- Equity Risk Premiums (the additional expected return from equities over bonds) are currently elevated Globally and in the US, while less so in NZ.
- Entering equity markets at a higher equity risk premium has traditionally been a smarter decision than entering at a lower equity risk premium.
- If we see a reduction in the equity risk premium from elevated levels, this is likely to favour growth/cyclical assets as opposed to defensives.
One of the key decisions that investors must make is how much to respectively allocate to equities and bonds. This decision is made in the knowledge that over time equities have generated superior investment returns. Compensation for the additional volatility, the additional return equities earn over bonds is known as the Equity Risk Premium (ERP). The ERP, while persistent over the long term, varies over the short to medium term, with the direction of the variance having broad implications for investment portfolios.
Where does the Equity Risk Premium currently sit?
We measure the ERP by taking the 12 month forward earnings yield of equities and deducting the 10 year bond yield of the equivalent market. In other words, comparing the return you would get from equities and bonds in the next 12 months if asset prices were unchanged. At the end of January this put the ERP for the US market at 3.5%, Global Shares at 4.2% and NZ Shares at 2.8%, which is historically elevated for both Global and US Shares, while slightly elevated for NZ Equities.
Source: Bloomberg, UBS, Harbour
As one would expect, the ERP for each country has tracked closely together throughout time, with the main point of divergence being prior to the “tech bubble” in the early 2000’s when the ERP for US and Global companies went well into the negatives on expectation of the stellar future growth tech companies were going to generate. The NZ market of the day didn’t sport any tech companies of note, hence had more conservative ERP.
There are three things that an elevated equity risk premium tells us about markets:
1. A high equity risk premium is typically good for future returns
An elevated ERP has historically been good for future returns, the key exception to this was the period preceding the “tech bubble” where the ERP was negative, yet returns were strong for a period, only to unwind sharply once the bubble burst.
The chart below looks at forward 12 month returns for various ERP Tranches for the US market (the market in which we have the longest dataset) from 1962 onwards:
Source: Bloomberg, UBS, Harbour.
Perhaps more compelling than the returns for each tranche, is the instances of negative forward 12-month returns. The historical relationship has been the higher the ERP, the greater the probability of protecting capital.
Source: Bloomberg, Harbour.
2. Geopolitics and volatility play roles in elevated ERPs
It is clear from looking at ERPs, that they tend to reach relative highs during periods of crisis, the Global Financial Crisis and European Debt Crisis are notable examples. Conversely, they tend to reach lows during periods of market optimism. Another, related driver, is the link between an elevated ERP and elevated political risk and volatility.
Below shows the Global Policy Uncertainty Index vs. the Global Equity Risk Premium, this relationship has a strong correlation.
Source: Bloomberg, UBS, Harbour, Policyuncertainty.com
Over the past ten years especially, market volatility is another contributing factor to the ERP. The march towards the historic lows the VIX index, which measures implied volatility of US Equity futures contracts, reached during 2017, occurred at the same period that the US ERP re-rated upwards by 1.8%. This relationship provides some credence to Warren Buffet’s famous quote “Be fearful when others are greedy and greedy when others are fearful."
Source: Bloomberg, Harbour
3. An increasing ERP is often good news for defensives (but bad news for cyclicals/growth)
Given a rising ERP is typically aligned with periods of market volatility or periods of heightened geopolitical risk, it is a logical extension that investors turn to more defensive assets at the expense of cyclical/growth equities.
This relationship is at its strongest during more extreme market events, for instance pre and post GFC in 08/09 and the European Sovereign Debt Crisis in 2011. Though notably in the period 2013 – 15 we saw strong outperformance from defensives without a rise in the ERP. More recently, the selloff in the last quarter of 2018 saw a rise in ERP and strong outperformance from defensives both have unwound somewhat in early 2019. This relationship is strongest in the NZ and Australian markets.
This relationship has implications for cross asset class investors with allocations to Real Estate, Infrastructure and Income orientated equities who may see underperformance during a period of rising equity risk premiums. Conversely, this provides opportunities when ERP’s have reached relative peaks.
Source: Bloomberg, UBS, Harbour.
Overall, we believe the ERP is a useful tool when assessing investment markets and its relative and absolute level can provide confidence in assessing attractive entry points into not only markets but the sectors within markets.
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