The Future of Global Financial Markets The Future of Global Financial Markets and the Implications for Pensionsand the Implications for Pensions

Howard Davies

Director - London School of Economics

Montreux16 May 2006

Three topics:Three topics:

1. The global economy: imbalances and all that

2. Changing asset classes in financial markets

3. Regulation.

Over the last year, global GDP growth has Over the last year, global GDP growth has been remarkably synchronized.been remarkably synchronized.

Global GDP, %

0123456789

10

And growth is forecast to continueAnd growth is forecast to continue

2007 GDP Forecasts: Economist Poll

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??

Even in Europe, sentiment has been improvingEven in Europe, sentiment has been improving

Morgan Stanley Index of European Business Conditions

0

10

20

30

40

50

60

70

June, 2005 Sept, 2005 Dec, 2005 March, 2006

50 = long-run average

But in spite of this healthy picture, there is But in spite of this healthy picture, there is plenty to worry about:plenty to worry about:

•slow growth and high unemployment in parts of continental Europe, putting strains on the Euro,

•public sector and consumption-led growth in the UK

and, most importantly

•trade imbalances between the US and China which threaten to revive protectionism in Washington

On one view, the problem is driven by On one view, the problem is driven by US trade and fiscal deficitsUS trade and fiscal deficits

US Twin deficits

Source: US Bureau of Economic Analysis, Morgan Stanley Research

Which have led to a huge discrepancy in Which have led to a huge discrepancy in consumption growthconsumption growth

Personal Consumption as a % of GDP

Source: China National Bureau of Statistics, Bureau of Economic Analysis, Morgan Stanley Research

and a massive difference in savings and a massive difference in savings rates between the US and Chinarates between the US and China

US and China: Savings rates

Source: US Bureau of Economic Analysis, World Bank, Morgan Stanley Research

Though it is the trade deficits which have Though it is the trade deficits which have attracted political attentionattracted political attention

Trade Surplus/ Deficit 2004

-700

-600

-500

-400

-300

-200

-100

0

100

200

Japan China Rest of Asia US

and the huge accumulated foreign and the huge accumulated foreign exchange reservesexchange reserves

0100200300400500600700800900

$ billion

Foreign Reserves

At some point, these balances ought to At some point, these balances ought to begin to unwindbegin to unwind

•The US is now a net debtor of $2.5 trillion

•Protectionist pressures in Washington represent the most potent threat to the global economy

But when and how?

The Global Asset Management market is The Global Asset Management market is changing as a result of these trendschanging as a result of these trends

US49%

EU29% Middle East

7%

Japan7%Australia

2%

Asia/ Emerging Markets

6%

Est c. $ 80 trn.

Growth rates

US 11%

Non- US 35%

There has been rapid growth in debt and There has been rapid growth in debt and equity issues in Asiaequity issues in Asia

0102030405060708090

100

2002 2003 2004 2005

equitydebt

$ billion

Asian equity and debt issues

In developed markets, the trend is away In developed markets, the trend is away from new equity raising to risk transferfrom new equity raising to risk transfer

•Equity IPOs broadly flat as a percentage of GDP in recent years

•US corporate bonds have doubled as a percentage of GDP in 15 years

•Credit derivatives volume had rocketed

Private equity has grown dramaticallyPrivate equity has grown dramatically

•US deal volume over $200 billion in 2005

•More than 100 $1 billion funds

•$ 2.5 trillion purchasing power

Too much money chasing too few deals?

Hedge funds have outperformed traditional asset Hedge funds have outperformed traditional asset classes over the past five yearsclasses over the past five years

-4

-2

0

2

4

6

8

10

0 10 20 30

Hedge FundsUS BondsGlobal EquityUS EquityEU Equity

Standard Deviation

Annualised

Return

Risk-adjusted Returns

2001-2005

As a result, asset allocation is shifting:As a result, asset allocation is shifting:

•towards private equity

•towards hedge funds

•towards international equities

•towards other real investments

There is considerable change in prospect in There is considerable change in prospect in the regulatory environment:the regulatory environment:

•Basel 2

•MiFID

•More active enforcement

The effects of Basel ought to be:The effects of Basel ought to be:

•to align economic and regulatory capital more closely

•to benefit diversifies and especially large retail banks

•to promote more differential loan-pricing

The effects of MiFID ought to be:The effects of MiFID ought to be:

•increased equity market competition resulting from the removal of exchange concentration rules

•greater flexibility of execution by enabling internalisation of trades across Europe

ButBut

•significant implementation costs across the industry

The Future of Global Financial Markets The Future of Global Financial Markets and the Implications for Pensionsand the Implications for Pensions

Howard Davies

Director - London School of Economics

Montreux16 May 2006