Despite being a critical source of capital for growing businesses and a source of superior long-term investment returns, equity markets are still not being used to their full potential, writes Christian Krohn.
Christian Krohn is the head of equities at AFME, the Association for Financial Markets in Europe.
While eurozone economic recovery this year has been resilient, widespread, growth remains subdued. Eurozone GDP projections for 2016 were lowered to 1.8% earlier this year – down from 1.9% previously forecast by the European Commission. Other persistent challenges remain with unemployment rates stubbornly high, and a pension time bomb is ticking ever more loudly.
With such a bleak outlook, equity finance will be crucial in ensuring long-term European competitiveness. Equity, as opposed to debt capital, confers ownership rights in the company to the capital provider and never has to be repaid. Such risk capital is essential for companies expanding into new markets or those starting up with uncertain outcomes. Equity markets give businesses access to the capital they need for innovation, value creation and growth. And because it is long-term capital, equity allows companies to take a longer-term approach to the pursuit of growth.
Equity is also an essential asset for saving, as it has historically generated higher returns than any other conventional liquid asset class. At a time when Europe is facing a huge challenge to fund the retirement of its growing population, these superior returns are an invaluable part of the investment mix.
Clearly, equity markets offer a large pool of potential capital. However, this critical source of funding is currently underused in Europe. The scale of such foregone funding and investment opportunity can be seen by comparing European and US markets. In 2015, US equity market capitalisation represented 159% of GDP, whereas Europe’s was just 73.3%. If European companies chose to close this gap – at least partially – and increase the ratio to 100%, around €3.5 trillion in additional capital could be deployed in the European economy to help fund economic growth. This would also increase the pool of available equity investments, for example, for pension saving.
Certainly, a healthy equity market helps create jobs. In the US, businesses have tended to grow far more quickly after raising capital on equity exchanges, with corresponding expansions in their workforces. This suggests that the same would likely be true in Europe. If Europe’s equity markets recovered to their previous highs relative to the size of the economy, this would substantially increase the level of equity funding in the economy, encourage entrepreneurial businesses, and enlarge the pool of potential investments for investors, including pension funds.
And equity markets are not only important for business, they also provide essential liquidity in the secondary markets for investment. The secondary equity markets match buyers and sellers. They set prices for companies’ shares and provide a liquid market, facilitating trading and making it easier for companies to raise equity capital. Academic studies have shown that a liquid equity market accelerates a country’s economic growth. However, that liquidity could come under threat from a number of regulatory proposals.
Increasing the role of equities
The European Commission has recognised the importance of addressing barriers to growth and is taking the right steps forward with its Capital Markets Union action plan. This initiative is an important opportunity to increase the role of equity markets in funding Europe’s economy as a complement to bank lending – particularly as Europe struggles to mount a sustainable, job-creating economic recovery.
AFME believes the European Commission should set a target of expanding equity market capitalisation from its current level of 73.3% of GDP to 100%. While Europe’s equity markets last touched this level in 2000, at the peak of the dotcom boom, it is far short of what the US has shown to be a sustainable level for many years. As Europe’s businesses seek to compete internationally, governments look to create jobs, and its people save for retirement, it is clear that equity markets matter.
AFME has released a new report, Why equity markets matter, which can be downloaded for free from the AFME website.