Ten years ago, the Western economies had just survived the most severe shock since the crash of Wall Street in 1929. Lehman Brothers had collapsed in the late summer of 2008, swiftly followed by other significant players in the financial system. The central banks in the US, the EU and Japan came to the rescue by applying increasingly lower interest rates and providing massive amounts of liquidity. As we enter a new decade, however, investors must be wondering how long this situation can continue.
A working paper by De Nederlandsche Bank’s Hudepohl, van Lamoen and de Vette (HLV) examines the effect on European stock markets of the central banks’ quantitative easing (QE).
Over the last ten years, the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England have together bought over $13 trillion worth of financial assets.
Figure 1 Quantitative easing and the development in STOXX 600
HLV states that, although QE in general is considered to have been successful, it has not been “without controversy” due to the risk it has engendered of creating asset-price bubbles.
Figure 1 shows the development in the STOXX 600 since December 2008. It is clear from the chart that stock prices rose during periods when either the Federal Reserve or the ECB were applying QE. Although the first period of ECB QE might be seen as an exception to this, stock prices did rise in the period following the ECB’s announcement that it would initiate QE. When the impact from QE later diminished, the ECB increased the size of its asset-purchase program in April 2016, with the result that equity prices began rising again.
From April 2017 until September 2019, the ECB scaled back its purchases and the STOXX 600 stayed flat. Since September 2019, when the ECB recommenced its QE program, the STOXX 600 has advanced by almost 12%.
One of the conclusions that HLV derive from their statistical analysis of the data is that QE changed the equilibrium for asset valuation, leading to increases in asset prices until a new valuation level had been established.
Currently, it appears that stock markets are searching for a new level, and equity prices will likely increase until that level has been reached.
Going forward, many investors expect central banks to stop buying assets and decrease their balance sheets. Should this happen, Hudepohl, van Lamoen and de Vette warn that:
“Reversing the purchases could therefore cause deflation of the stock market bubble, i.e. downward exuberance.”
A new decade has begun, and central bank policies, especially those of the ECB, will continue to play an important role. Should the ECB decrease its asset purchases, this could have an adverse effect on equity prices that may exceed investors’ worst expectations.
Does this imply that a new decade also would be require a new investment strategy? Not necessarily. Whatever the future holds, owning a diversified portfolio that contains some uncorrelated assets such as those from alternative lending is always a sensible idea.
- Quantitative Easing and Exuberance in Stock Markets: Evidence from the euro area by Tom Hudepohl, Ryan van Lamoen and Nander de Vette. DNB Working Paper No. 660 ↑