Ben buys, bulls buoyant
How asset prices react to quantitative easing
Sep 22nd 2012
How sound is this latest rally? Research by Morgan Stanley shows that previous rounds of monetary stimulus have had the effect of boosting the valuation of the stockmarket (a higher price-earnings ratio) without boosting profits (as measured by earnings per share). In addition, QE has boosted investor sentiment. So one interpretation of the evidence is that QE results in what Fredrik Nerbrand of HSBC describes as a “sugar high”—a rush of blood that does little for long-term economic growth.
However, analysts may be underestimating the economic benefits of QE. It is impossible to know what things would have looked like without the previous rounds of monetary stimulus. And even if QE has no effect on economic growth, it may still be rational for investors to buy equities. That is because Ben Bernanke, the Fed’s chairman, also signalled that interest rates would be kept at their current ultra-low levels until 2015. Such low rates will also keep a lid on short-term bond yields. So investors will be pushed out of low-risk assets and into the stockmarket.
Charles MacKinnon of Thurleigh Investment Managers also argues that shares in global firms with a diversified profits base are an attractive asset class in an era when governments are generally trying to reduce the value of their currencies. The BoJ’s action this week is widely seen as an attempt to weaken the yen.
The other asset class to benefit from previous rounds of QE has been commodities. This seems rational. If investors think QE helps economic growth, then demand for commodities should rise.
Low interest rates reduce the opportunity cost of holding non-yielding assets such as gold. And investors may perceive that QE increases the long-term risks of inflation, which also makes some commodities more attractive.
If you look at the data on inflation expectations, there are few signs of alarm. But a recent paper* from the Bank of England shows a greater level of uncertainty about the inflation outlook (as measured by the options market) than was the case three or four years ago.
Such uncertainty is perfectly understandable. After all, QE on this scale has never been tried before. There are three possible outcomes. One is that the economy remains stagnant with inflation low, as in Japan; the right strategy in those circumstances would be to buy government bonds. Another is that the economy recovers to pre-crisis growth levels; the right strategy then would be to buy equities.
The third possibility is that inflation accelerates rapidly as central banks lose control; in that case, buy commodities, especially gold. Investors have to hedge their bets against all three outcomes, which explains the apparently contradictory combination of rising equity and commodity prices, along with low bond yields.
But how long will those low bond yields last? The ten-year Treasury-bond yield has edged up to 1.8% from July’s low of 1.4%, and German ten-year yields have risen from 1.2% in July to 1.7%. There is a technical explanation for both moves. The Fed’s latest round of QE focuses on mortgage-backed securities rather than government bonds. And the ECB may have brought Europe one step closer to debt mutualisation, prompting a narrowing of the spread between the borrowing costs of Germany and the periphery.
Higher bond yields are a mixed blessing. To some extent they are an indication that investors are less nervous about the possibility of a double-dip recession. But if they increase too far, they will act to tighten monetary policy. Pushing bond yields down, not up, was the original justification for QE. Bolstering share prices was supposed to be only a side-effect.
* “Option-implied probability distributions for future inflation”, Quarterly Bulletin, Q3 2012