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Many gloomily predicted a shrinking capital markets landscape, over-regulation and the fall of traditionally powerful financial centers such as London and New York. However, a different vision in 2022 emerged consisting of a new Equilibrium.
Brave New World : Equilibrium
This New Equilibrium consists of: government intervention receding (as memories of the financial and sovereign debt crises fade), traditional financial axis of power further solidifying their positions at the top, and the world seeking stability and predictability in the context of riskier and more uncertain geopolitical situations. In addition, much of the landscape where financial institutions operate will change significantly. This change will come from economic and government policies, from innovation, operational restructuring, technology, from smarter and more demanding clients, companies harnessing powerful data, and from continued growth of the shadow banking system.
Global Capital Markets: The Value Migration
Unfavorable economic conditions, escalating capital requirements, and stubbornly high costs continue to depress the performance of many investment banks. Their collective 6% ROE in 2015 capped off five years of dismal revenue results.
Yet the same cannot be said for the capital markets industry as a whole—the ecosystem that includes buy-side firms, sell-side firms, information service providers, and exchanges. Indeed, even as regulation forces investment banks to retrench and hinders their ability to compete, other players remain unaffected and will even, in some cases, benefit. Over the next five years, revenues in the capital markets industry will grow by an estimated 12%, increasing to $661 billion from $593 billion in 2015.
The asset base of buy-side entities is expected to reach around $100 trillion by 2020, up from an estimated $74 trillion in assets under management (AuM) in 2014. If this transpires, the buy side will generate nearly $300 billion in fees by 2020, constituting 45% of the overall capital markets revenue pool (assuming favorable market conditions and current fee structures). However, investment banks, on the sell side, are expected to generate just over $205 billion by 2020, a decrease to 31% of the total revenue pool from 53% in 2006.
Information service providers and exchanges are poised to benefit. They will profit from increased demand for technology solutions and greater access to market information and analytics. Growth in electronic exchange trading and the use of central clearing will mean that their share of the capital markets revenue pool will grow to 19%, representing an estimated $125 billion, by 2020 – an impressive rise from 8% in 2006.
Yet even as competition intensifies, opportunities for investment banks will continue to arise. Some larger or niche players will be able to absorb market share from those that are retrenching. Others will require a change in mindset and approach to explore alternative revenue opportunities beyond their traditional roles as capital raisers and market makers. Such players might consider leveraging internal data and technology systems to diversify revenues and enhance their market positions.
Moreover, the role of capital itself is changing. Escalating capital costs, occurring simultaneously with the growth of buy-side assets and revenues, indicate that the industry is moving toward leveraging benchmarks and other index products aimed at passive investors. Both the ability to discover liquidity and the demand for risk transformation services are becoming less dependent on capital. If investment banks are to compete, they must recognize their ability to generate revenues as information companies.
As volatile as U.S. stock and bond markets have been in 2022, emerging markets (EM) have had it worse. EM stocks are currently in one of their longest bear markets, with the MSCI Emerging Markets Index down about 40% from its February 2021 peak.
Together, these have produced disappointing growth. And because China is a major trading partner to virtually all other EM regions, and accounts for one-third of the market capitalization in most EM benchmark indices, its fate weighs heavily on investor willingness to allocate to EM.
Global inflation in oil and food prices and the strong U.S. dollar have further dragged on the markets. The strong dollar raises the cost of dollar-denominated debt and imports for emerging markets.
Together, these challenges have led global investors to slash EM positions and shun the asset class, driving historically cheap valuations. The MSCI EM Index now trades at about 10 times forward earnings estimates, and the MSCI China Index about eight times. This is in marked contrast to the S&P 500 Index, which still boasts a forward price-to-earnings ratio of 17 and is over-owned by investors globally.
- A more pro-growth, stimulus-oriented stance in China: Morgan Stanley economists believe China will begin prioritizing economic development over some of its goals related to security and social stability, which have been front and center for the past two years. We also see a possible end to China’s zero-COVID policy by the new fiscal year in April 2023. A full re-opening could allow private consumption to rebound substantially and boost China’s inflation-adjusted GDP growth from below 3% to 4.5% in 2023. Importantly, as China pursued a very different policy response to COVID from most of the West, it is not experiencing high inflation or rising interest rates. This gives Beijing significant runway for stimulus.
- A peak in the strength of the U.S. dollar: We may see the dollar losing momentum as the Federal Reserve’s rate-hiking cycle matures and as relative economic growth outside of the U.S. improves. As the dollar potentially weakens, EM countries could benefit from the relative appreciation of their own currency. Additionally, commodity exporters, such as countries in Latin America, could see commodity prices strengthening due to greater global demand.
- Shifting global trade relationships: While U.S.-China relations remain complicated, the reorganization of strategic supply chains could create new opportunities for EM nations other than China. In areas such as consumer and industrial goods, we anticipate new relationships between the U.S. and India, Latin America and non-China-linked countries in Southeast Asia. Meanwhile, we also expect China to continue to court economic integration with some of those same countries, extending efforts first nurtured through its Belt and Road infrastructure program.
All in, we think it may be time for investors to reassess their exposure to emerging markets. Investors should consider rebalancing EM exposure with an eye toward China onshore companies, as well as opportunities in South Korea, Taiwan and Brazil.