What if the upturn doesn’t turn up?

Investors remain wary of the equity markets – but is the problem cyclical or structural? Bleak but hopefully temporary economic conditions should not obscure underlying problems.

Clearly investor appetite for equities continues to be weak. But isn’t that a reflection of macro-economic uncertainties rather than market structure problems? 

Of course the poor economic outlook for developed markets is a major factor. However, the equity markets haven’t helped themselves over the past few years. When demand is so constrained, measures that could reassure investors should at least be considered.

Besides, we know market structure issues can have a significant impact on equity market activity. After the US flash crash of 6 May 2010, US$25 billion was immediately withdrawn from the equity markets by US mutual funds and it took more than six months for flows to turn positive again.

Today there’s no one single issue to blame but the outlook is undeniably bleak. In May, global equities benchmarks recorded their worst performance since September 2011, with the FTSE All World index sliding 9% during the month. While most of the declines took place in euro-zone countries such as Italy and Spain, the US’s S&P 500 fell 6.3% in May, but remains 4.2% over the year. As we know, sliding prices tend to depress volumes which in turn increases trading costs, through higher volatility and market impact.

For the third year in a row, commission payments from US institutional investors to their domestic equities brokers declined, according to Greenwich Associates. They now stand at their lowest level (US$10.86 billion) since 2007, and there’s little prospect of a resurgence:  a quarter of firms interviewed by Greenwich said they planned to reduce active domestic allocations by 2014.

But surely a few success stories for equity market investors are more likely to prompt a turnaround in sentiment than tinkering with the rules?  

The last few months have supplied ample evidence that market structure can hamper the chances of investors realising the kind of returns that breed confidence and stimulate volumes. The equity markets have been starved of new blood in recent years but already in 2012 two high profile US IPOs – BATS Global Markets and Facebook – have damaged investor confidence rather than boosted it. In both cases, the highly automated trading infrastructures on which equity markets now run failed to execute a transparent and efficient auction process. And for Facebook the technology glitches were compounded by accusations that downward revisions of revenue forecasts were accessible only to a privileged few. Having touched US$45 per share on debut, Facebook’s decline to US27.72 last Friday has been accompanied by discussions about the conflicts of interest inherent in an investment banking model that allows IPO lead managers to also serve as research providers on the stocks they underwrite.  

While one can blame the economic situation for the lack of IPOs – 81 firms went public in the US last year, compared with an average of 311 between 1980 and 2000 – there is no guarantee of a listings explosion when developed economies show signs of sustainable growth. Private equity firms are now as likely to check out of their start-up investments through trade sales, while partnerships and family firms are proving perfectly able to expand without taking the traditional route to wider share ownership. If IPOs cannot be conducted competently, the equity markets are likely to continue to struggle to generate investor interest.

OK, so what kinds of market structure reforms are most likely to support investor confidence in the equity markets?  

One barrier to improving investor confidence is that market observers seem hopelessly divided on causes of weakness in market structure. For every academically rigorous report on the malign influence of high-frequency trading, another will inevitably emerge – replete with charts and data points – proving the benefits of low-latency arbitrage beyond question.

Another is problem is that two factors that tend to encourage investors – low trading costs and transparency – are so often set against each other. For example, will central clearing of OTC derivatives reduce volumes through greater post-trade costs or create greater trading activity, by bring new entrants into a more transparent and safer post reform market place?

If one accepts that western democracy’s recovery from the global financial crisis will be marked by further crackdowns on market practices perceived “too risky” by politicians and regulators, the prospects for improved investor confidence should perhaps be measured in terms of the impact of wider reform packages – whether by design or unintended consequence.

And then there’s the reform process itself. While the Volcker rule in the US and the proposals from the UK’s Independent Commission on Banking have support in principle, special pleadings and exemptions may leave investors as uncertain as ever.

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