Although some have called the ECB’s choice to buy asset-backed securities (ABSs) rather than government bonds "QE-lite", Tony Yates at Bristol University says this might actually prove more effective than buying government bonds. This is because government bonds are a close substitute for cash, and so conventional QE means merely swapping one safe asset for another, which limits its effectiveness. However, to the extent that ABSs are less like government bonds and more like corporate bonds, buying them should do more to reduce corporate bond yields and hence companies’ borrowing costs. This should raise capital spending by more than the same quantity of purchases of government bonds would.
That said, we cannot be confident of QE’s stimulative effect. We don't know how much of it the ECB will do - although ECB president Mario Draghi promised "sizeable" buying - nor do we know which ABSs it will buy; to the extent that it buys better quality ones, its impact will be lessened.
But it’s reasonable to suppose that if QE does anything at all, it will boost European equity prices. One reason for this is a simple portfolio rebalancing effect; some of the cash which investors get in exchange for ABSs will be reinvested in shares. Another reason is that QE should raise average expectations of economic growth. This needn’t be because investors expect QE to cause a boom. QE could improve expectations by reducing the risk of a serious slump, or by signalling that the ECB is willing to do more to support the economy than investors had feared.
All this should be good for UK equities. There’s a massive correlation between annual changes in UK and euro area share prices - of 0.88 since January 1999. This is partly because European shares are substitutes for UK ones, and prices of substitutes should rise and fall together, and partly because a stronger euro area economy is good for the UK economy; forget politicians' nonsense about a "global race" - we need our neighbours to prosper.
However, our story doesn’t end here. There’s another effect of euro QE. It is likely to weaken the euro, in part because some of the cash raised from selling ABSs will be invested overseas. Just as Abenomics weakened the yen and Bank of England QE depressed sterling, so euro QE should lower the euro.
This is not a bug. It’s a feature. Mr Draghi has for months wanted a weaker euro, as this is one way to boost exports and to reduce the threat of deflation.
But a weaker euro is bad for the UK. It would reduce the profits of UK firms which export to the region. Granted, sterling would probably fall against the US dollar if the euro drops - this usually happens - but this would be only a modest relief at best given that the euro area is our biggest trading partner.
This poses the question: how should holders of UK equities weigh the good news of higher euro area share prices against the bad news of a weaker euro?
We can find out by running a regression equation to uncover the associations between UK equity returns, sterling, and euro area returns. Doing so for annual changes in monthly data since January 1999 gives us a clear result. A 10 percentage point rise in MSCI’s index of euro area equities is associated with a 6.2 per cent rise in the UK market. But a 10 per cent rise in sterling against the euro is associated with a 2.1 per cent drop in the UK market.
This gives us a "three for one" rule of thumb; a 3 per cent rise in sterling would wipe out the benefits to holders of UK equities of a 1 per cent rise in euro area shares. Intriguingly, this relationship is rather stable. Between December 1987 and December 1998 the coefficients on euro area share prices and the €/£ rate were 0.51 and minus 0.2 respectively - which is very close to their post-1999 values.
This is consistent with the theory of uncovered equity return parity - the idea that exchange rates move to partly offset differential returns in equities; Danai Tanamee at the University of Kansas has shown that countries which see high equity returns tend to see their currencies fall relative to countries with lower equity returns.
Herein, though, lies the good news. The stress in that last paragraph is upon "partly". Euro area share prices tend to move by more than the €/£ rate does; since 1999 they have been three times as volatile as the exchange rate. A 10 per cent rise in euro equities (say) is unlikely to be accompanied by a 30 per cent rise in sterling. In this sense, euro QE - insofar as it does anything at all - should be a net positive for UK equities, to the extent that the benefits of higher euro share prices are greater than the damage of a stronger pound.
