The ECB buying equities: SNORE

Europe’s economy, if you hadn’t heard, is in a bit of a mess.

The data recently have been particularly dreadful. Last week the German manufacturers, one of the few sectors in which Europe can claim to have global pre-eminence, reported that industry conditions were in “free fall”:

Desperate times call for desperate measures. So BlackRock’s chief investment officer of global fixed income, Rick Rieder, called for the European Central Bank to buy equities in an FT op-ed last week. Growth needs to be stimulated, he argued, and by lowering the theoretical cost of capital, euro area companies will invest more to stimulate growth. Merryn Somerset Webb provided an excellent counter argument a few days later.

One of her main points was that a central bank buying equities would warp market prices. It’s not an unfair criticism, as distortions have opened up in bond markets where the ECB has been a willing bidder, and where it hasn’t.Such as in the world of covered bonds.

So a fair assumption would be that similar distortions would affect equity markets in Europe. The only central bank that has bought equities as part of its monetary policy mandate, the Bank of Japan, provides a useful case study.

Since the BoJ started buying equities, via exchange-traded-funds, in 2009, it has accumulated a 28 trillion yen position (around $260bn) in Japanese equities, around 4.7 per cent of the entire market, according to Nikkei Asian Review. By 2020, it is estimated the BoJ will be the largest holder of equities in the Japanese market.

So naturally, one would expect some distortions to open up in a market with such a willing buyer of stocks: price-to-earnings ratios rocketing, dividend yields falling and stock-compensated management lording it up in pricey sake bars.

But that is not what’s happened. A study by Sayuri Shirai, a former board member of the BoJ, found that the price-to-earnings ratio of Japan’s leading stock market index, the Nikkei 225, actually fell between 2010 and 2018:

So even as the BoJ has stepped up its asset purchases, the equity-risk premium has risen.

Studies on how the timings of equity purchases affected markets have proven difficult, given the limited data set. Friends of this parish Toby Nangle and Tony Yates found that upon four announcements of further ETF buying by the BoJ, Japan’s Topix index advanced between 2 to 4 percentage points compared to global equities:

However, also note the exchange rate effect of the announcements. A weakening yen, as Nangle and Yates note, has a negative correlation with the stock market. So the effects of an index bounce could be as much about FX, as they are about the BoJ’s monetary bazooka.

One of the reasons the relative change could also be small, argue the two, is that further equity buying by the BoJ was already “baked-in” to asset prices. One way this could have been done was via pre-existing monetary policy. If you believe, as any good business student should, that equity prices represent the discounted value of future cash flows, then with a zero-interest rate environment, equities would have already re-rated thanks a bottomed-out interest rate.

Regardless of the policy’s efficacy in Japan, the logic of a lower capital cost driving investment is a curious one. First off a business is unlikely to use equity finance for a project if debt is cheap, given the dilutive effects of equity issuance. Only a high-growth loss leader, or a financially distressed business, would choose to use equity instead of debt financing in such circumstances. It is not spurious to suggest both sorts of businesses would fall outside of the ECB’s rules, as taking losses on risky or distressed equity could prove embarrassing. That is, if the reaction to the bank’s losses on bonds issued by Steinhoff -- a South African retailer which collapsed in 2017 -- are anything to go by.

Second, a new investment project will only be enticing to a business if they perceive requisite demand for a new product or service. With euro area inflation — often used as a proxy for consumer demand — at 1.3 per cent as of June, new capital spending does not promise the same rewards it does in a growth environment. International businesses based in Europe looking to expand may take advantage of cheaper equity, but spend it in markets where the prospects for returns are more enticing, therefore having little effect on the local economy.

So the evidence of the potential warping effects of equity buying by a central bank is scant, and it’s also hard to imagine how it would make a substantive difference to investment activity after a near-decade of zero-interest rates and focused quantitative easing.

Yet, it is also difficult to argue that if the ECB were to buy equities, it wouldn’t mean anything. It, of course, would feel like a big deal. Whether it would make much difference to the euro area economy is another matter altogether.

An alternative to more ECB madness would be for Germany to spend some of its humongous current account surplus. However, we’d rather not indulge in fantasy politics. No matter how obvious the policy may be.

This article has been amended since publication to clarify that Rick Rieder is chief investment officer of global fixed income at BlackRock.

Related Links:
ECB can boost growth across Europe by buying stocks - FT
ECB purchases of equity would be a dangerous step - FT
Jens Weidmann says critics of Germany’s trade surplus ‘justified’; - FT