IE