What can we learn from the “equity risk premium” ?
The “equity risk premium” could stake a claim to being the most important number in investment, says Duncan Lamont, Head of Strategic Research at Schroders. There are different ways to measure it but conceptually they all come down to the same thing: assessing the return pickup from investing in equities compared with bonds. In general terms a risk premium can be thought of as a measure of the additional return that investors demand or expect for taking on a particular kind of risk, relative to some alternative.
Other examples include a credit risk premium, for corporate bonds compared with government bonds, or an illiquidity premium, for illiquid private assets compared with more easily tradable public assets. These assets are the core building blocks for the vast majority of portfolios, most famously in the classical 60% equity/40% bond portfolio. Their valuations and outlooks also have a bearing on most other asset classes, including private assets. That’s why it matters so much.
The rationale
Buy a bond and hold it until it matures and you know what you will get back. Invest in equities and the range of outcomes is wide. You could make a lot of money, but you could lose a lot. Equities have to have a higher expected return to compensate investors for taking on this risk. Otherwise why bother? And the “equity risk premium “is one way to assess this extra payback.
If it’s high, and you have conviction, it can be an argument for allocating more to equities and less to bonds, and vice-versa.
Importantly, this is all about expectations. There is no way of knowing how equities or bonds will perform until it happens. You can balance the probabilities in your favour but just because you expect equities to do better doesn’t mean they will. Risk means more things can happen than will. That risk is the price of the entry ticket to the equity market.
In this article we look at three of the most popular ways of assessing the equity risk premium and what they say about the prospects for equities compared with bonds today:
- The historical approach. This looks at the past performance of equities compared with bonds over a long time horizon. And, with disregard for compliance disclaimers, uses this as an estimate of what they might be expected to earn in in future.
- The simple approach: the yield-gap. An easy to calculate, and hence popular, approach to assessing the relative prospects for equities and bonds is to compare the earnings yield on the equity market (the inverse of the price/earnings multiple) with the yield on the 10-year Treasury. When the earnings yield is high relative to bond yields, this approach argues that equities are cheap relative to bonds, and hence more appealing. The opposite is also true.
- The “what’s priced in” approach. This approach looks at equity prices and consensus expectations for earnings growth and “backs out” the return assumption that is priced into the equity market. In simple terms, the equity market price equals the sum of discounted future cashflows from the market. That discount rate can be thought of as the return demanded by investors (it is the internal rate of return).
There are different ways to assess the outlook for equities compared with bonds. None is perfect but all can be useful. Historical estimates may seem like the easy option but they take no account of current market valuations and are sensitive to the time period assessed, which depends on availability of data. For non-US markets this can be particularly problematic and lead to potentially misleading conclusions.
Our more forward looking measures tell a consistent story. Bond yields have re-priced more than equities. US equity investors today are being rewarded with a smaller return premium for bearing equity risk than at any time in recent memory, at a time when macroeconomic risks are high and central banks are in less supportive mood. More risk, less reward.
The US looks particularly bad on this basis with things not as worrying in Europe and the UK. The US may have been the strongest performing market for much of the past 15 years, but our analysis of the ERP suggests that it will struggle to repeat that feat. And, with the US having risen to now make up 68% of the global developed stock market, global equity investors are highly exposed to US performance. Long-term investors may be better served by allocating more to non-US markets in the decade to come.
Further reading : What can we learn from the “equity risk premium” about the prospects for equities vs bonds, by Duncan Lamont, Head of Research and Analytics at Schroders.