Easy money = higher stocks? Think again

Last fortnight I wrote people are so awed by market behaviour in 2020 after the shock of Covid that even with the benefit of hindsight they are unable to find reasons to explain what could have driven the markets relentlessly and to such great heights. The most common explanation for stock price movements is earnings growth (“stocks are slaves of earnings”). As long as earnings growth is assured, stocks will move higher. If a company delivers much higher growth than expected, the stock would jerk upwards in what is called an “earnings surprise”. This was certainly not the case in late May, when the markets took off. Earnings were not only far from being assured but the outlook was decidedly gloomy. And anyone mentioning the term “earnings surprise” would have been considered mad. It is worth noting this because we tend to forget our opi­nions, even about the recent past, and rationalise the eventual outcomes (“I knew it”, or “it was expected”).

A number of readers told me I had missed a critical factor that had driven the markets higher: The lower cost of money and the higher availability of money (together called easy money). Apparently, prices of risky assets rise under easy money conditions. It is the number one reason, people think, the US markets, along with other risk assets, have gone up. The case for linking easy money to a bull market is this. The US Federal Reserve has kept interest rates artificially low (low cost of money) for a long time and has also flooded the system with a lot of liquidity through different bond-buying schemes such as Quantitative Easing (QE1, 2, 3, 4) and Operation Twist. Cheap and ample liquidity has led to money moving into risk assets like stocks, gold, and crypto currencies — so goes the theory.

This is a very widespread belief — almost orthodoxy. The question is: Is this also a post-facto or post-hoc “reason” to explain the bull market? After all, most of the orthodoxy in finance and economics is usually wrong, including theories that are part of widely taught finance curricula. It turns out that a bit of digging will tell you that the correlation between easy money and stock prices is weak. We only need to look at Japan, the world’s oldest lab for the easy money experiment, as also Europe, to know this.

25 years of failed easy money

The Bank of Japan (BoJ) has been trying to print money (high liquidity at a low interest) to put Japan back on the path of growth for the past 25 years. It has tried nine fiscal stimulus packages, starting with its first Quantitative Easing in 1997, but has failed to generate economic growth. Interestingly, such massive liquidity should have created a property and stock-market boom, but defying conventional wisdom, asset prices remain weak. Convinced that the experiment will succeed someday, it pushed rates into negative territory in January 2016 as another stage of monetary experimentation. Still no growth and no bull market in risk assets. Indeed, the continuous direct intervention of the BoJ in the bond market made the market unstable and Bank of Tokyo-Mitsubishi UFJ, Japan’s largest private bank, threatened to leave.

It may surprise you to know that the BoJ is one of the rare central banks that has the mandate to buy equity index funds and it has been buying them for years. The BoJ is among the top 10 shareholders in 90 per cent of the stocks listed on the Nikkei 225. This is as direct a central bank’s market intervention in stock markets as you can think of. But all that gush of cheap money did nothing. The Nikkei keeps languishing. Japan is not alone. The European Central Bank acted exactly the same way as the US Fed. But there too, there is no economic growth and no stock price rise. The central banks of Sweden, Switzerland, and Denmark have all tried negative interest rates with no improvement in economic growth or a major stock boom. Clearly, the conventional wisdom that markets rise if money is cheap is not true. The US seems to be an exception. And here is another surprising fact. In 2015, when the US Fed began to shrink its balance sheet, the US equity market should have crashed. But after a few months, the market resumed its rally right until September 2018. The fact is, markets don’t move up and down on a single factor, and that too, one that everybody agrees on. Indeed, it is almost axiomatic that if everyone believes that easy money is the reason stocks are higher, then such belief will turn out to be wrong.

It is in global markets that the easy money theory had a chance to play out in full. But even those markets cannot sustain the correlation between easy money and stocks. Now, how far-fetched is it to link it to a rise of the Indian markets? There are too many complex domestic and international factors that drive markets and these factors are ever-changing. That is why markets are now called complex, emerging adaptive systems. The factors are country-specific, continually emerging, and never static. When a new set of factors comes into play, the market adapts to them. But all this is too complicated for our desire to make sense. We want simple answers, preferably a single answer. Of course, I understand that it seems intuitively obvious that easy money would find its way into stocks. But evidence on the ground is too thin.

The writer is the editor of www.moneylife.in | Twitter: @Moneylifers