Saturday, 09 April 2016 00:00

Can Expansionary Monetary Policies Support Equities

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The equity markets trending higher is a function of several factors and some of the major factors includes GDP growth trend, corporate earnings trend, inflation, geo-political factors and the liquidity factor.

Since the financial crisis of 2008-09, the fundamental factor of liquidity has played an important role is supporting asset markets globally and it includes equities. This article discusses if expansionary monetary policies can continue to support equities even if other factors remain negative or sluggish.

The reason for discussing this point now is the fact that US corporate sector is potentially in an earnings recession and anaemic global GDP growth is likely to add to the woes. However, there are investors who expect the markets to trend higher if the fed unleashes another round of expansionary monetary policies. I must add here that for the US, the QE never ended with real interest rates still in negative zone.

Coming to the point of discussion, I would first like to use the example of Japan, which has been pursuing significant expansionary monetary policies since March 2013. In the last three years, Japan’s monetary base has expanded by 169% and the chart below shows the monetary base expansion and Nikkei index returns during the same period.


Monetary Base Expansion And NIKKEI Index Returns


From March 2013, Nikkei index returns were 66% by July 2015. However, even as the monetary base continues to expand, returns have trimmed in the last eight months. Clearly, expansionary monetary policies might provide some boost to equity returns, but the upside is not sustainable if it’s not supported by GDP growth and corporate earnings growth.

For the US, a major expansion in monetary base started in September 2008 and the chart below shows US monetary base expansion from this period and the S&P 500 returns.


Monetary Base Expansion And SP 500 Returns


The S&P 500 index has been largely sideways in the last 24 months and that’s reflected in the chart, but even with no expansion in monetary base during this period, the markets have not declined. The reason has been decent corporate earnings, dividends and buybacks. With earnings showing signs of fatigue and with US GDP growth likely to stall in 1Q16, I expect markets to get monetary policy boost. However, it is entirely likely that markets correct before any action by the policymakers.

The bottom-line however is that expansionary monetary policies alone can’t boost equities and Japan is a good example from the recent past. Expansionary monetary policies can however result in speculation across asset classes and several other unintended consequences. Specific to the US, I expect renewed expansion of monetary base in 2016 and it remains to be seen if it can trigger further upside for equities.

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