A world awash in money: capital trends through 2020

January 2013 | FEATURE | BANKING & FINANCE

Financier Worldwide Magazine

The financial crisis that began in 2008 has had a wide ranging and lasting effect on global capital markets. Without a doubt, the markets of today are vastly different to those we saw pre-crisis. Bain and Company’s report ‘A world awash in money: capital trends through 2020’, examines whether the intervention of central banks and financial policy makers has created a new financial paradigm as we approach 2020, or whether pre-crisis conditions will re-emerge once the prolonged period of uncertainty has finally passed.

Since the start of the crisis in 2008, says the report, we have seen a ‘superabundance’ of capital develop and this will remain as the decade progresses toward 2020. Meanwhile, the intervention of central banks has depressed benchmark interest rates in many markets to record lows. This new reality of superabundance and low interest rates will continue to pose questions and challenges to the markets for years to come.

Despite the stagnation of developed markets, the channels and fundamental structures through which the economy inflated so massively in the 1980s – financial innovation, high speed computing/communication, and a reliance on leverage – all remain intact. Moreover, total global capital will continue to expand. 2010 saw global capital swell to $600 trillion and this figure is expected to rise to $900 trillion by 2020, primarily on the back of the development of financial sectors in India, China and other emerging markets. Total financial assets currently stand at approximately 10 times the value of global output of all goods and services.

Data suggests that the size to which the financial sector has grown, and the continued, self-generating momentum of capital expansion, will be the defining factors of the shape and tempo of global economic growth. As it currently stands, large financial flows are creating “dangerous pockets” of excess capital in certain regions while cutting off access to other areas where risk premiums are excessive. For businesses and investors looking to succeed in this new financial environment, shifts in expectation and practice will be required. Current business strategies will need to be re-evaluated, a greater sense of investor discipline will need to be exhibited, and the ability to spot and manage risks and opportunities more effectively will need to be developed. In order to be successful going forward, corporate and financial investors will need to adapt to the following set of new rules.

Hurdle rates

According to the report, in a period of prolonged capital surplus it is vital that investors appropriately lower their interest rate expectations, and amend internal investment hurdle rates and portfolio investment return targets accordingly. Without taking these actions, institutional investors will not be well equipped to deal with the large gaps between the returns they need to make payouts and those the markets will actually generate. The extended period of capital surplus will be defined by “persistently low interest rates, high volatility and thin real rates of return”.

Integral to the generation of capital over the next decade will be the role of China. Chinese GDP growth, which is currently slowing down, will soon return to its rapid growth rate and should maintain this expansion over the coming years. Accordingly, there will be a change in direction for the Chinese economy on the road to 2020. It is progressively moving away from its role as an absorber of foreign capital and starting to generate an increasingly large amount in its own right. China’s contribution to the expansion of global capital in 2010 was $39 trillion. By 2020, Bain estimates it will provide $125 trillion to the global capital surplus.

Foreign direct investment in China will decline as future growth prospects slow; indeed, the Chinese economy is no longer a particularly fertile environment in which capital can be productively absorbed. Likewise, the continued increase of fixed investments at recent historic levels cannot be sustained, as marginal returns on capital are already diminishing.

The emerging markets will see the most rapid rate of expansion in financial assets in the coming years. It is estimated that capital raised in emerging markets will account for more than 40 percent of the global increase by 2020. This equates to some $130 trillion. With the lowering cost of capital and low real interest rates changing calculations on all projects, the superabundance of capital will require investors to account for lower interest rates when creating new, lower hurdle rates.

Bubble risks

The superabundance of capital in the years ahead will most likely give rise to ‘bubble risks’. Readily available capital can, and will, be easily deployed into opportunities that provide “the false promise of higher yields”. Indeed, due to the abundance of capital, investors are finding it harder to source enough sufficiently attractive – and productive – assets to absorb it all. Furthermore, the volume of liquidity being inserted into the markets by major central banks has led to greater fears of inflation. The report notes that “given the ample spare capacity for production across the world, however, we expect that inflation will not show up in core prices in most markets but in asset bubbles”. Going forward, these bubbles cannot be regarded as isolated events with a local impact – they will be global crises with overarching and catastrophic consequences when they burst.

Bain’s report suggests that capital superabundance will “increase the frequency, intensity, size and longevity of asset bubbles”. In light of this, investors and companies will need to be much more mindful of the risk of bubbles and establish mechanisms through which they can better protect their businesses. It is crucial that investors insulate themselves from the effects of bubbles by developing a better understanding of the economics of their core business, by knowing its sustainable rate of growth, and by being quick to spot red flags indicating when it risks exceeding its sustainable limits.

Bubbles are likely to be more disruptive while global interest rates are low and they will be found most commonly in commodities.

This is due to investors seeing commodities as a means through which to participate in the rapid growth of emerging economies while keeping their capital in the more developed and infrastructure rich advanced economies.

As the decade progresses, three quarters of all global financial assets will remain in the established financial centres located within the advanced economies. Investors prefer to keep their capital in the advanced economies due to the ‘trust architecture’ which may not be so prevalent in the emerging markets, says the report. Accordingly, the accumulation of capital within these centres will magnify the potential for bubbles to form in both the advanced and developing markets, as there will be too much capital chasing too few growth opportunities within the advanced markets, driving asset prices skyward.

That said, as the decade progresses, the ease with which capital can be easily moved around world markets will see the impact of bubbles increase greatly.

Investment in IP and infrastructure

The next big investment opportunities will be for those who are willing to play the long game, according the report. Investors who “lift their sights from the short-term market signals to take in the broader sweep of the macroeconomic landscape that a capital-abundant world requires will discover big growth opportunities”. Within the context of a capital soaked economy we will see a shift in “the balance of power from owners of capital to owners and creators of good ideas – wherever they can be found”. The saturation of the market with capital will certainly lead to fierce competition between investors and companies looking for the next viable opportunity, particularly in the developed markets.

Investment in the development of revolutionary, transformative technology platforms in fields such as nanotechnology, biotechnology, artificial intelligence and robotics will represent a “promising path to buoyant growth” for investors. These game changing technologies will require companies and investors to lower their hurdle rates and expand their horizons when it comes to short term returns. In the long term they will find themselves ideally positioned to take advantage of the proliferation of start up companies and the propagation of these ground breaking technologies. The report suggests that these new, pioneering technologies will contribute at least $1 trillion to global GDP growth by 2020; this clearly represents an excellent opportunity for patient investors.

Equally impressive are the prospects for investors who are willing to invest in infrastructure development. Again, the data suggests that this is an industry likely to contribute a minimum of $1 trillion to global GDP growth by 2020. The development of new water, energy and transportation systems in the rapidly developing emerging markets represents an excellent opportunity for investors, as does the refurbishment and development of existing structures in the developed world. In these areas, private sector engineering, construction and consulting firms will play a leading role. In order to truly benefit from these exciting sectors, investors and businesses will, again, need to commit to the long term. The success of investors will no longer be predicated on enormous reserves of capital; rather, investors’ ability to spot “true value creation potential” will hold the key to future gains.

Further to the infrastructure opportunities within emerging markets, the flow of capital towards those regions will likely improve over the course of the decade. “The capital needs of the faster-growing EM would appear to make them a natural destination for the large stock of financial assets that remain concentrated mostly in the advanced economies”, the report states. The development of ‘trust architecture’ and increasing political stability in these markets will only serve to increase their attractiveness. Equally, financial firms that establish headquarters in emerging markets will be well placed to help guide the ongoing developments, using “their own institutional connections and trusted networks to facilitate capital flows”.

Balance sheets

Balance sheets will also become a vital tool in the coming years; successful firms will use them to “reinforce their strategic goals”. Companies that can employ their balance sheets in order to operate in the same way as a hedge fund will find success by “actively managing their mix of long and short positions to insulate themselves against a more volatile macroeconomic environment across their portfolio of business activities”. If companies can utilise their cash reserves as well as their product development mechanisms and pricing policies, they will be able to outmanoeuvre the competition.

The post-crisis world will require investors and businesses to adopt a new ethos. The superabundance of capital and persistently low interest rates will necessitate investors to reconsider their strategies going forward. Lowering internal hurdle rates and looking to the long term will be crucial to future profitability. In a world awash with capital, infrastructure development will represent excellent long term, high yield opportunities, and, as the superabundance of capital continues, innovation will become the new currency.

Richard Summerfield