Bond yields have shot up worldwide. The US 10-year yield stands at 2.90 percent compared to 1.50 percent at the beginning of the year. This has led not only to one of the biggest falls in bond prices ever, but also to a less attractive valuation of equities.
Equity risk premium
The equity risk premium on equities has fallen to 3.30 percent, close to its lowest level in almost 20 years. The S&P 500 index is trading at a price/earnings ratio of almost 23 at the time of writing, which is more than 20 percent above its long-term average. When calculating the equity risk premium, the deviation of the current valuation from the long-term average is taken into account as there is often ‘mean reversion’.
Europe cheaper
However, this low equity risk premium is mainly due to the US. In other parts of the world, the risk premium looks a lot more attractive. The graph below shows that European equities are a lot cheaper than their American counterparts.
This is because interest rates in Europe are much lower than those in America. Despite the recent rise, the German 10-year interest rate is still below 1.0 percent. In addition, the current P/E ratio is about 30 percent lower than their long-term average. Together, these factors contribute to the risk premium on European equities being well over 8 percent.
It’s all relative
Even though the US equity risk premium has fallen sharply, it is still significantly positive. In a world with still very low nominal interest rates and in many cases negative real interest rates, this is still attractive. Investors who are willing to do a lot to avoid negative (real) returns will probably still choose high-risk investments, including equities. But whether it will be enough to offset the effects of a tighter monetary policy and a possible recession, I dare to doubt.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His “chart of the week” appears every Monday on Investment Officer Luxembourg.
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