Europe’s equity markets matter

Christian Krohn

12 February 2016

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As Europe struggles to mount a sustainable, job-creating economic recovery, it is becoming increasingly obvious that well-functioning equity markets matter. Equity markets can fund businesses’ growth, create jobs, and deliver long-term pension returns for Europe’s ageing population.

Despite this, the role of equities in Europe’s capital markets has diminished since the Global Crisis and is only slowly recovering to its prior level, which is below that of other regions. European Commission data show the decline, with Europe’s average equity market-to-GDP-ratio having fallen from 85% in 2007 to 64% in 2013 (see Figure 1).

Figure 1. Capital markets share in the EU has decreased since the Global Crisis (stock market capitalisation as a percentage of GDP)

True, the picture varies from member state to member state. For example, the UK’s equity market-to-GDP ratio was 121% in 2013, while Germany’s was just 51% (see Figure 2). However, comparing the EU as a whole to the similarly sized US economy shows the extent to which European equity markets are underused and helps explain why US growth has been robust while Europe’s has been subdued.

In 2015 the US equity market capitalisation represented 159% of GDP, whereas Europe’s was just 73%. If Europe’s market capitalisation-to-GDP ratio were to increase to 100%, this would imply that more than €3.5 trillion in additional equity capital could be deployed in European companies. This would also increase the pool of available equity investments, for example, for pension saving.

Figure 2. Stock market capitalisation (as % of GDP) in 2013 in each EU28 country (*2012)

Making the business case for equity markets

Revitalising Europe’s equity markets has much to offer European businesses. Equity capital complements funding sources like bank and non-bank loans, bond financing, invoice financing, and export finance. Equity, not debt, gives company ownership rights to the capital provider. Such risk capital is crucial to further company growth, for example to expand into new markets or even to start from scratch.

Take Europe’s small and medium-sized companies. Between 2002 and 2010 these businesses accounted for 99% of all European enterprises and 85% of job creation in the EU. Supporting these businesses is vital for Europe’s economy, but they need access to capital to innovate and grow. Equity is ideally suited to this task.

Equity capital does not need to be repaid, which allows companies to take a longer-term approach to the pursuit of growth. As businesses grow, they contribute to the broader economy: new jobs are created, more wealth is generated, and money goes back into the economy (e.g. through consumption and tax collection). 

The pension time bomb

Then there is Europe’s ever-ticking pension time bomb. The number of over 60 year-olds is swelling by about two million each year – a rate twice as high as in the late 1990s and early 2000s. By contrast, the number of people between 20 and 59 will fall every year over the coming decades. And longer life expectancy is compounding the problems facing Europe’s pay-as-you-go pension system where working people’s taxes fund current pensions.

According to one estimate, Europe’s citizens will have to save €1.9 trillion more each year in order to fund a comfortable retirement. This assumes that people need a retirement income equal to 70% of what they were earning at the time of retirement. Europe’s citizens need to make sure that their pension savings generate the best possible returns over the long run, which is where equity investment comes in.

The strong long-term returns of equities are well documented. Over the past 50 years, European equities have delivered an average 6% return each year, compared with 4.9% for bonds and 0.9% for cash (after discounting inflation).

Europe’s challenge

What is the root cause of Europe’s underutilised equity markets? Partly the phenomenon is due to both culture and regulation. For example, Europe has a long history of preferring bank debt to capital markets as a source of finance. In addition, regulatory initiatives such as the Financial Transactions Tax and MiFID’s transparency rules will likely reduce liquidity in the secondary equity markets. Understanding and addressing such barriers are the next necessary steps in ensuring equity markets play a full role in Europe’s long-term economic prosperity.

References

AFME (2015) “Why equity markets matter”, December.

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Topics:  Financial markets

Tags:  equity markets, Europe, ageing problem, funding, economic growth

Managing Director with responsibility for the Equity Divisions and the MiFID programme, AFME

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