Role of the Equity Markets in the Crisis & After
By Alan Yarrow
2013 may mark a turning point for equities. With equity indices enjoying January rallies and many returning to their pre-crisis levels, what role did the equity markets play in the crisis and what does the future hold?
Risk-taking is the foundation of equity appetite in the UK. We were inherently a risk taking nation, built on piratical foundations. In recent years government regulation has encouraged holding sovereign debt. Equity investors are optimists, they consider the upside. Debt investors are pessimists, they consider the downside.
Throughout the ‘80s and ‘90s equity markets boomed. This saw equities become a successful way to resolve some of the problems of the pension fund deficit. During the global financial crisis not only did equity markets fall, the impact of Quantitative Easing meant that yields on government bonds also declined resulting in a worsening of pension fund deficits on two fronts.
Government interference in investments has widened the gap between pension fund assets and liabilities; a problem that will worsen when rates inevitably rise. Another time bomb comes in the form of zombie companies that banks have allowed to exist. This will lengthen the time it takes to get out of recession where previously a write-off, whilst more painful, was immediate.
A reduction in the risk appetite of major banks and institutions has engendered a new paradigm in which there is a reduced equity exposure. The reduction in appetite for equities has been compounded by the regulatory response to the crisis. Solvency II, for example, attaches a higher risk factor to equities than it does to debt, making it less desirable for insurance companies to hold equities. The combination of a retreat by long term institutions combined with the burden of new regulation closed down the equity markets during the crisis. The government effectively crowded out the equity market.
The Kay Review of the UK equity market was the Government’s response to short-termism, a factor which arguably exacerbated the global financial crisis. It seems bizarre that the review, which made 17 recommendations, focused exclusively on the equity markets and ignored the debt markets entirely. The global financial crisis was a debt led crisis fuelled by excessive lending in what Minsky would call speculative euphoria. Unlike the equity led dot-com bust of the same decade, the global financial crisis was systemic. It cannot have escaped people’s notice that regulation of equity markets is tougher than it is for debt markets yet it was the debt markets that put us so close to financial meltdown. The dreaded Financial Transaction Tax proposed in Europe is another example of the disequilibrium of regulation as it won’t affect government debt.
At present there is a disparity between the yields on equity and debt combined with a misallocation of cash towards the debt market. This provides the pools of cash sitting on the sidelines to help the rally already witnessed this year to gain momentum. Whilst 2013 may not conventionally be thought of as ‘lucky’, the year of the snake may just prove to be a ladder for a bullish year for equities.
There was once a time when speculation fuelled the economy, perhaps “stagging” a new issue wasn’t such a bad idea after all.
Alan Yarrow was appointed Chairman of CISI in September 2009, having previously served on its Board between 2001 and 2005. Alan left Dresdner Kleinwort in December 2009, after 37 years with the group, latterly as Group Vice Chairman and Chairman of the UK Bank.