Quantitive easing and the European Equity Market

Predictions of a Quantitive Easing program by the European Central Bank will probably materialize tomorrow. Many will question what the fuss is all about, however, for market participants QE is akin to antibiotics for a sick person. In this article I will not delve too much into the economics of QE. Instead the article will provide investors with an insight on what to expect from the European equity market following the announcement.

QE is the in vogue term being used to describe an increase in money supply through asset purchases. Yes, the Central Bank thinks that people do not have enough money and they are dishing it out. Typically the Central Bank would purchase government bonds from the market, paying in Euros. The effects include an increase in bond prices due to the reduced supply of bonds, and an increase in money supply directly from the increase in cash. Since the amount of cash for the same amount of financial assets in the Eurozone now is greater, equity prices would typically go up. So the primary and main beneficiaries of QE would be holders of financial assets.

Rumors of a €650billion program are circulating. Let us put this in perspective. Currently the Eurozone’s money supply amounts to roughly €10,300 billion, thus the program would add circa 6% to the money supply. Hope is that this should help kick-start a recovery. Definitely it is enough to already be shifting markets, and while equity markets have already partly priced in QE, further upside is possible. Several doubts remain especially regarding the form and the size of the program, not to mention the execution risk of implementing QE.

Economists typically advocate a shock and awe approach; the program should be of such size and form that it will leave no doubt on the ECB’s intention of doing what it takes. However, Germany will surely oppose the move probably capping Mario Draghi’s intentions.

Assuming that the announcement tomorrow is of sufficient size, equity markets are expected to react positively. In addition, the initial program will probably be insufficient to end the job; therefore additional bouts of QE may be expected going forward. Amongst the beneficiaries of QE, banks, and peripheral countries, such as Italy and Spain will probably top the list in the short-term. However, for those who believe that the ECB will not disappoint, most of the European equity market is an attractive proposal; equities like Airbus, Bayer, Daimler and Carrefour have all gained more than 8 percent in January and should continue to perform.

In the short-term equity holders will continue to benefit. In the longer-term, a consistent increase in the money supply may give a breather for governments to reform ailing economies. Thus the success, or otherwise, of monetary policy will eventually depend on the fiscal discipline of European governments. Hopefully QE won’t be akin to giving antibiotics to a man with a broken leg… and asking him to start walking.