Interview
Measuring the Equity Risk Premium
- Equities are currently viewed as attractive relative to bonds due to an elevated equity risk premium of approximately 6.5% in Europe and 4.5% in the US, though this premium is expected to decline modestly in the near term.
- The firm projects the equity risk premium in Europe to decrease by roughly 80 basis points to 5.8% by the end of 2021, a forecast driven primarily by expectations for GDP growth, policy, economic uncertainty, and private debt levels.
- Assuming the equity risk premium falls and pan-European bond yields rise modestly by 40 basis points, the cost of equity is projected to decline by 40 basis points, implying a potential 10% rise in equities that aligns with 12-month target prices.
- While equities are expected to outperform bonds over the next 12 months if historical relationships hold, the outlook also suggests that equities and bonds may deliver fairly similar returns over this same horizon.
- Long-term growth assumptions in the dividend discount model have been revised downward to reflect a trend of lower GDP and nominal earnings growth over the past decade.
- Approximately 70% of the forecasted decline in the equity risk premium is attributed to an optimistic view regarding economic growth in 2021, while the model indicates no significant linear relationship exists between the equity risk premium and inflation levels.
- A primary risk to the constructive view is the failure to obtain a vaccine or if it underperforms market expectations, which could lead to slower economic growth recovery and higher equity risk premiums.
- Negative outcomes such as an unexpected rise in bankruptcies or unemployment would likely increase the equity risk premium and negatively impact returns, whereas a gradual rise in cyclical inflation is considered positive for risk assets.
- Higher uncertainty in inflation forecasts, characterized by greater dispersion, is identified as being more negative for equities in general compared to specific inflation levels.