The 'Emerging' Threat to Stocks

01/20/2012 11:30 am EST


A new report contends middle-class investors in the developing world prefer bank deposits to stocks and mutual funds, writes David Parkinson for The Globe and Mail.

In the past decade, the rapid development of emerging markets has been a major driving force for global equities. In the next decade, it could pose a major impediment.

A report from the McKinsey Global Institute—the business and economic research arm of US consulting firm McKinsey & Co.—predicts that as the middle class in the world's emerging economies continues to grow, creating a new generation of potential investors, the share of investment money heading into equities is doomed to shrink.

The researchers project that by 2020, equities will represent only about 22% of global financial assets—down from 28% in 2010.

That's primarily because investors in developing economies have demonstrated a distinct distaste for equity investing, compared with their developed-world counterparts. And that's unlikely to change much over the decade, the report argues.

"Emerging market investors keep most of their assets in bank deposits, which reflects lower income levels, underdeveloped financial markets, and other barriers to diversification," the report said.

And while experience has shown that, as countries grow richer, investors gain an increasing appetite for equities, it also shows that this evolves slowly, as stronger markets and more sophisticated regulatory frameworks develop. "Today, most emerging markets lack these conditions," the authors wrote.

"In a recent survey, more than 60% of investors in emerging Asian economies said they prefer to keep savings in deposits rather than in mutual funds or equities—a figure that has changed little over the past decade," they said.

But what's the big worry? After all, investing by people in emerging markets is still growing rapidly—four times as fast as developed markets over the past decade.

By 2020, financial assets held by emerging-market-based investors will make up as much as 36% of all global assets, by McKinsey's forecasts—up from 21% today. Maybe the slice of the pie will be smaller for equity markets, but the overall pie will be nearly double its current size (again by McKinsey's reckoning)—thanks mostly to emerging-market investors.

Surely that still spells some pretty substantial global-equity-market growth, doesn't it?

Well, yes. But the shift in the global asset-allocation mix will make things more difficult for publicly traded companies and equity-market investors, the report's authors say. That could hurt stock values and leave us more vulnerable to the kind of financial-market volatility we've endured since 2008.

"Even though total investor demand for equities would still grow by more than $25 trillion over the next decade in our base case scenario, this demand would not be sufficient to cover the amount of additional equity that corporations will need," the McKinsey researchers projected. "We calculate that companies will need to raise $37.4 trillion of additional capital to support growth."

And how do markets deal with insufficient supply to meet demand? They make the companies pay more for capital. That means issuing more shares, at a lower price per share, to attract the investment dollars they need. The cumulative effect would be cheaper stock markets and lower valuations.

Most of this would likely be felt in the stock markets of the emerging economies themselves, the researchers said; developed markets, especially in the United States and Canada, still look likely to attract sufficient investor capital to cover corporate demands.

But the prospect of undercapitalized equity markets in emerging countries does suggest that the stock markets in those places may be underperformers. This flies in the face of common logic that investors should be putting more money in emerging markets to capitalize on their growth opportunities.

Companies may also turn increasingly to debt markets as a more attractive alternative to raise capital. As we've seen in the past few years, a reliance on excessive debts is hardly the road to financial-market stability.

"Public equities disperse corporate ownership and give companies resilience in downturns; equity is a highly effective 'shock absorber.' By contrast, higher leverage increases the risk of bankruptcy and economic volatility, and makes the world economy more vulnerable to shocks," the report said.

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