Do investors reliably reallocate between equities and cash in response to changes in government monetary stance? In their July 2013 paper entitled “Asset Allocation and Monetary Policy: Evidence from the Eurozone”, Harald Hau and Sandy Lai apply regressions to examine how variations in the tightness of monetary policy (real short-term interest rates) affect investor allocations to stock and money market funds. Specifically, they examine relationships among real short-term interest rates, equity and money market fund flows, stock index returns and estimates of local institutional ownership of stocks in eight countries: Austria, Finland, France, Germany, Italy, the Netherlands, Portugal and Spain. Using quarterly data for these variables during 2003 through 2010 (32 quarters), they find that:
- Over the sample period, the average real short-term interest rate ranges from -0.10% in Spain to 0.22% in Finland.
- A 0.1% decrease in the real short-term interest rate relates to a 1.0% increase (0.8% decrease) in equity market fund (money market fund) assets under management.
- Weighting all countries equally, a 0.1% decrease in the real short-term interest rate relates to a 1.4% higher stock market return (relative to the risk-free rate). This effect is stronger in countries where domestic institutional investors represent a large share of local stock market capitalization.
- The effect persists after controlling for country real spending growth, GDP growth and change in corporate return on assets, suggesting that monetary policy is the driver.
In summary, evidence suggests that monetary policy shifts do affect investor allocations to stocks and cash, and thereby the return on stocks.
Cautions regarding findings include:
- The sample period is short and may not be representative of long-term interactions between monetary policy and asset class allocations.
- Analyses are in-sample, and the sample period is too short for useful out-of-sample testing.
- Relationships are contemporaneous rather than predictive. In other words, an investor must predict monetary policy in order to exploit its relationship to stock market returns. For example, an investor predicting a 2% increase in the Federal Reserve’s short-term interest rate target might project a 28% decline in the stock market.
- The methodology assumes assumes linear relationships among variables. These relationships may not be linear over large ranges.
