Is QE unquestionably supportive for risk assets? I think not.

We have written about quantitative easing (QE) many times over the years, yet there remains more to be said: the great QE experiment is not yet over. Given the result of the EU referendum, speculation is rife as to whether the Bank of England will embark on another round of QE to stimulate the UK economy; arguably making this a good time to debate the efficacy of such strategies.

It’s safe to say that the most surprising aspect of QE has been the lack of inflation, but central banks which have undertaken – or are still undertaking – QE claim that it has worked by preventing deflation through portfolio rebalancing. The shift in funds into riskier assets has led to higher stock markets. My take on this? Central banks are over exaggerating their claims at best, or grabbing at straws at worst.

Let’s take the US model experience as an example. I agree that the Fed’s balance sheet and S&P 500 index have been positively correlated since 2009, but I would argue that the relationship is casual, not causal. The Fed announced its QE programme only after US stock markets had collapsed to cheap levels, and stopped it only once those markets had recovered. As such, the Fed seemed to use the S&P index as a temperature gauge for the economy (“the share price of the country” as it were), rather than the index appreciation being the direct result of the QE activity undertaken. QE started when stocks were cheap, and finished when they became fair value.


Not yet convinced? The above chart demonstrates a coincidental relationship, but what about other economies? The QE experiment in Europe was initiated in March 2015, a time when the Stoxx 600 equity market was much more buoyant, and not trading at distressed valuation levels. It seems ludicrous to argue that a causal link has been in play in Europe. This is illustrated below.


So what have we learnt? QE appeared positive for risk assets when their valuations were depressed in the US, but had little impact when equities were fairly priced in Europe. Because interest rates have already fallen to a large extent (thereby lowering the discount rate that equity investors use), investors will not be able to boost the present value of future cash flows. This means that it is difficult for equity market valuations to increase to the same extent as previously when yields collapsed. Given the sluggish economic outlook and potentially higher interest rates in the US, it is also difficult to argue that profits in the future will be much higher as well.

QE does have some economic effects; it’s just (I’m not ashamed to say) still difficult to discern just what these are. It hasn’t yet been inflationary (even though the basic principles of QE suggest that increasing the supply of money should reduce its value) and I believe that the link to stock market strength is somewhat illusory. Arguably, the greatest effect of QE has been the reduction in bond yields across the curve and not a portfolio rebalancing into riskier assets.  In theory, the portfolio rebalancing effect is most powerful when investors view equities as an alternative to bonds. Given the difference in volatility characteristics of both asset classes, it is unlikely that this will ever be the case (some investors still choose to buy negative yielding fixed income securities for example). If the Bank of England is hoping that QE will prop up the UK economy and inflation through a causal link then the current economic data supporting this theory is mixed at best.

Discuss Article

  1. Daniel Lockyer says:

    Thank you for this – always thought provoking. Have you considered that the composition of the S&P 500 is very different to the composition of the Eurostoxx? I don’t have the data but I imagine Europe has more distressed financials and more cyclical companies while US has more consumer staples, tech and stronger financials. I therefore reckon the correlation with ECB balance sheet would be closer with European listed ‘bond proxies’ – as you say equities viewed as alternatives to bonds. Finally ,it is also impossible to know the counter-factual arguments – how would the Eurostoxx have performed without QE?

    Posted on: 02/08/16 | 11:18 am
  2. R Stewart says:

    Perhaps QE in the form of central bank bond purchases has given some comfort to bond investors to extend their maturity profile? With the return of the coupon income to the borrower (HMT in the UK) QE has mitigated the cost of a significant amount of government borrowing and arguably has contributed to yield curves flattening, even where long-dated issuance has been boosted. The resulting (likely) low to negative real returns from long duration assets have been accepted with surprisingly little protest (even though pension fund deficits have ballooned). NIRP on the other hand turns the time-value of money on its head, has driven nominal bond yields below zero where it has been implemented, and is likely to erode bank profitability, which threatens to undermine the strength of the financial system through weakening the ability to grow a bank capital base that supports risk taking. NIRP may also make a banking system that relies on sticky customer deposits increasingly fragile. Lets hope the BoE does not go down that path!

    Posted on: 02/08/16 | 4:09 pm
  3. Nick Abe says:

    There are two primary benefits to QE: liquidity and confidence. While impossible to prove, I believe both indexes would be materially lower in the absence of QE. The entire issue around 2008, and to a lesser extent 2011, was a lack of liquidity due to a contraction in lending (for whatever reason). If lending contracts, then all else equal, the money supply will shrink (or in less extreme cases the growth in money supply). If the money supply is shrinking, or not growing as quickly as normal, then a whole host of problems emerge. By implementing QE you increase confidence that those problems won’t emerge, allowing people to move into riskier assets with more confidence.

    The reason the European stock market hasn’t performed as well with QE is that there are other, better (in the minds of investors) options available. Why invest in Europe who are printing money, have Brexit, Greek/Italy, etc., when you can invest in the US who is (comparatively) in good shape? QE has probably worked well in Europe (I believe they would be firmly in a deflationary environment without it) – the stock market is just the wrong measure of its success.

    Posted on: 03/08/16 | 2:29 pm

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