Sandy Lai Hong Kong University 1 Asset Allocation and Monetary Policy: Evidence from the Eurozone Harald Hau University of Geneva and SFI

Motivation Did low real interest rates contribute to the build-up of risk leading up to the financial crisis? Rajan (2006, 2010); Borio and Zu (2008); Adrian and Shin (2010) Risk-Taking Channel of Monetary Policy Banks: lowering credit standards at low real short rates (e.g., Maddaloni and Peydro, 2011) Household risk taking in real estate (e.g., Taylor, 2008) Investor risk taking in the stock market (our focus) Asset price inflation as a side effect of an excessively accommodating monetary policy © Harald Hau, University of Geneva and Swiss Finance Institute 2

Three Identification Challenges Endogeneity of monetary policy Both monetary policy and portfolio investment react to changing economic conditions How to measure investor risk choices Measure local risk taking through equity fund inflows and money market fund outflows. Quantification of the asset price effect of monetary policy Identify equity fund inflows driven by changes in real short-term interest rate. Measure the return effect of equity fund inflows relative to a benchmark. © Harald Hau, University of Geneva and Swiss Finance Institute 3

Identification Idea I Both monetary policy and portfolio investment react to changing economic conditions © Harald Hau, University of Geneva and Swiss Finance Institute 4 Examine real rate variations orthogonal to monetary policy: Cross-sectional real rate variations within a currency union are (by construction) exogenous to monetary policy Follows Maddaloni and Peydro (2011)

Identification Idea II How to measuring local investor risk choices? Home bias in fund investment: German investors mostly invest through German funds, etc. Inflow into equity fund and outflow from money market fund represent increase in investor risk taking. © Harald Hau, University of Geneva and Swiss Finance Institute 5 Use Lipper fund data: Eliminate Belgium, Ireland, and Luxemburg (large share of non- local investors) Aggregate Analysis: 8 countries with fund in- outfows Disaggregate Analysis: 4,939 equity funds, and 1,441 money market funds

Identification Idea III How to measure effect on equity prices? Identify equity fund inflows and use flow-return relationship. © Harald Hau, University of Geneva and Swiss Finance Institute 6 Study return effect relative to a local benchmark of the 15% most flow-insensitive stocks (LIFI =Low Investor Flow Index) LIFI stocks should still be subject to discount rate changes, but not to local risk shifting into stocks.

Aggregate Equity Fund Flows (Table 3) © Harald Hau, University of Geneva and Swiss Finance Institute 7 LSDV: Biased in small T samples GMM: Use lagged values as instruments. Results for DGMM and SGMM similar Lowering the real short rate SR by 10 bps implies a 1% higher contemporaneous local equity fund inflows (and 1.4% permanent effect).

Aggregate Money Market Fund Flows (Table 4) © Harald Hau, University of Geneva and Swiss Finance Institute 8 Same aggregate flow persistence as for equity funds Weaker evidence that looser monetary policy conditions ( Δ SR<0) correlates with money market fund outflows

Disaggregate Equity Fund Flows (Table 5) © Harald Hau, University of Geneva and Swiss Finance Institute 9 Δ SR effect similar to the aggregate data Similar flow persistence of 34% at lag 1 and 13% at lag 2 Strong performance-flow relationship

Disaggregate Money Market Fund Flows (Table 6) © Harald Hau, University of Geneva and Swiss Finance Institute 10 Δ SR effect similar to aggregate data At fund level, we find a flow persistence of 29% at lag 1 and 10% at lag 2. Weaker performance-flow relationship than for equity funds

Causality Issues: Is Δ SR the Flow Trigger? Local short rate decrease Δ SR (= local inflation Δ P>0) is s a result of positive AD and negative AS shocks Equity flows could directly react to the positive AD shocks that also increase GDP and firm profitability. © Harald Hau, University of Geneva and Swiss Finance Institute 11 AD Price A S GDP

Causality Issues: Is Δ SR the Flow Trigger? © Harald Hau, University of Geneva and Swiss Finance Institute 12 TEST 1: Control for GDP growth and Δ ROA directly. Both variables are better proxies for macroeconomic shocks than Δ SR under nominal rigidities TEST 2: Use only funds that invest mostly in foreign equity. Cash flow shocks of foreign stocks are less likely to correlate with the inflation rate (and real short rate) of the fund’s domicile. Base Model With Add. Controls Foreign Focus

Causality Issues: Hedging against the Inflation Risk? © Harald Hau, University of Geneva and Swiss Finance Institute 13

Low real rates impact stock returns through A lower discount rate (discount rate effect) Additional equity inflows (flow effect) Estimated flow effect in a simultaneous equation model: Eq.1: Identify equity flows that are triggered by ΔSR. We can further relate and to lagged changes of short term real interest rates. Small terms in with k>2 are ignored. Equity Return Impact of Flows © Harald Hau, University of Geneva and Swiss Finance Institute 14

Equity Return Impact of Flows Eq.2: Estimate flow effect on the return difference between flow sensitive and flow insensitive stocks: (Assume constant flow impact γ) Substitution gives second equation: with constraints: © Harald Hau, University of Geneva and Swiss Finance Institute 15

Equity Return Impact of Flows © Harald Hau, University of Geneva and Swiss Finance Institute 16 Results for the flow equation are not much changed simultaneous equation approach Differential return effect (flow effect) is economically large: 10bp lower SR implies a 1.4% return increase

Equity Return Impact of Flows © Harald Hau, University of Geneva and Swiss Finance Institute 17 Home bias re- enforces link between local monetary policy conditions and equity return impact. The equity flow effect more than doubles: 10bp lower SR implies a 3.4% return increase

Summary and Robustness Checks Summary Lower real short rates are associated with investor reallocation from money market funds to equity funds. Equity flows from loose monetary policy conditions have a large return effect, particularly in countries with greater home equity bias. Robustness Checks Use the country-specific Taylor Rule residual in place of SR. Use equal fund weights instead of fund-value weights within country. Robust to the control of fiscal expenditure in individual countries as well as to the pre-crisis period. Robust to an alternative benchmark return index based on fund holdings as well as to an alternative threshold of 10% or 20% in constructing the LIFI index. © Harald Hau, University of Geneva and Swiss Finance Institute 18