Higher Rates Have All But Erased the Equity Risk Premium

16 October 2023

Pascal Blackburne

The major take-away of the past few weeks has been the breakout in long-term yields. The 30-year US Treasury briefly hit 5% in the opening days of October, certainly an important threshold for investors. And a similar move is underway in Europe. The tipping point may not yet have come for the “great shift” out of equities and into bonds, but a near 3% real return on risk-free government bonds (assuming central banks manage to get inflation down to their 2% target) does look attractive.

With data reports continuing to depict an unexpectedly resilient US economy and the Fed thus maintaining a hawkish stance, long-dated US government nominal yields are currently hovering around 16-year highs. The level of real return (adjusted for inflation) that they will actually deliver hinges of course on the Fed’s success in curbing inflation. US consumer price index readings have backed down in recent months but, as we discussed in our last Investment Letter, stand to pick up again in 2024 because of energy-related base effects.

Still, even if inflation does not fall all the way down to the official 2% target, current nominal yields on long-term Treasury bonds (4.75-5%) make for an interesting investment in our opinion. Not only should they be sufficient to preserve investors’ capital and purchasing power, but they also look attractive relative to the previously expensively valued equity markets. Particularly when one considers that current stock prices take into account excessively optimistic consensus earnings forecasts. The 10% average earnings’ growth expectations for the next 12 months will prove a tough hurdle for many companies. Indeed, our contacts with managements suggest that profits have been sustained so far by the unwinding of order books, but new order flows are (very) weak.

It will thus be a tour de force (if not impossible) for companies to maintain their profits. Which in turn means that the equity risk premium – the extra return that an investor demands to invest in equities rather than buying bonds (ca. 3%) – is melting like snow in the sun.

The only factor that would support the required risk premium in the near future (and thus reduce the odds of a stock market correction) would be a serious drop in interest rates. A scenario that we view as rather unlikely in the short run.

At the same time, however, we should stress that we do not expect central banks to push rates significantly higher, because of the pressure that would put on public finances. Particularly so in the US where, because of a shorter average maturity of government debt, high interest rates are already weighing heavily on the budget deficit. From USD 500 billion in 2022, interest costs have risen to USD 700 billion in 2023 – a whopping 40% increase.

Which brings us to the US dollar. Assuming the Fed is indeed almost done with its hikes (i.e. that the interest rate differential vs. Europe might contract) and considering the high current level of the greenback on a purchasing parity basis, the most likely path over the next months is, in our view, a depreciation – making currency protections as important as ever.

A worthy alternative to US Treasuries are, in our view, European government bonds. Longer dated Italian government bonds (BTP), for example, are now yielding about the same as their US counterpart (and without currency risk) ; a level not seen since the sovereign debt crisis of 2011-2012 and even above the 4.6% average of the 2000-2010 period.

In addition, there are now also nice yields on long-term corporate bonds of excellent quality (investment grade).

A good time, therefore, to expand the bond portfolio (to the detriment of the equity component) and extend its average duration.

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