Private Equity Is Eating the U.K. Stock Market

Since the Brexit referendum, the total value of companies quoted in London has been falling.

A blog post by LearnBonds of the U.K. reveals something very interesting about the world economy and the state of capital markets. The politics of Brexit has inflicted all kinds of thrills and spills over the last four years. But the underlying trend is clear: The size of the British market is shrinking.

While the index has risen more than 23%, the total value of shares has increased by only 2.7%. The reason is the ebbing importance of stock markets as a way to raise money. Companies aren’t bothering to issue new shares, but instead going to private equity companies; buying back their own stock; or selling out altogether to nonpublic investors. All these measures affect the size of the market, but don’t hurt the value of individual shares within it, which is what drives indexes. Indeed, many of these measures help drive up share prices. But if large institutions want to gain access to the full range of opportunities in the British economy, they need to take stakes in private equity. For individual investors, for whom investing in private equity remains virtually impossible, their opportunity set shrinks.

One player in the drama has remained completely unhurt. Listing revenue, hosting IPOs and so on, used to be the lifeblood of a stock exchange’s business. But the stagnation in the value of the companies listed on the LSE has done no damage to its share price, which has tripled over the last four years.

LSE owns FTSE-Russell, one of the top three indexing groups (with MSCI and S&P Global) which have enjoyed enormous profits from the growth of passive investing. A new paper by Johannes Petry, Jan Fichtner and Eelke Heemskerk outlines how this Big Three has taken on enormous power over markets, with a role as the gatekeepers to equity capital now very similar to the role of ratings agencies in controlling access to credit. Their revenues have been rising dramatically.

The London Stock Exchange offers us the world of contemporary shareholder capitalism in a nutshell. The money goes to indexing groups and private equity operators while the sum of equity capital shrinks. But normal investors, thanks to the financial engineering that pushes up share prices and the low costs of index investing, are doing OK for now. Let’s hope it stays that way.

A Little Bit of Politics

The U.S. presidential election regularly appears on lists of macro risks, but it doesn’t appear to be moving markets yet. It’s still too distant. That said, re-election for Donald Trump is the preferred outcome at present, and will stay that way unless and until the Democrats choose someone other than Senators Bernie Sanders and Elizabeth Warren. Market gains, which promote a sense of well-being and boost savings, should help Trump’s chances. So it shouldn’t be a surprise that since August, Predictit’s estimate of the probability of a Trump re-election has moved almost perfectly in line with the S&P 500.

Which is cause and which is effect? At present, if I had to guess, I would put markets in the lead. The August swoon, driven by an intensification of the trade war, probably helped raise doubts in the public mind about the president’s trade policy. Meanwhile, his recent ascent to be judged a better than 50% shot for the first time has almost certainly been helped by a roaring stock market.

Note for now that this is still a wide open election. The Predictit market, which isn’t totally efficient, currently has the Republicans at 52%, and the Democrats at 50%. If the race stays as close as this into the autumn, we can expect it to start to lead the stock market.

Minsky’s Latest Moment

In the U.S., wage growth is under control. So is unemployment. Inflation has been close to the Fed’s 2% target for more than a decade, and GDP has been growing steadily.

Meanwhile the stock market is going ballistic, amid remarkably low levels of volatility. The latest cover of Barron’s features the words “Dow 30,000” in large letters, bringing back uncomfortable memories of the book “Dow 36,000” that came out shortly before the bursting of the dot-com bubble in 2000.

Which of these paragraphs should matter more to investors, the Federal Reserve, and voters and politicians? The first seems obviously more important. The Fed is charged with maintaining low inflation and full employment, and these measures have a direct impact. The second merely means that some people with money in the stock market have recently grown much richer, and may be at risk of becoming poorer again.

But there is an argument that stretched asset prices matter more, because they pose the nearest and most substantial danger of a recession. Since the early 1980s, recessions in the West have all been driven by asset price busts, and not by the traditional fear of excessive wage increases leading to inflation. If this is true, monetary policy, and the regulation of capitalism more generally, need to be radically different.

That, essentially, is the argument of the late economist Hyman Minsky, which we will be discussing in a live book club chat on the terminal (go to TLIV to take part) on Thursday, starting at 11 a.m. New York time. Some are inclined to question the relevance of Minsky’s ideas. For the moment we now face, I think there are two key questions.

Is China Really in Danger of a Minsky Moment?

Zhou Xiaochuan, who stood down as governor of the People’s Bank of China in 2017, said in his closing speech: “If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky moment.’ That’s what we should particularly defend against.” Even William Rhodes, once the spearhead of many Citibank attempts to ease countries through debt crises, is prepared to speculate openly that China faces a Minsky Moment. The phrase keeps recurring in commentary on China, and on the U.S. stock market.

China’s debt has ballooned over the last decade. The possibility of a Minsky Moment has stood at the top of the risks that worry macro investors almost constantly throughout that period.

There’s an argument that China’s system is so divorced from the capitalism that Minsky was covering that such an implosion is impossible there. According to Robert Barbera, the Johns Hopkins University economist who was a friend of Minsky and will join Thursday’s discussion, the dynamic that Minsky was worried about saw financial institutions marking their exposures to market, until their exposures ended in bankruptcy. This can bring a cascade of bankruptcies in its wake.
In China, where there is far less fealty to free market ideology, there is no compunction in averting bankruptcies.

Authorities have been bent on doing this for years now, and have great power to do it. Can this continue? As Barbera puts it: “It’s not nearly as easy to identify a Minsky Moment in China, but if and when it goes bust, God help us all.”

Source: Bloomberg

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