I recently read an article about the decision of European Central Bank to cut the Quantitative Easing program. After approximately three years, I wondered what effects this program had on real economy.
Quantitative Easing Program
Quantitative Easing is the program executed by Mario Draghi in 2015 consisting in a monthly debt purchase of €60.000 million in debt. This policy was inspired by the analogous programs carried out by the FED in the previous years and Central Bank of Japan in the 90’s.
Basically, the QE has consisted in purchasing debt to banks and governments and increasing their credit accounts in ECB. The final goal was to encourage financial institutions to lend money with the purpose of reactivating GDP and reaching targeted inflation rate. But, if personal solvency doesn’t improve, should the banks lend money? Saying yes would have worsen institutions solvency and liquidity. What happened is that financial institutions used part of the money to pay down outstanding credit in ECB and invest in more secure assets, so not all money was put on real economy.
We can see the evolution in the ECB’s Balance sheet in the following table:
The table contains the size of ECB’s balance sheet as well as the two main accounts in both assets and liabilities sides from 2011 to 2017. We can see how both accounts (and balance size) have grown enormously due to QE. I have added the YoY % change to show how both accounts have grown at practically the same rates.
Previously, we stated that not all the money was put into circulation. Two variables that could be used to measure money supply are M1 and M3. If we look at both aggregates, we can see that both measures have been increased, but not in line with ECB Balance sheet growth rate.
Effects on real economy
The compound annual growth rate for both M1 (currency in circulation and overnight deposits) and M3 (M1, deposits with an agreed maturity up to two years, deposits redeemable at notice up to three months, repurchase agreements, money market fund shares and debt securities up to two years) have been, respectively, 6,8% and 3% for the given time frame (2011-2016). We see a clear signal that not all the money was sent straight to real economy. In fact, we can check the evolution on Spain GDP to check if it has expanded at the same pace:
As it is reflected in the previous graph, percentage of change in GDP has varied from -2,9% to 3,3%. We can now see how ECB efforts (and growth in balance sheet) have not impacted GDP and money in circulation in the same proportions.
From a stock market point of view, we can take the metric EBITDA as a proxy of corporate performance. In the following picture we can see the evolution of this metric for Spanish publicly traded companies.
We see that growth has been a timid CAGR of 0,6% for the 2011-2017 period. Thus, from this point of view, neither individuals nor companies have been directly benefited from QE.
This kind of monetary policy has been criticized by many groups of economists, such as Austrian School of Thought. This school defends the idea that such monetary policy doesn’t bring anything good for real economy but assets price inflation. To check this fact, I have run an exercise to measure the margin of safety lost in the way.
Margin of Safety Evolution
Margin of safety is a term coined by Benjamin Graham and David Dodd and used for the first time in their book “Security Analysis” in 1925. Basically, the authors state that a divergence between price paid for a stock and its intrinsic value gives you protection against to risks:
- Possible downturn of the stock market.
- Bad decisions made by the investor.
We all know that there is no golden rule to calculate a stock’s intrinsic value. Some analysts and money managers use different valuation methods, such as:
- FCFE/FCFF discount models.
- Dividend discount models.
- Valuation through multiples (P/E, P/Sales, P/FCF), among others.
- Residual Income models.
For illustration, I have used a valuation method based on multiplying the 5-years average EPS by 12, which is in line with the historic return of Spanish Stock Market. This may not be as accurate as deep analysis. Besides, earning metrics can be manipulated through bad accounting practices, but this model can serve to see the effects of QE. In the following table, we can see the average EPS for Spanish market and the average price per share:
The table shows how aggregated intrinsic value has decreased at a 8% CAGR while average price has increased at a 14% in the same time frame. Now, we see how stock prices have been inflated:
Margin of safety has gone from a 30% to a -65% in the last six years. Thus, we should agree with the fact that Quantitative Easing and low interest rates policy has had a certain effect on GDP but certainly inflated Spanish stocks prices.
In such situations, all investors should be aware of the price paid for our investments. After all, it is a key element that impacts directly in our returns. As Graham said, an adequate margin of safety protects us against bad decisions and market overvaluation.