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China’s rising stature in global finance

The country’s financial markets are deepening, foreign investment keeps pouring in, and capital is flowing outward. What would it take for China to assume a new role as world financier?

China, as the world’s largest saver, has a major role to play in the global financial rebalancing toward emerging markets. Today, these countries represent 38 percent of worldwide GDP but account for just 7 percent of global foreign investment in equities and only 13 percent of global foreign lending. Their role seems poised to grow in the shifting postcrisis financial landscape, since the advanced economies face sluggish growth and sobering demographic trends. As a lead player in that shift, China could become a true global financier and, with some reform, establish the renminbi as a major international currency.

Yet a long-closed economy—even one with more than $3 trillion in foreign reserves—can’t swing open its doors overnight. China’s domestic financial markets will have to deepen and develop further, and returns earned by the government, corporations, and households must rise if the country is to attract and deploy capital more effectively. At the same time, the barriers that prevent individuals and companies from investing more freely outside the borders of China, and foreigners from investing within them, will have to diminish gradually, and the country must build the trust of global investors. Continued reform in China, coupled with its vast domestic savings and outsized role in world trade, could make the country one of the world’s most influential suppliers of capital in the years ahead.

Growth and growing pains in China’s markets

As China’s financial markets have become more robust and deeper, the value of its domestic financial assets—including equities, bonds, and loans—has reached $17.4 trillion, trailing only the United States and Japan (Exhibit 1). That’s a more than tenfold increase in a span of two decades, and it doesn’t include Hong Kong’s role in channeling funds to and from China.

 

Exhibit 1

A surge in lending has boosted China’s financial assets by $3.8 trillion since 2007, but growth has not kept pace with that of GDP.

 

In contrast to most advanced economies, where lending has been stagnant amid widespread deleveraging, bank loans in China have grown by $5.8 trillion since 2007, reaching 132 percent of GDP—higher than the advanced-economy average of 123 percent. About 85 percent of that Chinese lending has been to corporations; households account for the rest. This rapid growth has raised the specter of a credit bubble and a future rise in nonperforming loans, though regulators have attempted to slow the pace in overheated areas such as real estate.

China’s corporate-bond market is also developing. Bonds outstanding from nonfinancial companies have grown by 45 percent annually over the past five years, bonds from financial institutions by 23 percent. There is ample room for further growth, since China’s levels of bond-market borrowing are significantly below those of advanced economies. Indeed, bond financing could provide an alternative source of capital for the country’s expanding corporate sector, enabling banks to increase their lending to households and to small and midsize enterprises.

Unlike many major equity markets, China’s stock market has not rebounded since the financial crisis and global recession. Total market capitalization has fallen by 50 percent since 2007, plunging from $7.2 trillion in 2007 to $3.6 trillion in the second quarter of 2012. Investors sent valuations soaring at the market’s peak, but fears of a slowdown and a more realistic view of company valuations dampened their enthusiasm, underscoring the fact that China’s equity markets, like those of other emerging economies, remain subject to sharp swings.

Cross-border investment surges

China has defied global trends in cross-border capital flows, which collapsed in 2008 and remain 60 percent below their precrisis peak. For China, by contrast, foreign direct investment (FDI), cross-border loans and deposits, and foreign portfolio investments in equities and bonds are up 44 percent over 2007 levels (Exhibit 2). Total foreign investment into China reached $477 billion at the end of 2011, exceeding the 2007 peak of $331 billion. Foreign companies, eager to establish a presence in China, account for roughly two-thirds of the inflows.

 

Exhibit 2

China’s capital flows have been approaching new heights.

 

Capital from foreign institutional and individual investors could provide another leg to growth as long-standing restrictions on foreign portfolio investment continue to ease. The number of qualified foreign institutional investors (QFII) approved by Chinese regulators has grown from 33 in 2005 to 207 in 2012 and will undoubtedly rise further. Regulators also are giving registered foreign funds more latitude to invest their holdings of offshore renminbi in China’s domestic capital markets. Both moves have further opened the door to foreign participation in those markets.

Famously, the People’s Bank of China, the nation’s central bank, has accumulated the world’s largest stock of foreign-currency reserves: $3.3 trillion at the end of 2012. While much of this money is invested in low-risk sovereign debt—for instance, US treasuries, which account for at least $1.2 trillion of China’s reserves—the growth in such investments has slowed considerably. Instead, China is both loosening restrictions on other types of financial outflows and moving to diversify its foreign holdings. That was the impetus behind the 2007 creation of the China Investment Corporation (CIC), one of the world’s largest sovereign-wealth funds, with assets of $482 billion. CIC’s holdings include shares in many of the world’s blue-chip companies; mining, energy, and infrastructure projects; global real estate; and even a stake in London’s Heathrow Airport.

Chinese companies are also stepping up their role in global finance. Foreign direct investment by both state-owned and private-sector Chinese companies grew from just $1 billion in 2000 to $101 billion in 2011. At the end of 2011, Chinese companies accounted for $364 billion of global foreign direct investment, with most of it tied to commodities. About half of these investments went to other emerging markets—a share higher than that for companies in advanced economies.

Much of China’s rapidly increasing global lending is tied to foreign investment deals involving Chinese companies (for instance, financing a mine in Peru, with construction to be undertaken by a Chinese company). Outstanding foreign loans and deposits totaled $838 billion at the end of 2011. To put this sum in perspective, consider the fact that the total level of loans outstanding from the world’s five major multilateral development banks is about $500 billion. Since 2009, Chinese loans to Latin America have exceeded those of both the Inter-American Development Bank and the World Bank (Exhibit 3).

 Exhibit 3

China now provides a higher volume of loans to Latin America than the World Bank and the Inter-American Development Bank.

 

Africa is another priority. At the 2012 Forum on China–Africa Cooperation, China pledged an additional $20 billion in new lending to that continent over the next three years. In March 2013, President Xi Jinping traveled to Africa for his first overseas trip as head of state, reaffirming this lending pledge and signing an agreement to build a multibillion-dollar port and industrial zone in Tanzania.

So far, the returns on many of China’s investments at home have been below their cost of capital. There is almost an expectation of low returns—in some cases, negative real returns—on corporate invested capital, on domestic bank deposits, and even on returns the government earns on its foreign reserves. The returns that will be earned on many of China’s recent foreign direct investments and foreign loans remain to be seen. The pace and process of the migration to market-level returns will be a challenge for policy makers.

The long road to renminbi convertibility

As China’s economy and financial clout continue to grow, so will use of the renminbi. China has aspirations to make it an international currency, perhaps eventually rivaling the US dollar and the euro for global foreign reserves. But realizing these ambitions will require substantial progress on several fronts. One is developing deep and liquid domestic capital markets for renminbi-denominated financial assets. Despite the progress described above, China’s financial depth (the total value of its financial assets as a share of GDP) remains less than half that of advanced economies. Developing larger bond markets, as well as derivatives markets to hedge currency and other risks, will be essential.

To take on a greater global role, the renminbi must also become an international medium of exchange. In recent years, China has promoted the use of its currency to settle international trade contracts; for instance, it has created swap lines to supply renminbi to 15 foreign central banks, including those of Australia and Singapore. As a result, the use of the renminbi in China’s trade has grown from around just 3 percent several years ago to an estimated 10 percent in 2012. According to a survey by HSBC, Chinese corporations expect one-third of China’s trade to be settled in renminbi by 2015.

However, to become a true international currency, the renminbi will have to be fully convertible—meaning that any individual or company must be able to convert it into foreign currencies for any reason and at any bank or foreign-exchange dealer. China’s central bank has acknowledged that the time has come to move in this direction and accelerate capital-account liberalization, and it recently outlined both short-and long-term road maps for this process. Short-term moves could include reducing controls on investment directly related to trade and encouraging Chinese enterprises to further increase outward foreign direct investment. For the longer term, the bank has outlined actions such as opening credit channels to flow both into and out of China and moving from quantity- to price-based approaches to monetary policy management. And over time, China will need to build trust in its institutions by developing a set of rules, applying them consistently, and sticking with them.

For now, however, the doors remain only partially open. Achieving the institutional development needed to fully liberalize capital accounts and remove currency controls will take time.

To assume the role of financier to the world, China will have to embrace financial globalization and advance reform more fully, and that won’t happen overnight. There is already movement toward greater openness, though, which makes China’s recent once-in-a-decade leadership transition a telling moment: if the new economic team picks up the pace of reform, the world financial system could have a very different look in just a decade’s time.

Shared by McKinsey & Company

Navigating the new era of Asian retail banking

Retail banking in Asia is growing quickly—but to capture the emerging opportunities, banks must understand the region’s complexity and respond in an appropriate way.

Retail banking in Asia is on the cusp of a new era. By 2015, more personal financial assets will reside there than in Europe, making Asia the world’s second-largest wealth-management region, behind only the United States. Retail-banking revenue in Asia, growing at 9 percent a year since 2010, is expected to reach more than $900 billion by 2020.

To help banks tackle the challenges of this evolving region, McKinsey publishedRetail banking in Asia: Actionable insights for new opportunities. The articles, combining insights from McKinsey’s proprietary data with the lessons of our extensive experience supporting clients throughout the region, offer new thinking and practical advice for executives interested in this market.

The new era in Asian banking will bring substantial opportunities, but capturing them will not be easy. Rapidly shifting consumer behavior will force banks to revisit or even completely revamp their business models. New regulatory requirements and high-risk customer segments will add to the cost of doing business, putting downward pressure on returns. Nontraditional competitors will enter the market, vying with established ones for their revenue pools. Attackers from outside the banking industry have already begun encroaching on it, using direct payment as their main entry point.

Retail banking in Asia offers detailed insights about this complex market and outlines specific steps banks can take in response. Among our findings:

  • Despite dramatic revenue growth, banks in emerging Asia should expect to see returns on equity decline by 4 to 5 percentage points in the coming years. In “Dimensions of innovation in Asian retail banking” we discuss three ways for banks to beat this downward pressure.
  • Unlike the early days of digital banking, when consumers valued low prices above all else, today customers want greater control over their finances, fair and transparent pricing, and a single, consistent, engaging experience. Findings presented in “Digital banking in Asia” suggest that banks must make digital banking an integral part of their new operational models, not a stripped-down version of the products and services offered through traditional banking channels.
  • Banks are at last seeing returns on their investment in multiple channels, but physical bank branches are not necessarily a thing of the past. They will continue to play a role in emerging markets—but in a new way. In “Is the branch obsolete in a multichannel world?” we advise bankers to understand the particular economics of their markets before making broad-based decisions about the size of their networks.
  • As in many parts of the world, “customer-centricity” is a much-discussed term in Asia, but many banks haven’t been able to turn this vague concept into something concrete. “Creating the customer-centric retail bank” presents three specific business models that can help make a bank’s efforts much more impact focused.

Retail banking in Asia is evolving quickly; the region’s emerging countries will soon have attracted more revenue in absolute terms than the developed ones. To win in this market, banks must understand their customers, their competitors, their own business models, and their regulatory environments. Getting it right will be essential if banks are to survive the battle that’s already under way.

Download the full compendium of articles, Retail banking in Asia: Actionable insights for new opportunities.

Published with cooperation from McKinsey & Company

Getting to know China’s premium-car market

Perhaps as early as 2016, China will overtake the United States as the world’s largest market for premium cars. Multinationals currently dominate it in China, but they must now adjust to a market where consumers are becoming more sophisticated than previous generations of buyers, who cared primarily about social status. The reason for the change, in part, is that more premium buyers will be driving their own cars rather than being chauffeured.

Our research compared the preferences of consumers in China and Germany because the latter country’s carmakers hold about 80 percent of the Chinese premium-auto market (exhibit). It suggests that in China, advanced power trains are much more important for attracting high-end buyers than they are in Germany. Fuel efficiency also looms larger for affluent consumers hesitant to step up to premium cars. Perhaps less surprisingly, price matters more in China, particularly for people interested in but less able to afford luxury cars, so there may well be a major market for lower-priced premium models. Germans care more about other attributes: handling and technology for the consumers most willing and able to pay for such cars, quality and comfort for less affluent consumers. Automakers in China shouldn’t stint even on these features, however; our research indicates that many Chinese view some of them as a “given” for premium cars.

Exhibit

The preferences of Chinese consumers who are willing and able to buy luxury cars differ from some of their German counterparts’ priorities.

For a more complete discussion of this research, download the full report,Upward Mobility: The Future of China’s Premium Car Market [PDF–900 KB].

Mapping China’s middle class

The explosive growth of China’s emerging middle class has brought sweeping economic change and social transformation—and it’s not over yet. By 2022, our research suggests, more than 75 percent of China’s urban consumers will earn 60,000 to 229,000 renminbi ($9,000 to $34,000) a year.

In purchasing-power-parity terms, that range is between the average income of Brazil and Italy. Just 4 percent of urban Chinese households were within it in 2000—but 68 percent were in 2012. In the decade ahead, the middle class’s continued expansion will be powered by labor-market and policy initiatives that push wages up, financial reforms that stimulate employment and income growth, and the rising role of private enterprise, which should encourage productivity and help more income accrue to households. Should all this play out as expected, urban-household income will at least double by 2022.

Beneath the topline figures are significant shifts in consumption dynamics, which we have been tracking since 2005 using a combination of questionnaires and in-depth interviews to create a detailed portrait by income level, age profile, geographic location, and shopping behavior. Our latest research suggests that within the burgeoning middle class, the upper middle class is poised to become the principal engine of consumer spending over the next decade.

As that happens, a new, more globally minded generation of Chinese will exercise disproportionate influence in the market. Middle-class growth will be stronger in smaller, inland cities than in the urban strongholds of the eastern seaboard. And the Internet’s consumer impact will continue to expand. Already, 68 percent of the middle class has access to it, compared with 57 percent of the total urban population.

Importance of the ‘upper’ cut

The evolution of the middle class means that sophisticated and seasoned shoppers—those able and willing to pay a premium for quality and to consider discretionary goods and not just basic necessities—will soon emerge as the dominant force. To underscore this group’s growing importance, we have described it in past research as the “new mainstream.” For the sake of simplicity, we now call consumers with household incomes in the 106,000 to 229,000 renminbi range upper middle class. In 2012, this segment, accounting for just 14 percent of urban households, was dwarfed by the mass middle class, with household incomes from 60,000 to 106,000 renminbi. By 2022, we estimate, the upper middle class will account for 54 percent of urban households and 56 percent of urban private consumption. The mass middle will dwindle to 22 percent of urban households (Exhibit 1).

Exhibit 1

The magnitude of China’s middle-class growth is transforming the nation.

The behavior of today’s upper middle class provides some clues to China’s future. Our research indicates that these consumers are more likely to buy laptops, digital cameras, and specialized household items, such as laundry softeners (purchased by 56 percent of the upper-middle-class consumers we surveyed last year, compared with just 36 percent of the mass middle). Along with affluent and ultrawealthy consumers, upper-middle-class ones are stimulating rapid growth in luxury-goods consumption, which has surged at rates of 16 to 20 percent per annum for the past four years. By 2015, barring unforeseen events, more than one-third of the money spent around the world on high-end bags, shoes, watches, jewelry, and ready-to-wear clothing will come from Chinese consumers in the domestic market or outside the mainland.

Generation 2 comes of age

China’s new middle class also divides into different generations, the most striking of which we call Generation 2 (G2). It comprised nearly 200 million consumers in 2012 and accounted for 15 percent of urban consumption. In ten years’ time, their share of urban consumer demand should more than double, to 35 percent. By then, G2 consumers will be almost three times as numerous as the baby-boomer population that has been shaping US consumption for years.

These G2 consumers today are typically teenagers and people in their early 20s, born after the mid-1980s and raised in a period of relative abundance. Their parents, who lived through years of shortage, focused primarily on building economic security. But many G2 consumers were born after Deng Xiaoping’s visit to the southern region—the beginning of a new era of economic reform and of China’s opening up to the world. They are confident, independent minded, and determined to display that independence through their consumption. Most of them are the only children in their families because when they were born, the government was starting to enforce its one-child policy quite strictly.

McKinsey research has shown that this generation of Chinese consumers is the most Westernized to date. Prone to regard expensive products as intrinsically better than less expensive ones, they are happy to try new things, such as personal digital gadgetry. They are also more likely than previous generations to check the Internet for other people’s usage experiences or comments. These consumers seek emotional satisfaction through better taste or higher status, are loyal to the brands they trust, and prefer niche over mass brands (Exhibit 2). Teenage members of this cohort already have a big influence on decisions about family purchases, according to our research.

Exhibit 2

Generation 2—Chinese consumers in their teens and early 20s—takes a more Western approach to shopping.

Even as the G2 cohort reshapes Chinese consumption patterns, it appears to be maintaining continuity with some of the previous generations’ values. Many G2 consumers share with their parents and grandparents a bias for saving, an aversion to borrowing, a determination to work hard, and a definition of success in terms of money, power, and social status. For the G2 cohort, however, continuity in values doesn’t translate into similar consumer behavior. Likewise, 25- to 44-year-old G1 consumers, despite their loyalty to established brands, are more open than their parents to a variety of schools of thought, and as retirees in the years ahead they will certainly demonstrate a “younger” consumption mind-set than today’s elderly do.

The rise of the west (and the north)

In 2002, 40 percent of China’s relatively small urban middle class lived in the four Tier-one cities: Beijing, Shanghai, Guangzhou, and Shenzhen. By 2022, the share of those megacities will probably fall to about 16 percent (Exhibit 3). They won’t be shrinking, of course; rather, middle-class growth rates will be far greater in the smaller cities of the north and west. Many are classified as Tier-three cities, whose share of China’s upper-middle-class households should reach more than 30 percent by 2022, up from 15 percent in 2002.

Exhibit 3

The geographic center of middle-class growth is shifting.

Tier-four cities, smaller still, will also be part of that geographic transition. Consider Jiaohe, in Jilin Province. This northern inland Tier-four city is growing quickly because of its position as a transportation center at the heart of the northeast Asian economic zone, an abundance of natural resources (such as Chinese forest herbs and edible fungi), and the fact that it is one of China’s most important production bases for grape and rice wine. In 2000, less than 1,000 households out of 70,000 were middle class, but by 2022, those figures are set to rise to 90,000 and 160,000, respectively.

Another Tier-four city, Wuwei, in Gansu Province, is growing rapidly because it’s within the Jinchang–Wuwei regional-development zone and at the junction of two railways and several highways. Wuwei too had less than 1,000 middle-class households (out of 87,000 total) in 2000. By 2022, though, 390,000 of the city’s 650,000 households should be middle class.

Continued strong growth in the size and diversity of China’s middle class will create new market opportunities for both domestic and international companies. Yet strategies that succeeded in the past, given the wide distribution of standardized products for mass consumers, must be adjusted in a new environment with millions of Chinese trading up and becoming more picky in their tastes. A detailed understanding of what consumers are doing, how their preferences are evolving, and the underlying reasons for their behavior will be needed.

Armed with better information, companies can begin tailoring their product portfolios to the needs of increasingly sophisticated consumers and revising brand architectures to differentiate offerings and attract younger consumers eager for fresh buying experiences. There will be not only challenges but also plenty of opportunities for companies whose strategies reflect China’s new constellation of rising incomes, shifting urban landscapes, and generational change.

Winning the battle for China’s new middle class

The rapid emergence of a prosperous, more individualistic, and more sophisticated class of consumers in China is creating unprecedented opportunities and challenges for companies serving them. The opportunity is clear: in less than a decade, more than three-fourths of China’s urban households will approach middle-class status on a purchasing-power-parity basis.

But the market is rapidly bifurcating between a still large (but less affluent) mass market and a new, even bigger group of upper-middle-class consumers—one that’s so large and significant we’ve referred to it in the past as the “new mainstream.”1The people in this more affluent segment tend to live in China’s higher-tier cities and coastal areas, enjoy household incomes between 106,000 and 229,000 renminbi ($16,000 to $34,000) a year, and have opinions strikingly different from those of their mass-market middle-class counterparts.

As China’s new upper middle class swells to include more than half of the country’s urban households by 2020—up from just 14 percent in 2012—it will strain many of today’s business models. Companies that have long catered to consumers trying to meet basic needs at affordable prices will face a shrinking market and risk losing millions of customers looking to trade up.

Simultaneously serving a familiar but declining mass market and an uncertain but promising new upper-middle-class one will require novel approaches. This article is a report from the front lines: how consumer-goods companies can craft brands that appeal to the rising middle class, develop “dual strategies” and transition plans for the evolving landscape, and build the marketing muscle to compete in an increasingly complex environment.

1. Aspirational brands

Until recently, Chinese consumers were generally too new to the market to focus on anything beyond the basic functional attributes of most products. These shoppers were also historically quite pragmatic, particularly in making purchase decisions in prosaic product categories where emotional connections aren’t strong. So for every Dove Chocolate or Starbucks that prospered by learning to create strong emotional ties as “occasion” products—emphasizing attributes such as “chocolate indulgence” or “the coffee break experience”— other equally recognizable brands struggled. China’s consumers simply weren’t ready for them.

How times have changed. As recently as 2010, functional benefits dominated the list of key buying factors for just about all of the 40 consumer-goods categories we studied. Just two years later, emotional benefits had become a top-five key buying factor in these same categories—and in many cases the top one or two. In the shampoo category, for example, upper-middle-class shoppers are 50 percent more likely than their mass-market counterparts to regard emotional factors as an important purchase consideration.

Consider the experience of SCA, a Swedish manufacturer of personal-care and forest products. The company uses traditional consumer roadshows to demonstrate the basic, functional benefits of its facial tissues to a broad base of Chinese consumers. But SCA also wants to position the products as affordable luxuries to which upper-middle-class consumers should aspire (the company already follows a similar approach in the wealthier Hong Kong market). “Our target is the white-collar young professional woman,” notes Stephan Dyckerhoff, president of SCA’s North Asia Hygiene Products division. “We want her to show off our product in much the same way she might show off using an iPhone.”

To achieve such big aspirations, the company looks for unique ways to strengthen the emotional connection between consumers and its products. One approach involves karaoke lounges, where SCA distributes special small packs of tissues to create a positive association between the product and activities customers enjoy. Such clever approaches to execution will probably be differentiators in a crowded market. Similarly, other leading companies are working hard on in-store execution and word-of-mouth effects (including social-media platforms where more and more consumers exchange ideas) to help ensure that China’s increasingly affluent consumers notice their products.3

2. Dual strategies

Aspirational brands, already relevant for China’s new upper middle class, will become even more important as it grows. “The new upper-middle-class opportunity is where the future is,” says Alan Jope, the head of Unilever’s businesses in north Asia. “It’s huge across categories and even more important than the luxury class of consumers.”

Yet as Unilever and other leading companies size up the new consumer, they also recognize the power that China’s consumer mass market still wields. “Consumers in coastal China may be getting wealthier and trading up,” notes Michael Yeung, the president of Wrigley Asia Pacific, “but China’s interior and lower-tier cities will continue to be a vast market for us.”

A few forward-looking companies are responding with dual strategies: a mass-market business designed for volume alongside an upper-middle-class one for profits. In practical terms, such a strategy often plays out along geographic lines: large regions divided into smaller clusters, each, perhaps, with its own product portfolio, pricing, marketing approach, and execution plan. The most sophisticated players establish clear profit-and-loss responsibilities for regions and recognize that the “shape” of that P&L—the relative importance of volume, value, cost control, and margins—will inevitably vary.

A major snack manufacturer uses such a strategy to create relatively cheap entry-level mass-market products while reserving higher-margin offerings for customers who trade up. To minimize product cannibalization, the company limits the distribution of entry-level products to lower-tier cities with average incomes below a certain threshold—and even there, only in more traditional “mom and pop” stores.4 This approach helps keep the company’s low-end products off the shelves of modern retailers that carry its premium ones. The company doesn’t stop at distribution: to combat gray-market sales, its employees routinely visit retail outlets, inspecting the shelves and using scan codes to determine where products originated and where they belong. Distributors that violate the rules are first warned, then cut loose if they don’t comply.

Meanwhile, the company reserves its more expensive offerings for wealthier cities in coastal areas, carefully marketing and packaging products to attract more sophisticated, aspirational shoppers who view higher-priced snacks as a way to reward themselves. This approach has helped the company to increase its revenues in China by more than 15 percent annually over the past three years. Volume growth leads the way in the country’s interior, while the richer coastal cities drive profitability.

Bayer Consumer Care has adopted a similar approach. The company recently undertook an initiative to widen its sales and distribution coverage in China’s smaller cities. But it also added sales representatives in 28 core municipalities in top-tier ones, where the company hopes to raise its game with new upper-middle-class consumers.

3. Disciplined transition timing

Timing is a crucial element of effective dual strategies. Companies must recognize the nature of shifts under way in different geographies and move fast to stay ahead of competitors. But they can’t move so quickly that their mass-market business is destabilized. All that takes discipline.

Consider the timing discipline of a global consumer-goods manufacturer pursuing a dual strategy. The company’s executives started by dividing consumers into about 40 geographic microclusters based on their income levels and preferences, as well as the activities of competitors. Next, teams representing each of the company’s major product categories looked at the microclusters with an eye toward grouping them into archetypes based on the stages of their evolution: solidly mass market, beginning the transition, or rapidly uptrading. The company then reviewed these recommendations and, to sharpen its thinking, used differences the teams had identified— for example, one microcluster was rapidly uptrading in shampoos but not yet in soaps.

The company’s activities in microclusters that remained solidly mass market went largely unchanged. Microclusters in the second category (beginning the transition) were included in a marketing plan to introduce more upmarket brands and products over a 12- to 24-month horizon. For the rapid uptraders, the company ramped up the pace: a 6- to 9-month window for new brands and stock-keeping units, as well as new promotional messages to help drive up average prices. To avoid being wrong-footed by rivals, the company created competitive-intelligence teams that travel through the country to collect insights and work with the sales force to coordinate the appropriate response. When a rival’s new product or strategy appears to affect the transition plan, the company can quickly change the pace of the shift to shut out competitors quickly and avoid losing market share.

This company’s ability to adapt quickly has been instrumental in the strategy’s success. The results have been impressive: 12 to 15 percent volume growth and a 15 to 20 percent boost in revenues in each of the past three years, along with a clear increase in earnings before interest and taxes (EBIT) as investments to establish the strategy begin to pay off.

As this example clearly shows, timing and geography often intersect when companies make strategic choices. Consider the balancing act of a multinational personal-care company with its body-care-products business. Recognizing that tastes are different in northern China—a relatively low-income region with a large mass market—the company focuses heavily on sales of its more traditional bar-soap products to match local preferences there. Meanwhile, the company is gearing up its marketing efforts to begin converting those customers to higher-margin liquid soap as they transition into the new upper middle class. By contrast, mass-market consumers in southern China already prefer liquid soap. As these customers become more affluent, the company works to persuade them to upgrade from cheaper, local brands.

4. State-of-the-art marketing

Successfully implementing sophisticated, time-based dual strategies requires serious marketing muscle. Multiple touch points are not only important but also, in many cases, increasingly digital. The key is to use them creatively to balance the tension between reaching a large mass audience and appealing to the greater individuality of the new middle class.

Consider Nike, long familiar for its TV advertising in China and for its ubiquitous urban billboards showing famous athletes. More recently, the company launched its first marketing campaign on WeChat, a popular Chinese mobile-messaging platform. The campaign, billed as a sports-subscription service, allowed users to “follow” the company and receive daily updates about an upcoming Nike sports festival. To encourage participation, the company aggressively placed QR codes5on taxis, outdoor posters, and other noticeable spots. WeChat’s broad reach—it has 200 million users—helped Nike to keep in touch with the mainstream, while opportunities for user participation helped heighten the sense of individuality for upscale consumers.

Pulling off such campaigns calls for sophisticated customer insights, which are becoming ever more important as the upper middle class grows and its tastes evolve. One global food and beverage maker has responded by creating “insights centers” in six regions of China to stay ahead of changing customer preferences and behavior. Similarly, in P&G’s Beijing Innovation Center, the company built a small hutong neighborhood—a set of narrow, traditional Chinese lanes formed by the walls of siheyuan, or traditional courtyard homes. Researchers in P&G’s simulated hutong observe consumers as they brush their teeth or change diapers, standing ready to propose immediate changes to product prototypes, much as researchers do in the simulated baby playrooms at the company’s Cincinnati, Ohio, headquarters. In the same Beijing facility, P&G stocks simulated supermarket shelves with its own products and those of competitors to better understand how consumers shop.

There’s another increasingly important source of insights: social media. In 2006 L’Oréal, for example, launched the social platform Rose Beauty by Lancôme, an online community where women in China could exchange beauty tips and seek expert advice. The community now has close to a million members, many of them active—in 2011, two-thirds of site visitors returned more than once a day, and nearly half of the discussion topics the company posted had more than five comments from users. The platform is not only an important promotional tool but also a valuable source of information for L’Oréal, allowing the company to better understand the expectations of Chinese women and to tailor its product-development efforts accordingly. Such smart applications of social media are just one example of how technology and data sources are becoming increasingly important in the world’s largest market (see sidebar, “Tech-enabled customer engagement”).

But technology will never eliminate the need for creativity, which remains central to smart marketing in China and sometimes generates lucky breaks. SCA recently invited Chinese consumers to come up with their own clever uses for an empty box of facial tissues to drive home associations between its products and resource sustainability. The winner received a trip to the company’s private forest in Sweden, where SCA grows trees in a sustainable way to be used as raw material in its products. What started as a marketing experiment soon drew the attention of a Chinese TV station, which flew reporters to Sweden along with the contest winner. The station ultimately aired a two-hour documentary on the experience, an outcome that exceeded even the company’s most optimistic expectations for the campaign.

China’s new middle class is becoming more important more quickly than most companies could have anticipated. Multinationals that haven’t begun preparing to serve increasingly affluent and demanding shoppers should start now—or risk watching their businesses deteriorate as the market shifts beneath them.

Disruptive technologies: Advances that will transform life, business, and the global economy

Executive Summary: 

The parade of new technologies and scientific breakthroughs is relentless and
is unfolding on many fronts. Almost any advance is billed as a breakthrough,
and the list of “next big things” grows ever longer. Yet some technologies do in
fact have the potential to disrupt the status quo, alter the way people live and
work, rearrange value pools, and lead to entirely new products and services.
Business leaders can’t wait until evolving technologies are having these effects
to determine which developments are truly big things. They need to understand
how the competitive advantages on which they have based strategy might erode
or be enhanced a decade from now by emerging technologies—how technologies
might bring them new customers or force them to defend their existing bases or
inspire them to invent new strategies.

Policy makers and societies need to prepare for future technology, too. To do
this well, they will need a clear understanding of how technology might shape the
global economy and society over the coming decade. They will need to decide
how to invest in new forms of education and infrastructure, and figure out how
disruptive economic change will affect comparative advantages. Governments
will need to create an environment in which citizens can continue to prosper, even
as emerging technologies disrupt their lives. Lawmakers and regulators will be
challenged to learn how to manage new biological capabilities and protect the
rights and privacy of citizens.

Why do translation services cost so much?

For a company that has not yet had a need for translation services, it might seem as if translation services cost quite a bit.

But once you analyze what really needs to happen in a translation, you’ll see that it is more economical to hire a professional translation services company like EPIC Translations rather than hiring your own translators.

For example, when you hire an employee in the Marketing department, you’re actually incurring quite a bit of cost in addition to the salary:

  1. taxes
  2. health insurance
  3. vacation
  4. and other overhead costs

If you’re paying $50,000 to your Marketing resource then the actual cost of having that resource is somewhere closer to $70,000 annually.

If you’re looking to export your business to other countries/markets, it is better to have your content (product manuals, marketing plan, company policies, legal agreements, etc) professionally translated.

Why, you might ask?

Because finding a qualified translator to hire on your own is quite an ordeal. Even if you decide to work thru this ordeal, you’ll have to sit the translator at least a week or two until he/she becomes familiar with your content type and target audience in order to produce an acceptable quality driven translation. Furthermore, if you’re expanding to Brazil, the translator you’re hiring in your U.S. office might not have recent familiarity with the Brazilian market. You’ll be paying quite a bit of money to bring in a translator to produce a translation that might lack the desired quality to take your company to new countries.

With that being said, it is better to hire a professional translation services company like EPIC Translations to produce cost-effective and quality driven translations because we will employ translators for you who are located in your target country and are part of your industry where you compete in! When it’s all done and said, it is cheaper to outsource to EPIC Translations than to hire your own translators.

 

 

Givers take all: The hidden dimension of corporate culture

By encouraging employees to both seek and provide help, rewarding givers, and screening out takers, companies can reap significant and lasting benefits.

After the tragic events of 9/11, a team of Harvard psychologists quietly “invaded” the US intelligence system. The team, led by Richard Hackman, wanted to determine what makes intelligence units effective. By surveying, interviewing, and observing hundreds of analysts across 64 different intelligence groups, the researchers ranked those units from best to worst.

Then they identified what they thought was a comprehensive list of factors that drive a unit’s effectiveness—only to discover, after parsing the data, that the most important factor wasn’t on their list. The critical factor wasn’t having stable team membership and the right number of people. It wasn’t having a vision that is clear, challenging, and meaningful. Nor was it well-defined roles and responsibilities; appropriate rewards, recognition, and resources; or strong leadership.

Rather, the single strongest predictor of group effectiveness was the amount of help that analysts gave to each other. In the highest-performing teams, analysts invested extensive time and energy in coaching, teaching, and consulting with their colleagues. These contributions helped analysts question their own assumptions, fill gaps in their knowledge, gain access to novel perspectives, and recognize patterns in seemingly disconnected threads of information. In the lowest-rated units, analysts exchanged little help and struggled to make sense of tangled webs of data. Just knowing the amount of help-giving that occurred allowed the Harvard researchers to predict the effectiveness rank of nearly every unit accurately.

The importance of helping-behavior for organizational effectiveness stretches far beyond intelligence work. Evidence from studies led by Indiana University’s Philip Podsakoff demonstrates that the frequency with which employees help one another predicts sales revenues in pharmaceutical units and retail stores; profits, costs, and customer service in banks; creativity in consulting and engineering firms; productivity in paper mills; and revenues, operating efficiency, customer satisfaction, and performance quality in restaurants.

Across these diverse contexts, organizations benefit when employees freely contribute their knowledge and skills to others. Podsakoff’s research suggests that this helping-behavior facilitates organizational effectiveness by:

  • enabling employees to solve problems and get work done faster
  • enhancing team cohesion and coordination
  • ensuring that expertise is transferred from experienced to new employees
  • reducing variability in performance when some members are overloaded or distracted
  • establishing an environment in which customers and suppliers feel that their needs are the organization’s top priority

Yet far too few companies enjoy these benefits. One major barrier is company culture—the norms and values in organizations often don’t support helping. After a decade of studying work performance, I’ve identified different types of reciprocity norms that characterize the interactions between people in organizations. At the extremes, I call them “giver cultures” and “taker cultures.”

Give, take, or match

In giver cultures, employees operate as the high-performing intelligence units do: helping others, sharing knowledge, offering mentoring, and making connections without expecting anything in return. Meanwhile, in taker cultures, the norm is to get as much as possible from others while contributing less in return. Employees help only when they expect the personal benefits to exceed the costs, as opposed to when the organizational benefits outweigh the personal costs.

Most organizations fall somewhere in the middle. These are “matcher cultures,” where the norm is for employees to help those who help them, maintaining an equal balance of give and take. Although matcher cultures benefit from collaboration more than taker cultures do, they are inefficient vehicles for exchange, as employees trade favors in closed loops. Should you need ideas or information from someone in a different division or region, you could be out of luck unless you have an existing relationship. Instead, you would probably seek out people you trust, regardless of their expertise. By contrast, in giver cultures, where colleagues aim to add value without keeping score, you would probably reach out more broadly and count on help from the most qualified person.

In light of the benefits of more open systems of helping, why don’t more organizations develop giver cultures? All too often, leaders create structures that get in the way. According to Cornell economist Robert Frank, many organizations are essentially winner-take-all markets, dominated by zero-sum competitions for rewards and promotions. When leaders implement forced-ranking systems to reward individual performance, they stack the deck against giver cultures.

Pitting employees against one another for resources makes it unwise for them to provide help unless they expect to receive at least as much—or more—in return. Employees who give discover the costs quickly: their productivity suffers as takers exploit them by monopolizing their time or even stealing their ideas. Over time, employees anticipate taking-behavior and protect themselves by operating like takers or by becoming matchers, who expect and seek reciprocity whenever they give help.

Fortunately, it is possible to disrupt these cycles. My research suggests that committed leaders can turn things around through three practices: facilitating help-seeking, recognizing and rewarding givers, and screening out takers.

Help-seeking: Erase the shadow of doubt

Giver cultures depend on employees making requests; otherwise, it’s difficult to figure out who needs help and what to give. In fact, studies reviewed by psychologists Stella Anderson and Larry Williams show that direct requests for help between colleagues drive 75 to 90 percent of all the help exchanged within organizations.

Yet many people are naturally reluctant to seek help. They may think it’s pointless, particularly in taker cultures. They also may fear burdening their colleagues, lack knowledge about who is willing and able to help, or be concerned about appearing vulnerable, incompetent, and dependent.

Reciprocity rings

It’s possible to overcome these barriers. For example, University of Michigan professor Wayne Baker and his wife, Cheryl Baker, at Humax Networks developed an exercise called the “reciprocity ring.” The exercise generally gathers employees in groups of between ten and two dozen members. Each employee makes a request, and group members use their knowledge, resources, and connections to grant it. The Bakers typically run the exercise in two 60-to 90-minute rounds—the first for personal requests, so that people begin to open up, and the second for professional requests. Since everyone is asking for help, people rarely feel uncomfortable.

The monetary value of the help offered can be significant. One pharmaceutical executive attending a reciprocity ring involving executives from a mix of industry players saved $50,000 on the spot when a fellow participant who had slack capacity in a lab offered to synthesize an alkaloid free of charge. And that’s no outlier: the Bakers find that executive reciprocity-ring participants in large corporate settings report an average benefit exceeding $50,000—all for spending a few hours seeking and giving help. This is true even when the participants are from a single company. For example, 30 reciprocity-ring participants from a professional-services firm estimated that they had received $261,400 worth of value and saved 1,244 hours. The ring encourages people to ask for help that their colleagues weren’t aware they needed and efficiently sources each request to the people most able to fulfill it.

Beyond any financial benefits, the act of organizing people to seek and provide help in this way can shift cultures in the giver direction. Employees have an opportunity to see what their colleagues need, which often sparks ideas in the ensuing weeks and months for new ways to help them. Even employees who personally operate as takers (regardless of the company’s culture) tend to get involved: in one study of more than 100 reciprocity-ring participants, Wayne Baker and I found that people with strong giver values made an average of four offers of help, but those who reported caring more about personal achievements and power than about helping others still averaged three offers.

During the exercise, it becomes clear that giving is more efficient than matching, as employees recognize how they gain access to a wider network of support when everyone is willing to help others without expecting anything in return rather than trading favors in pairs. After running the exercise at companies such as Lincoln Financial and Estée Lauder, I have seen many executives and employees take the initiative to continue running it on a weekly or monthly basis, which allows the help-seeking to continue and opens the door for greater giving as well as receiving.

Dream on

There are other ways to stimulate help-seeking. Consider what a company called Appletree Answers, a provider of call-center services, did back in 2008. John Ratliff, the founder and CEO, was alarmed by the 97 percent employee-turnover rate in his call centers. The underlying challenge, Ratliff believed, was that rapid expansion had cost the company its sense of community. Appletree had undergone 13 acquisitions in just six years and grown from a tiny operation to a company with more than 350 employees. As the cohesion of the group eroded, employees began prioritizing their own exit opportunities over the company’s need for them to contribute, and customer service suffered.

During a brainstorming meeting, the director of operations suggested a novel approach to improving the culture: creating an internal program modeled after the Make-A-Wish Foundation. Ratliff and colleagues designed a program called Dream On, inviting employees to request the one thing they wanted most in their personal lives but felt they could not achieve on their own. Soon, a secret committee was making some of these requests happen—from sending an employee’s severely ill husband to meet his favorite players at a Philadelphia Eagles game to helping an employee throw a special birthday party for his daughter.

After granting more than 100 requests, the program has helped promote a company culture where, in the words of one insider, “employees look to do things for each other and literally are ‘paying it forward.’” Indeed, employees often submit requests on behalf of their colleagues. The program has helped reduce the uncertainty and discomfort often associated with seeking help: employees know where to turn, and they know they’re not alone. In the six months after Dream On was implemented, retention among frontline staff soared to 67 percent, from 3 percent, and the company had its two most profitable quarters ever. “You’re either a giver or a taker,” Ratliff says. “Givers tend to get stuff back while takers fight for every last nickel . . . they never have abundance.”

Such programs aren’t limited to small companies. In a study of a similar program at a Fortune 500 retailer, Jane Dutton, Brent Rosso, and I found that participants became more committed to the company and felt the program strengthened their sense of belonging in a community at work. They reported feeling grateful for the opportunity to show concern for their colleagues and took pride in the company for supporting their efforts.

Boundaries and roles

Despite the power of help-seeking in shaping a giver culture, encouraging it also carries a danger. Employees can become so consumed with responding to each other’s requests that they lack the time and energy to complete their own responsibilities. Over time, employees face two choices: allow their work to suffer or shift from giving to taking or matching.

To avoid this trade-off, leaders need to set boundaries, as one Fortune 500 technology company did when its engineers found themselves constantly interrupted with requests for help. Harvard professor Leslie Perlow worked with them to create windows for quiet time (Tuesdays, Thursdays, and Fridays until noon), when interruptions were not allowed. After the implementation of quiet time, the majority of the engineers reported above-average productivity, and later their division was able to launch a product on schedule for the second time in history. By placing clear time boundaries around helping, leaders can better leverage the benefits of giver cultures while minimizing the costs.

Alternatively, some organizations designate formal “helping” roles to coordinate more efficient help-seeking and -giving behavior. In a study at a hospital, David Hofmann, Zhike Lei, and I examined the importance of adding a nurse-preceptor role—a person responsible for helping new employees and consulting on problems. Employees felt more comfortable seeking help and perceived that they had greater access to expertise when the preceptor role existed. Outside of health-care settings, companies often develop this function by training liaisons for new employees and leadership coaches for executives and high-potential managers. Designating helping roles can provide employees with a clear sense of direction on where to turn for help without creating undue burdens across a unit.

Rewards: To the givers go the spoils

In a perfect world, leaders could promote strong giver cultures by simply rewarding employees for their collective helping output. The reality, however, is more complicated.

In a landmark study led by Michael Johnson at the University of Washington, participants worked in teams that received either cooperative or competitive incentives for completing difficult tasks. For teams receiving cooperative incentives, cash prizes went to the highest-performing team as a whole, prompting members to work together as givers. In competitive teams, cash prizes went to the highest-performing individual within each team, encouraging a taker culture. The result? The competitive teams finished their tasks faster than the cooperative teams did, but less accurately, as members withheld critical information from each other.

To boost the accuracy of the competitive teams, the researchers next had them complete a second task under the cooperative reward structure (rewarding the entire team for high performance). Notably, accuracy didn’t go up—and speed actually dropped.

People struggled to transition from competitive to cooperative rewards. Instead of shifting from taking to giving, they developed a pattern of cutthroat cooperation. Once they had seen their colleagues as competitors, they couldn’t trust them. Completing a single task under a structure that rewarded taking created win–lose mind-sets, which persisted even after the structure was removed.

Johnson’s work reminds us that giver cultures depend on a more comprehensive set of practices for recognizing and rewarding helping behavior in organizations. Creating such a culture starts with expanding performance evaluations beyond results, to include their impact on other individuals and groups. For example, when assessing the performance of managers, the leadership can examine not only the results their teams achieve but also their record in having direct reports promoted.

Yet even when giving-metrics are included in performance evaluations, there will still be pressures toward taking. It’s difficult to eliminate zero-sum contests from organizations altogether, and indeed doing so risks extinguishing the productive competitive fires that often burn within employees.

To meet the challenge of rewarding giving without undercutting healthy competition, some companies are devising novel approaches. In 2005, Cory Ondrejka was the chief technology officer at Linden Lab, the company behind the virtual world Second Life. Ondrejka wanted to recognize and reward employees for going beyond the call of duty, so he borrowed an idea from the restaurant industry: tipping.

The program allowed employees to tip peers for help given, by sending a “love message” that adds an average of $3 to the helper’s paycheck. The messages are visible to all employees, making reputations for generosity visible. Employees still compete for bonuses and promotions—but also to be the most helpful. This system “gives us a way of rewarding and encouraging collaborative behavior,” founder Philip Rosedale explained.

Evidence highlights the importance of keeping incentives small and spontaneous. If the rewards are too large and the giving-behavior necessary to earn them is too clearly scripted, some participants will game the system, and the focus on extrinsic rewards may undermine the intrinsic motivation to give, leading employees to provide help with the expectation of receiving.

The peer-bonus and -recognition programs that have become increasingly popular at companies such as Google, IGN, Shopify, Southwest Airlines, and Zappos reduce such “gaming” behavior. When employees witness unique or time-consuming acts of helping, they can nominate the givers for small bonuses or recognition. One common model is to grant employees an equal number of tokens they can freely award to colleagues. By supporting such programs, leaders empower employees to recognize and reinforce giving—while sending a clear signal that it matters. Otherwise, many acts of giving occur behind closed doors, obscuring the presence and value of helping-norms.

Sincerity screening: Keep the wrong people off the bus

Encouraging help-seeking and recognizing those who provide it are valuable steps toward enabling a giver culture. These steps are likely to be especially powerful in organizations that already screen out employees with taker tendencies. Psychologist Roy Baumeister observes that negative forces typically have a stronger weight than positive ones. Research by Patrick Dunlop and Kibeom Lee backs up this insight for cultures: takers often do more harm than givers do good.

As a result, Stanford professor Robert Sutton notes, many companies, from Robert W. Baird and Berkshire Hathaway to IDEO and Gold’s Gym, have policies against hiring people who act like takers. But what techniques actually help identify a taker personality? After reviewing the evidence, I see three valid and reliable ways to distinguish takers from others.

First, takers tend to claim personal credit for successes. In one study of computer-industry CEOs, researchers Arijit Chatterjee and Donald Hambrick found that the takers were substantially more likely to use pronouns like I and me instead of usand we. When interviewers ask questions about successes, screening for self-glorifying responses can be revealing. Mindful of this pattern, Barton Hill, a managing director at Citi Transaction Services, explicitly looks for applicants to describe accomplishments in collective rather than personal terms.

Second, takers tend to follow a pattern of “kissing up, kicking down.” When dealing with powerful people, they’re often good fakers, coming across as charming and charismatic. But when interacting with peers and subordinates, they feel powerful, which leads them to let down their guard and reveal their true colors. Therefore, recommendations and references from colleagues and direct reports are likely to be more revealing than those from bosses.

General Electric’s Durham Engine Facility goes further still: candidates for mechanic positions work in teams of six to build helicopters out of Legos. One member is allowed to look at a model and report back to the team, and trained observers assess the candidates’ behavior, with an eye toward how well they take the initiative while remaining collaborative and open. In such environments, the fakers are often easy to spot through their empty gestures: as London Business School’s Dan Cable reports, the takers “try to ‘demonstrate leadership’ and ‘take initiative’ by jumping up first.” When it comes to predicting how people will actually treat others in a company, few pieces of information are more valuable than observing their behavior directly.

Finally, takers sometimes engage in antagonistic behavior at the expense of others—say, badmouthing a peer who’s up for a promotion or overcharging an uninformed customer—simply to ensure that they come out on top. To maintain a positive view of themselves, takers often rely on creative rationalizations, such as “My colleague didn’t really deserve the promotion anyway” or “that customer should have done his homework.” They come to view antagonism as an appropriate, morally defensible response to threats, injustices, or opportunities to claim value at the expense of others.

With this logic in mind, Georgia Tech professor Larry James has led a pioneering series of studies validating an assessment called the “conditional reasoning test of aggression,” a questionnaire cleverly designed to unveil these antagonistic tendencies through reasoning problems that lack obvious answers. It has an impressive body of evidence behind it. People who score high on the test are significantly more likely to engage in theft, plagiarism, forgery, other kinds of cheating, vandalism, and violence; to receive lower performance ratings from supervisors, coworkers, and subordinates; and to be absent from work or quit unexpectedly. By screening out candidates with such tendencies, leaders can increase the odds of selecting applicants who will embrace a giver culture.

Walk the talk

Giver cultures, despite their power, can be fragile. To sustain them, leaders need to do more than simply encourage employees to seek help, reward givers, and screen out takers.

In 1985, a film company facing financial pressure hired a new president. In an effort to cut costs, the president asked the two leaders of a division, Ed and Alvy, to conduct layoffs. Ed and Alvy resisted—eliminating employees would dilute the company’s value. The president issued an ultimatum: a list of names was due to him at nine o’clock the next morning.

When the president received the list, it contained two names: Ed and Alvy.

No layoffs were conducted, and a few months later Steve Jobs bought the division from Lucasfilm and started Pixar with Ed Catmull and Alvy Ray Smith.

Employees were grateful that “managers would put their own jobs on the line for the good of their teams,” marvels Stanford’s Robert Sutton, noting that even a quarter century later, this “still drives and inspires people at Pixar.”

When it comes to giver cultures, the role-modeling lesson here is a powerful one: if you want it, go and give it.

Printed from McKinsey Insights & Publications

Whither the US equity markets?

The underlying drivers of performance suggest that over the long term, a dramatic decline in equity returns is unlikely.

US equity markets stretched once again into record territory in April, setting new highs on both the Dow and the S&P 500 indexes. That’s good news for investors—it wasn’t that long ago when the market was headed in the other direction. The question on everyone’s mind, though, is where the market is headed next.

In the short term, of course, there’s no telling what will happen—and speculation is risky. Investors and companies alike are notoriously weak at timing their investments to the market. But those are short-term questions; what really matters from a corporate-strategy perspective is the long term, and what really counts in the long term is the market’s relationship to the real economy.

In fact, much of the equity market’s performance in the United States, as we’ve seen over at least the past 50 years, is clearly linked to the performance of the real economy, including GDP growth, corporate profits, interest rates, and inflation—in spite of short-term volatility. And in the absence of some disruption of that link, the market should continue to thrive. In a nutshell, if GDP were to grow at rates comparable to the 2 to 3 percent annual real growth of the past 50 years and inflation is kept in check, investors should be able to expect annual stock-market returns of 5 to 7 percent in real dollars over the next 10 to 20 years.

Of course, it’s worth remembering the old saw about economists predicting nine of the past four recessions: in economics, it’s often easier to predict the long term than the short term. The same applies to the stock market. So while we’d never attempt to forecast periods as short as even five years—affected as they are by volatile shifts in investor expectations—today’s fundamentals make us relatively sanguine about the market’s performance over the longer term. Indeed, it would take catastrophic changes in real economic performance spread over multiple decades in the real economy or a fundamental shift in investor behavior—unlike anything we’ve seen in more than a century—to reduce long-term equity returns to below around 5 percent in developed markets. In this article, we’ll first examine the connection between equities and the real economy and then consider the likely causes of breaks in that connection over specific periods of time.

Stock-market performance and the real economy

Over the past century, stocks have earned about 9 to 10 percent per year. Adjusted for inflation, that means investors have earned annual real returns on US common stocks of about 6 percent per year.

That 6 percent is no random number—and understanding where it has come from in the past tells us something about how likely it is to continue in the future. In fact, that number is a natural consequence of economic forces derived from the long-term performance of companies and industries in aggregate and from the relationships among economic growth, corporate profits, and returns on capital—and how they convert into shareholder returns (TRS). Once these relationships are made clear, the connection between the stock market and the real economy becomes apparent, and historical returns make sense: that is, share-price appreciation combined with cash yield has resulted in about 6 percent real TRS—depending on the precise measuring period. Here’s how it works, using the last 50 years of the S&P 500 index as an example.

Share-price appreciation. From the end of 1962 through the end of 2012, real share prices grew at 2.7 percent per year, roughly the same rate as real profit growth and real GDP growth. Share prices and real profit tend to grow at the same rate because the P/E ratio tends to revert to a normal level of around 15 times earnings—as long as the economy, inflation, and interest rates are in a “normal” range of stable longer-term levels. In fact, both theory and the data show that a P/E ratio of 15 is consistent with average returns on equity of 13 percent, a real cost of capital of about 7 percent, inflation of 2 percent, and long-term profit growth of 2.5 percent.

Cash yield. Over the 50-year period, investors earned another 3.1 percent per year in dividends and share repurchases, as companies paid out around 55 to 65 percent of their profits to shareholders. That payout ratio, combined with an average P/E ratio of 15, results in a cash yield on stocks between 3 and 4 percent per year. Payout levels may be volatile over the short term, but over the longer term, dividend and share-repurchase payouts are driven by company cash flows—the profits a company earns less the portion of these profits it must reinvest to grow. Anything left over must eventually be paid back to shareholders, even among companies that sit on their cash for years.

Combined, that level of share-price appreciation and dividend yield results in a total real return of 5.8 percent per year, slightly lower than the 100-year average due to recessions and high inflation in the 1970s. It’s not inconceivable that fundamental economic forces might tilt the balance and undermine the equity markets. Radical shifts in investor risk preferences, for example, could permanently shift the long-term P/E ratio from 15 to some other number. So could extreme changes in the performance of the economy, such as substantially higher or lower long-term GDP growth or a large change in the ratio of corporate profits to GDP, bigger than the one that has taken place in recent years.

But such things haven’t happened thus far, and as long as they don’t, shareholder returns are unlikely to deviate much from the 6 percent real long-term return. In fact, even with relatively extreme assumptions about long-term earnings growth, it is difficult to foresee real long-term shareholder returns of less than about 5 percent (Exhibit 1). (Readers can explore the likely impact on shareholder returns of a range of assumptions on earnings growth and on the value of today’s share prices relative to historical norms using an interactive calculator.

 

Exhibit 1

Absent radical shifts, returns are unlikely to deviate much from the long-term norm.

 

Stock-market eras, 1962–2012

It would be hard to argue that the market’s movements can be explained by anything other than a random process over periods as short as a day, a week, or even several years. There are simply too many moving parts. Shifts are often as much about changes in expectations as they are about actual performance. Market observers like to focus on trough-to-peak periods, like the 11 percent real returns from 1983 to the market’s peak in 2000. But linking the market to the real economy does let us tease out the impact of different fundamental forces behind its performance over longer periods. By understanding what shaped past events, we are in a better position to explain where we are today and what the future might look like.

To better understand why the market has deviated from its long-term trajectory in the past, it helps to look at its performance through the lens of underlying economic trends rather than the usual approach of examining calendar decades or peak-to-trough cycles. We defined five eras in the past 50 years, distinguished by key events in the real economy—inflation, interest rates, and corporate-profit growth (Exhibit 2).

Exhibit 2

Five eras illustrate the market’s connection to the real economy.

The era from 1962 to 1968 was a robust period, with a fast-growing economy and low, stable inflation and interest rates. Not surprisingly, then, the real return to shareholders was 9.4 percent, above the long-term average.

Contrast that fairly short period of calm to the years 1968 to 1996, when real returns fell below the long-term average to about 5 percent. During the first era of this much longer period, from 1968 to 1981, inflation (and the resulting high interest rates) slowed the real economy and the stock market and led to low P/E ratios. As most economics observers understand, when inflation is high, companies are unable to increase their returns on capital enough to make up for it. This leads to higher investment and lower cash flows for a given level of growth, and therefore lower P/E ratios. Inflation also depresses P/E levels because investors discount expected cash flows at a higher cost of capital. Indeed, high inflation and interest rates drove down the P/E ratio from 17 in 1968 to about 9 in 1981, when inflation was 9.4 percent and interest rates were nearly 14 percent. That decline in P/E ratios, plus the negative effects on economic growth, resulted in real returns to shareholders of –1.3 percent per year.

As inflation was brought under control in the early 1980s, P/E ratios and economic growth returned to normal levels. Real returns to shareholders were 13 percent per year. While commentators have held those returns up almost as a golden age of stocks, the reality was more mundane; it was just a return to normalcy.

The years 1996 to 2004 appear very different depending on whether you look at the total return over the entire period or only at what happened in the middle. From beginning to end, real returns to shareholders were about 6 percent. What everyone remembers, though, is what happened in the middle. The S&P 500 index went from 741 at the beginning of 1997 to a peak of 1,527 in mid-2000 before falling back to 1,212 at the end of 2004.

This movement was caused not by a market-wide bubble but by a very large sector bubble in technology and megacap stocks, whose P/E ratios ballooned in 1999–2000 to twice those of rest of the index. The S&P 500 index is weighted by the value of its stocks—and while the range of P/Es is typically fairly narrow, movements in a handful of the largest stocks can shape the entire index. The collapse of the bubble in 2000 led to a convergence of P/Es and a return to normal over the next four years.

Similar circumstances define the period from 2004 to 2012. This time around, it was unusually high corporate profits, not a high P/E ratio, that drove the S&P 500 up to a new high of 1,565 in October 2007. These profits, however, were concentrated in the energy sector, with oil prices reaching $145 per barrel, and in the banking sector, with overoptimistic assumptions about the value of loans and unsustainable speculative activities. In their initial panic over the credit crisis, investors drove the S&P 500 index briefly as low as 676 in March 2009. That lasted just a couple of months, however, as investors realized that as bad as the recession might be, the long-term outlook couldn’t be so bleak. For the rest of the period (2010 to 2012), corporate profits and P/E ratios began to return to normal. At the end of 2012, corporate profits and GDP had not yet returned to long-term trend levels, leading to subpar real shareholder returns of about 2 percent for the 2004–12 period.

By early March 2013, as the S&P 500 again neared record-high levels, the forward P/E multiple stood at around 16. However, at this writing, there is still great uncertainty about the trend in corporate profits and whether GDP and corporate profits will return to long-term trends in 2013 or 2014.

Unlike the market for fine art or exotic cars, where value is determined by changing investor tastes and fads, the stock market is underpinned by companies that generate real profits and cash flows. Most of the time, its performance can be explained by those profits, cash flows, and the behavior of inflation and interest rates. Deviations from those linkages, as in the tech bubble in 1999–2000 or the panic in 2009, tend to be short-lived.

Printed from McKinsey Insights & Publications