Brief comments on Mckinsey “QE and ultra-low interest rates: Distributional effects and risks”

QE and ultra-low interest rates: Distributional effects and risks (McKinsey)

McKinsey state that QE does not appear to have affected equity prices.  In a sense, you could say that because most of the cash used to buy the bonds has remained on the Fed’s balance sheet, and because the supply of money itself has little impact on future real returns, and if investors and agents assume that QE itself will not directly impact economic activity then in a rationale world it is unlikely that QE would impact equity prices – equity prices being determined by the future real supply of returns.

I think if you assume that everything is normal, that profit margins are not too high, that economic growth will revert to historical norms and there are no significant risks that should impact your discount rate assumptions, then markets have not been overvalued and hence could not possibly have been discernibly enhanced by QE.  That is, it is not QE that has impacted market valuations but rationale expectations of risk and return.

There are a couple of issues with this:

First of all profit margins for the market as a whole are way above historical average levels which will directly impact valuation levels.  

Secondly and very importantly, the supply of government fixed interest investments would be very much higher than it currently is and whether or not this is currently impacting the expected cost of capital or not, it would impact the price of bonds and the relative attractiveness of equities.  It may also have impacted the supply of corporate debt and hence the ability of companies to raise capital, especially banks.  Supply does matter in a real world.  

Thirdly, prospective valuations are directly impacted by the real rate of growth of earnings and there are a number of still significant headwinds to growth.  Unemployment remains high in a vary large number of countries, total debt remains at historically high levels and many economies remain significantly structurally imbalanced.  

Fourthly, the distribution of wealth and income has also become increasingly skewed.  Asset prices and consumption remain heavily dependent on future expenditure.  If expenditure per capita is to be constrained over the next 5 to 10 years (a time frame where discounted present values of cash flows are most significant) then asset prices will likewise inevitably be impacted.  For the moment it remains unclear just how much this differential has impacted demand for risky assets (high profit margins and skewed income profiles may for a while increase demand flows for risky assets in certain segments) – so reduced consumption per capita at one end and increased saving per capita in segments which have driven investment saving at the other may also serve to obscure the real picture.

Personally I find the depth of analysis limited in this report and it fails to assess factors which may be currently more important in determining return.  The real question is, where should equity prices be at the present moment in time if they were to be able to accommodate a lower real rate of economic growth and significant shocks to return along the way.  Growth may well be lower while price risk may well be higher.  If QE is masking the impact of this on equity prices, then QE is having an impact.

Additionally, if QE is having such a limited impact why are the Fed loathe to rein it in?

Leave a Reply