Citi: This Is One Reason Why More Quantitative Easing Probably Won't Work

While debt is cheap, equity is expensive.

We Expect no Change in ECB Policy, Says Investec's Shaw

As central banks in Europe and Japan gear up to further expand quantitative-easing policies, market participants have issued a flurry of stark warnings about the potentially-negative unintended consequences, from the hit to pension funds to the risk of fueling market bubbles.

But the more-prosaic prognostication — that further easing simply won't stimulate slowing economies by reviving enfeebled corporate investment — may be the hardest-hitting retort from the perspective of central banks in the U.K., euro-area and Japan.

While a clutch of reasons for moribund business investment in advanced economies have been advanced, central banks would do well to wake up to another typically over-looked cause, according to a new report from Citigroup Inc.

Corporate investment faces a financing hurdle as the weighted-average cost of capital for companies (known as WACC) remains elevated thanks to the stubbornly high cost of equity, Hans Lorenzen, Citi credit analyst, said in a report published this week. The report pleads with central banks to forgo further asset purchases, citing diminishing returns from such stimulus programs and their questionable efficacy more generally. 

Corporates aren't feeling the financing benefits offered by the global fall in real long-term interest rates thanks to a historically-high equity risk premium — which, in simple terms, is the excess return the stock market is expected to earn over a perceived risk-free rate, Lorenzen said.

Although companies typically aren't dependent on equity issuance to fund investment programs — relying instead on fixed-income markets — the equity risk premium is an important factor influencing investment decisions made by company boards. The higher the cost of equity, the higher the theoretical overall cost of capital for corporates.

In other words, investments that don't on paper appear to make returns materially greater than the company's WACC will face financing challenges.

Citigroup Inc

And high equity risk premia is a global issue, thereby discouraging capital-investment plans around the world. 

Citigroup Inc

While elevated equity risk premia have been the subject of much debate, Lorenzen blamed stock market volatility and U.S. regulations that have encouraged life insurance and pension funds to invest in fixed-income at the expense of equities for their lofty levels.

"The increase in the premium is structural given the lack of flows into stock market thanks to regulation that's discouraged marginal money into equities, while Sharpe ratios indicate poor risk-adjusted returns relative to the volatility, which has also discouraged multi-asset allocators from investing in stocks," he said in an interview.

Debt-financed share buybacks by U.S. companies — fueled by low policy rates — could also, over time, increase the equity risk premium, depending on the calculation model, other things being equal, Lorenzen added. 

More food for thought then for advanced-economy central banks as they meet this month

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