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Booming markets mask the death of the cult of equity

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Booming markets mask the death of the cult of equity

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Equity valuation

Booming markets mask the death of the cult of equity

Money has flooded out of global stocks over the past decade, despite record prices

Despite record share prices, more equity is being withdrawn from public markets than entering

Consider the incredible, shrinking equities markets. Data for 2017 show in vivid detail how, despite record share prices, more equity is being withdrawn from public markets than entering. The trend is obvious not just in Europe but in the US and emerging markets.

Data from Dealogic illustrate just how dramatic the trend has been. Between 2000 and 2017 some $821bn of new equity was added to European markets via initial public offerings. That, though, has been dwarfed by the $4.96tn of equity withdrawn from the market, mainly in the form of share buybacks, divestments or as a defensive response to an unwanted suitor. A portion of that, $429bn, has been withdrawn through companies delisting.

In the US — where the $40.3bn value of IPOs last year, was the highest since 2014 — public market activity barely made a dent. Between 2000 and 2017 roughly $4.88tn was withdrawn, which compares with the total value of new shares floated at $697bn. Even emerging markets are not immune; the data show that since the turn of the century $3.79tn has been withdrawn. That has more than offset the issuance of IPOs totalling $1.26tn, with 2017 raising the most new equity capital for issuers in any year since 2010.

This trend of de-equitisation has implications not just for asset values but for the wider economy. It also has implications for fund managers whose purpose is to achieve the best risk-adjusted returns for capital owners.

De-equitisation, the shedding by corporates of equity in favour of debt, has been the theme for the past decade as low interest rates allowed companies to borrow at costs that were previously unimaginable.

Of the $6.8tn in new bonds, 55 per cent was raised on behalf of corporates. Ultra-low rates on government debt have encouraged investors to seek returns elsewhere, driving them into corporate and emerging-market debt.

However, such explanations for de-equitisation are unsatisfying. So-called capital structure theory, known as Modigliani-Miller after the Nobel Prize-winning economists who developed it, says that, all things being equal, a company’s true value is independent of how it is financed.

The cost of finance, whether in debt or equity, is neutral. That assumes the tax treatment of equity dividend payouts is the same as that of debt interest payouts and in most jurisdictions debt interest has an edge.

Nevertheless, with corporate tax rates in the US and UK cut to levels unimaginable a few decades ago, the relative benefits of debt issuance are less obvious than they once were.

Moreover, the Dealogic numbers allow us to look at patterns since 2000. Although rates in advanced economies were slashed in 2001-03, they began to climb, rising above 5 per cent in the UK in 2007. Yet that was the peak year for equity withdrawal in European equity capital markets, hitting a total of $410bn.

In fact, equity withdrawal in Europe in 2017 was still lower than it was with higher rates in 2000. Record-low interest rates do not seem to explain enough about why issuers, and investors, appear to prefer debt over equities.

Strategists have suggested something more straightforward may be at work: a growing demand by investors for “safe” assets has wildly outstripped supply.

The idea is most closely associated with MIT professor Ricardo Caballero who laid out the idea in 2005 and suggested it may have fuelled demand for triple A-rated asset-backed securities.

The slowing pace of growth in advanced economies combined with faster-expanding developing economies has led to a surfeit of capital that does not want too much risk. In a paper last year, Mr Caballero and two colleagues defined a safe asset as “a debt instrument likely to preserve its value during adverse systemic events”.

That demand suggests that the premise driving investment markets from the mid-20th century — that equity returns in the long run always outperform those of bonds — is severely challenged.

That idea is behind the so-called cult of equity which drove not only pension fund investment in the final decades of the 20th century but also that of retail investors.

This assumption led UK pension fund investment in equities to rise to close to 80 per cent of assets by the late 1990s, despite the encroaching prospect of large payouts as workers retired. The dotcom crash at the start of this century was a wake-up call.

Perhaps the most critical element in unravelling the cult of equity was a 1997 actuarial paper. This pointed out that the most common method of assessing whether scheme assets could cover liabilities simply did not make sense: in short, it required the assumption that £1 invested in equities was worth more than £1 invested in debt.

As investors gradually digested that notion — a process that took at least a decade — the cult of equity began to come to an end.

Norma Cohen is the FT’s former demography correspondent and a PhD candidate at Queen Mary University of London

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