Interview
Measuring the Equity Risk Premium
- Global equities have experienced one of the fastest rebounds following the March bear market trough, pushing valuations to near all-time highs (P/E) relative to the tech bubble.
- Elevated equity valuations are partially justified by bond yields trading near all-time lows.
- The Equity Risk Premium (ERP) remains structurally high despite the sharp equity rally, as bond yields have barely increased, preventing a deflation of bond valuations.
- 80% of the variation in the Equity Risk Premium is driven by variations in bond yields, creating an inverted relationship where lower yields correspond to higher premiums.
- In the current cycle, low bond yields reflect weak growth expectations and deflationary fears (particularly in Europe), which negatively impact equity returns by suppressing revenue growth and reducing the inflation hedge value of equities.
- To mitigate the distortion caused by low bond yields, the analysts adjusted their fair value models by revising down long-term growth and nominal earnings assumptions.
- This model revision reduced the calculated Equity Risk Premium by approximately 2 percentage points.
- Current estimated ERP levels are 6.5% for Europe and 4.5% for the US.
- Based on the historical post-2008 relationship between ERP and excess returns, an ERP of 6.5% (Europe) and 4.5% (US) suggests equities will outperform bonds over the next 12 months.
- Forecast for the ERP by end of 2021:
- The model predicts a drop of 80 basis points to 5.8% in Europe.
- The forecast relies on GDP growth, policy, economic uncertainty, and private debt-to-GDP as key explanatory variables.
- Implications of the forecasted ERP decline:
- Assuming a modest 40 basis point rise in pan-European bond yields, the cost of equity is projected to fall by 40 basis points.
- This valuation adjustment implies a potential 10% upside for European equity indices over the next 12 months.
- Key risks to the constructive equity view include:
- Failure to secure an effective vaccine or delays in economic recovery, which could slow growth expectations.
- An unexpected rise in bankruptcies or unemployment.
- A failure to realize the forecasted 70% decline in the ERP, which is heavily dependent on optimistic growth assumptions for 2021.
- Inflation outlook:
- Gradual, cyclical inflation from a demand shock is viewed as positive for equities.
- Structural inflation (similar to the 1970s) could damage returns, though this is deemed unlikely in the near term.
- There is no significant direct relationship between inflation levels and the ERP.
- High dispersion (uncertainty) in inflation forecasts is strongly correlated with higher ERP, which is negative for equities.