QVMM - Equity Risk Premium: Reflective Of The Current Environment?

2023-09-02 01:55:00 ET

Summary

• Elevated stock market valuations, coupled with higher bond yields, have driven the equity risk premium to near 20-year lows.
• The lofty valuations, while not contagious to the entire equity market, don’t seemingly reflect heightened recession risks.
• Rather than be potentially under-compensated for taking additional equity risk, investors today might consider increased high-quality bond allocations.

Elevated stock market valuations, coupled with higher bond yields, have driven the equity risk premium to near 20-year lows. ¹ The lofty valuations, while not contagious to the entire equity market, don’t seemingly reflect heightened recession risks.

Rather than be potentially under-compensated for taking additional equity risk, investors today might consider increased high-quality bond allocations, which can hedge their portfolios toward a more stable income stream.

¹ The equity risk premium is the excess return that investing in the stock market provides versus the risk-free rate.

S&P 500 equity risk premium

Basis points, 2008–present

Source: S&P Dow Jones, Federal Reserve, Bloomberg, Principal Asset Management. Data as of August 30, 2023.

In the coming quarters, many equity analysts expect robust corporate earnings recoveries; an optimistic outlook that has been supportive of strong year-to-date stock performance.

However, the current economic backdrop is fraught with uncertainty, and investors may not be appropriately pricing in the strong likelihood of recession in the next 6-12 months.

Today, global central banks remain broadly hawkish, and many leading economic indicators are already in contraction. Europe is teetering on a stagflationary recession, while the world’s growth engine, China, is experiencing deflation.

Although U.S. growth appears buoyant for now, its future, and the current global picture, leave earnings resilience far from assured.

Therefore, given the economic uncertainties, and with the S&P 500 risk premium at its lowest level in nearly two decades, investors are rarely getting adequate compensation in the equity market.

In fact, future earnings disappointments seem to be so underappreciated that price-to-earnings multiples remain close to their pre-Fed hiking highs in early 2022 - hardly reflective of the current environment and associated risks.

Despite recent U.S. economic resilience, investors should remain alert to an upcoming recession.

Increasing allocations to high-quality credit may be appropriate, as bonds now provide an even more valuable portfolio hedge, offering income, capital stability, and diversification, as well as potentially sizeable capital gains once recessionary markers become more conspicuous.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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