Michael Butler is chairman and CEO of investment bank Cascadia Capital. What follows is the introductory chapter to a new book he is writing called Financing the Future and the Next Wave of 21st Century Innovation. Butler has agreed to serialize the chapters here at peHUB, and we can expect around one per week:
The world is awash in money today. And the vast flows of new capital that are streaming across borders, cascading between continents and welling up around the planet have made this a time of true – and unprecedented – prosperity. In fact, the interconnected global economy is generating more wealth today than we’ve ever seen before.
This sense of material well-being breeds optimism, and optimism fuels progress. So, we are living in a Golden Era of Capitalism, where self-interest increasingly helps support community interest.
We see that in Africa, for example, where the Gates Foundation is tackling some of the most intractable and heart-breaking healthcare problems imaginable; we see that in the innovative and rapidly spreading sustainable technology revolution, which has now reached just about every corner of the earth; and we see that in the way China, India and other rapidly emerging economies are improving the quality of life for their citizens.
As an investment banker who’s been doing deals on Wall Street and throughout the world for more than two decades, I’m focused on near-term returns; but I’m increasingly aware of the need to finance the future. And to fund our future it’s important to better understand the future. That’s the purpose of this book.
I’ve never believed in crystal balls, nor do I think we can forecast what’s to come with any real sense of accuracy. And, if we’ve learned anything over the past decade – the first decade of the 21st century – it’s that we live in a volatile and unpredictable time. Change is disorienting the billions of people who populate the planet and turning their lives upside down in the process.
Looking ahead, it is possible – and right, I think – to ask many of the important questions. At the very least, we should ask the questions that make sense at this precise moment. The answers, even if they’re fragmentary, will provide us with a better grasp of what we’re up against and what we should expect as we try to extend capitalism’s reach in the second decade of this still young century.
When battered Wall Street firms replenish their depleted finances thanks to infusions of capital from developing nations, when the Chinese stock market runs like no bull we’ve ever seen before, when Japan’s economy sits dead in the water, when oil hits $100 a barrel, when the dollar plummets and the Euro soars – these are huge happenings and mega shifts that require scrutiny and assessment.
That analysis calls for an understanding of the new power players in the global capital markets – the hedge funds, the private equity firms, the sovereign government investors, and the post-Internet Era venture capitalists. They may have different risk appetites, unique approaches to debt and equity instruments, and a variety of investment strategies, but each one of these entities has done its part to dismantle the dam that kept capital flows bottled up for so long around the world.
Technology, fiber optics and electronic marketplaces have also played a role here, and so has deregulation. We hear lots of complaints in the United States about excessive and tangled up compliance statutes, and if we look at other countries, it seems that the new rule is less rules.
This is not to say that the world is a financial haven – or heaven – on earth. There are problems out there, and plenty of them. And some of these problems will bite us, and bite us hard. As I write this, for example, we sit at a crossroads; which way will the U.S. economy go – further up or burdened down by housing woes, consumer spending fatigue and the crush of rising energy costs? I also wonder if the U.S. is sacrificing or surrendering too much of its independence to the world; after all, we rely heavily on the Middle East for our energy supply and we ask the Chinese to buy so much of our government debt.
I’ve spent a good many days (and nights) thinking about all this, trying to wrap my arms (and brain) around it. And, in an effort to help walk us up to – and into – the financial future, I’d like to introduce 10 key themes that will have particular currency and relevance today and tomorrow. As you read (or skim) this book, you’ll find these 10 themes reverberating on page after page and in chapter after chapter.
1. A rising tide lifts all global boats.
The total value of the world’s financial assets – equities, private and government debt securities and bank deposits – grew 17 percent in 2006, to $167 trillion. That’s faster than the average historical rate of growth; but more importantly, it’s 14 times larger than the world’s total financial assets is 1980. To put this swelling wealth in perspective, the world’s gross domestic product (GDP) has expanded just five-fold since 1980.
The encouraging news is that 72 countries had financial assets that exceeded the value of their GDP in 2006, compared to just 33 in 1990. And all industrialized and large emerging nations now have financial assets that are two-to-three times the size of their GDP.
So, even though the U.S. still holds nearly one third of the world’s total financial assets, the vast global wealth is spreading and is no longer as concentrated as it once was. In fact, since 1990, the total value of financial assets in emerging nations grew at more than double the rate in developed nations – 21 percent versus 8 percent.
Equities provided the largest stimulus to global financial asset growth in 2006, which isn’t surprising considering the fact that stock markets in emerging nations grew so rapidly and corporate earnings in developed nations jumped so dramatically.
The lesson here is that the expansion of financial assets throughout the world offers broader access to capital for borrowers, more efficient pricing and greater opportunities for risk-sharing. Increased global wealth also drives economic growth as the new wealthy buy products and make investments.
2. Cross-border investing has crossed the line.
American companies are building plants in China; Asian banks are scooping up Latin American debt issues; Middle Eastern players are investing in European private equity firms; and U.S. pension funds are funneling cash into Eastern European industries. It’s all part of the $8.3 trillion in global foreign investment that took place in 2006 – $1.3 trillion more than crossed borders in 2005 and three times the total in 2002.
Some of the detailed numbers here are eye-popping. Foreign investors, for example, currently own 1 out of 3 government bonds in the world versus 1 out of 9 in 1990; this is largely driven by the fact that Asia’s central banks hold such a large chunk of the $2 trillion in U.S. government bonds right now. In terms of global equity issues, 1 out of 4 is presently owned by a foreign investor, triple the percentage in 1990. And 1 out of 5 private debt securities in the world is held by foreigners today – again, three times the 1990 total.
There are two take-aways here: first, the power, influence and global reach of the Middle Eastern petro-players and Asian government backed corporates, who invested somewhere between $3.4 trillion and $3.8 trillion in foreign nations during 2006; and second, the new reality that local savings are not as important as global cross-border capital flows when it comes to building and sustaining a specific nation’s standard of living. Foreigners now make or break GDP growth in individual countries all around the world.
3. The global financial marketplace is now divided into excess savers and excess consumers.
The excess savers, of course, are the Asian central banks and the Middle Eastern oil investors; the excess consumers reside here, in the United States. Once again, a couple of well-chosen numbers tell the whole story: China’s central bank had $1.1 trillion in reserve assets at the end of 2006, making it the single wealthiest investor in global financial markets. The U.S., meanwhile, is absorbing 70 percent of the world’s surplus capital. This is a worrisome trend because of our growing dependence on foreign capital and the implications this has on market liquidity.
4. Insatiable hunger for superior returns is driving the new global capitalism.
Powerful investors around the world are trying to put together diverse and dynamic portfolios that will turbo-charge results; in the process, they have poured money into alternative vehicles like hedge funds and private equity firms. These massive injections of capital have functioned like steroids by enabling hedge funds and private equity firms to bulk up in a hurry.
Total hedge fund assets reached $490 billion in 2000; by the end of 2006, that number had ballooned to $1.5 trillion, and analysts believe it will hit $3.5 trillion by 2012. On a more micro level, the five largest hedge funds in the world each control $30 billion in assets; taking leverage into account, it’s safe to say that they each have investments of up to $100 billion.
The story is the same for private equity firms, whose total assets exceeded $700 billion in 2006, about 2.5 times the total in 2000. Looking ahead, analysts see $1.4 trillion in private equity assets by 2012.
5. We are currently faced with a tough tradeoff in the world’s financial markets: increased risk and decreased transparency versus a lower cost of capital.
There’s little question that the new muscle players – hedge funds, private equity firms, petro-investors and Asia’s central banks – have brought huge structural shifts to bear on the global markets. And one of those changes is sustainable liquidity, which means lower rates, enhanced credit growth and increased innovation and progress around the world. A number of analysts believe that Asia’s central banks have lowered long-term interest rates in the U.S. because of their large holdings of our government debt instruments.
But what’s the downside here?
The petro-investors and Asian central banks seem to blur public and private boundaries, and it’s unclear if their motives are always purely economic; for their part, the hedge funds often apply lots of leverage and the private equity firms frequently push for looser bank covenants. So, despite lower rates, are we threatening national security? And are we looking at a raft of potential defaults?
I don’t have the answers, but as I said earlier, we have to ask the questions.
6. The sub-prime mortgage fallout is well worth monitoring.
As of this writing, it remains to be seen whether this is a harbinger of global things to come, or a painful work out of market excess. We do know, however, that the sub-prime unwinding has seriously cut into capital reserves at a number of top-tier financial institutions. I remain hopeful, though, despite the fact that several investment banks have had to reach out to investors around the world for cash infusions. My positive outlook is bolstered by this number: $1 trillion, which is where overall bank capital currently stands. If things go reasonably well, this will serve as a firewall in the quarters to come. However, even if this capital serves as a firewall there will be short- and long- term dislocation.
7. China, China – and more China.
The Chinese are everywhere, and making sense of their approach to global capitalism isn’t always easy. But we have to try because their clout is beyond awesome and their numbers are simply staggering. No matter what we think about the Chinese, there is one inescapable fact: they are the world’s largest net exporter of capital.
China is a country, for example, whose domestic financial assets increased by 44 percent in 2006; whose $8.1 trillion financial market is three times the size of its GDP; and whose investments abroad exceed foreign investments in China by $217 billion. To put things in perspective, this $217 billion investment surplus is larger than that of Japan, Germany or the Middle Eastern oil exporters.
8. The high cost of oil is going to be a major structural factor in the global capital markets over the short-term.
The world economy may – or may not – be able to absorb the cost of $100-a-barrel oil; again, we don’t know the answer yet. But it’s clear that the petro-players will have a powerful seat at the investment table over the next decade at least. A recent McKinsey analysis, for example, runs the numbers and shows that oil exporters will have nearly $6 trillion to invest abroad by 2012 – up from approximately $3.4 trillion-$3.8 trillion in 2006. And that’s fairly conservative, because it assumes $50-a-barrel oil.
There is some good news here, though. Oil that’s priced at $100 a barrel or more will almost certainly drive investment in alternative energy sources and energy efficiency in the industrialized economies of the West. In addition to the positive environmental impact, this will generate economic benefits as well – in the form of new high-wage “green” jobs.
9. The surprising rise of Euro-power.
Confounding the experts, who wrote the EU off just several years ago, Europe is now challenging the U.S. in the global capital markets. Europe’s fast-growing financial assets, for example, surpassed $50 trillion in 2006, slightly less than the U.S. total of $56 trillion. And, as of mid-2007, the value of the Euro currency in worldwide circulation surpassed that of dollar notes. We do need to be careful here, however: Europe’s current growth forecast is clouded by the possibility of increasing inflation due to high oil prices. Also, the EU may admit emerging countries from the Western Balkans in the next few years and the economic consequences of this integration are unknown at this time.
10. The New Energy Economy will hold up reasonably well over the long-term – even if the tide turns and a severe global downturn washes over us.
I am actually very bullish here and believe that there is a 20-30 year secular uptrend waiting for renewable energy enterprises on the other side of any recession that may strike.
And a recession triggered, in part, by higher oil or fossil fuel prices will actually help sustainable industries for a variety of counter-cyclical reasons.
First, higher energy prices will highlight the excessive cost of our fossil-fuel dependency; as a result, companies will begin searching for ways to manage these costs and the accompanying volatility risks.
For their part, investors will finally come to terms with the fact that there is a fundamental long-term problem in the energy sector; I think they will step up by investing in new technologies, start-ups and early-stage companies that solve some of these problems. As I noted earlier, this will create more jobs in well-capitalized clean technology companies.
And third, a number of companies that were not economically viable at cheap oil or energy prices will quickly become economically viable. A wide variety of transportation innovations on the fuel side or the vehicle side, for example, will become cost competitive versus traditional products.
So there you have it – 10 themes that will frame the financial future and line our path to prosperity in the second decade of the 21st century. Navigating that path will almost certainly be a challenge. But making the journey will be interesting and worthwhile. My hope is that this book will help serve as a guide.