Don't (Only) Sweat the Small Stuff

While we're all obsessing over the sub-prime crisis, the credit crunch in general, the housing market's retrenchment, the inability to mark to market CDO's, the devilish tendency of "liquidity" to be robust when you don't need it and nonexistent when you do, whether worldwide financial institutions' losses and writedowns will total $150-billion, $250-billion, or some other number entirely, and the implications of all of this for our firms in terms of practice groups and geographic focus, it may make sense to stand back, take a deep breath, and look at what's going on with global capital markets over the long run.

Stepping up to this particular plate is one of the most familiar suspects: McKinsey.

In their "Long term trends in the global capital markets," they offer the following perspective:

• Globally, financial assets are on a growth tear, and this should be expected to continue.
• As a consequence, financial markets are deeper than they ever have been.
• Cross-border transactions and investment links have never been stronger.
• Emerging markets are continuing to surge, outpacing GDP growth in those economies.
• New sources of capital are emerging.
• Japan continues to be challenged.
• The euro is emerging as a potential worldwide rival to the dollar, as European cross-border transactions accelerate.
• Nevertheless, the United States has unparalleled strengths, and despite all the ink being spilled over "sovereign wealth funds" and the like, the actual composition of foreign equity ownership might surprise you.

Now, to unpacking some of this wealth of data and analysis.

Growth of financial assets

Over the past 25 years, all financial assets (the value of all bank deposits, government debt securities, corporate debt securities, and equity securities) have grown strongly: From 2006 to 2007 alone, +17% from $142-trillion to $167-trillion. Bank deposits are a decreasing share. This shows the "CAGR" (compound annual growth rate) of equity securities' value over the past 10 years to be 10.4%, private debt securities 10.7%, government debt 6.8%, and bank deposits 7.8%. (It's heartening that the slowest growth has been government debt.)

Financial market growth outpacing GDP

"Financial depth" is the ratio of a country's financial assets to its GDP, and the good news it that it's been increasing consistently across all global regions. Why is this good news? More liquidity, more capital access for borrowers, better risk allocation.

In 1990, only 33 countries had financial assets whose value exceeded GDP; by 2006, 72 did. Likewise, in 1990 only 2 countries had financial assets triple their GDP; by 2007, it was 26.

Growing cross-border links

Cross-border investments are at an all-time high, making us more financially interdependent across the globe than ever before. If cross-border investments are deemed to include foreign investments of multinationals, ownership of foreign debt and equity by investors, and foreign lending and deposits, it totals $74.5-trillion at the end of 2006, or about half of all global financial assets.

Of greater interest is the changing composition of this investment. Ten years ago the US was the predominant hub. Today, while the US is still first among equals, the eurozone and the UK have built important links to emerging markets, and the Middle East is emerging as a major player on the global stage.

Here are the schematic cross-border flows, first the $31-trillion of such flows in 1999 and second the $48-trillion of such flows in 2006 (constant dollars):

Of particular note here is not just the overall growth, but trends in its composition:

• The US more than maintained its share, as did the mature economies of the UK and the Eurozone.
• In relative value, Japan lost ground.
• The strongest ties (red arrows) remained between the US and the UK and the Eurozone.
• Flows to Latin America more than doubled.
• Whereas in 1999 many of the linkages showed less than $1-trillion of movement (light blue/grey lines), by 2005 those weak links had all but disappeared.
• The emerging economies of Russia and Eastern Europe, and of "emerging Asia" roughly tripled their participation in the global economy, on this measure.
• But the most stellar performance of all came in the Middle East's increasing integration into the global financial economy, with flows more than quadrupling.  (And you were wondering why Latham just announced the simultaneous opening of three offices there, in Abu Dhabi, Dubai, and Doha?)

Emerging markets emerge

Last year, one quarter of the entire growth of global financial assets arose from emerging market economies. And they still appear to have substantial running room, accounting for only 14% of financial assets but 23% of global GDP.  And although bank deposits are still the most valuable asset class, reflecting these economies' immaturity, they accounted for 35% of all IPO value in 2006, up from 10% in 2000.  Chinese companies alone raised as much in IPO's in 2006 as did all companies in the eurozone combined.

New providers of capital

You would imagine that the world's richest countries would be the pre-eminent suppliers of global capital, but just because that's logical does not mean it's true. In fact, emerging markets are, as we all know, the largest suppliers of capital, with outbound foreign direct investment, at $139-billion in 2006, doubling from 2005 and sextupling from 2001.

But the flow is not just one-way. A total of $700-billion of inbound foreign direct investment took place in 2006, amounting to 6.4% of those countries' GDP. In other words, the developed and the developing world are linked in the capital markets as never before.

Here are the net capital flows (outflows - inflows) in constant 2006 dollars (billions) for 34 emerging markets including Brazil, China, India, the Philippines, Russia, South Korea, and Thailand (among others):

The continuing ennui of Japan

There are almost too many ways to enumerate the continuing weakness of Japan, but here are a few:

• Despite its proximity to emerging Asian economies, it accounted for just 6% of foreign funds invested there.
• Its government debt is truly enormous, amounting to 150% of GDP and one-third of all its financial assets.  Not counting that debt, its financial depth ([value of financial assets]/[value of GDP]) would essentially be at the 1990 level.  In that same period, the financial depth of the US has increased 168 percentage points and the eurozone 173.

The sources of direct investment into the emerging Asian countries in 2006 (totaling $2.2-trillion) show the US with a commanding lead at 29%, Hong Kong plus Singapore plus Taiwan at 24%, the UK at 18%, the eurozone at 14%, and Japan's slice smaller than "the rest of the world:"

The strength of the euro

While the euro's rise against the dollar is by now old news, what's less well known is that in the spring of 2007 the total value of all euros in circulation surpassed that of all US dollars in circulation for the first time—and there may be no looking back.    And while central banks and other financial institutions still hold two-thirds of their reserves in dollars, the euro's share has grown from 18% in 1999 to 25% today.  It is probably already the most popular currency for companies issuing international bonds.

The US' relative strength

But it's far too soon for Yanks to despair. 

The US remains the most liquid and largest financial market, with nearly one-third of all assets, and the strongest absolute growth rate of any market in the world.  Also on the positive side of the ledger is that only 5% of US financial assets constitute government debt.

And we keep attracting nearly 25% of all global inflows, as the largest single destination for foreign direct investment—as well as being the largest single source of outgoing foreign direct investment.

Foreign ownership of equities

Given all the alarms raised about increasing foreign ownership of US assets, where do you suppose the US ranks in foreign-owned equity as a percentage of all outstanding equity, compared to, say, the Eurozone, the UK, and Japan?

Dead last, by a long shot.  Here are the figures, for 1990 and 2006:

At 14% foreign ownership (today), the US trails all other economic regions by far, and is just barely ahead of emerging Asian markets in its proportion of domestic control.

Where does this leave us?

At the most fundamental level, if you ever doubted globalization is here to stay, get over it. 

At the strategic and tactical levels, as you look at the ongoing market turmoil, with new reports seemingly daily of another name-brand institution taking a big writedown or another arcane corner of the credit markets getting the flu, take a deep breath and have the courage to raise your eyes above the short-term chaos towards the horizon.

• The US is not sliding into global capital markets irrelevance.
• The axis of power in Asia is shifting from Japan to China.
• The eurozone will continue to matter more than ever.
• The Mideast is emerging from its provincial, resource-heavy and passive stance to becoming a globally aware, capital-heavy and active player.
• Cross-border flows are enormous and look primed to escalate even further.

Then ask yourself what capabilities your firm has to capitalize on these trends.  If you don't like the answer, now, when the conventional wisdom seems to be advising "hunker down," may be the time to pick up some capability for less than it would have cost you a year ago.  And if you do like the answer, I'd advise pretty much the same:  Steal a march on your more timid competitors so that you're prepared to emerge from this period of stress more capable and more broadly positioned than before.

Hard to do, you're saying?  With some of your key practice areas showing severe signs of stress? 

Yes, you must address the current smoke before it becomes a fire.  But what you cannot do is to permit "sweating the small stuff" to be the enemy of building on the big stuff: Financial globalization with a vengeance.