Potential Shift in Equity Risk Premium

Investing.com — A key indicator measuring stocks' attractiveness compared to bonds might be about to change, according to analysts at UBS.

The Equity Risk Premium (ERP) aims to quantify the excess returns investors expect from stocks over risk-free government bonds. UBS analysts state this gauge possesses "strong predictive power for equity performance."

Recently, the ERP has been decreasing, reaching the 15th percentile of a 100-year distribution. This indicates that equities have been more expensive relative to bonds only 15% of the time in the past century. Historically, this latest ERP level translates to an average of only 1.32% additional reward from the S&P 500 compared to the benchmark 10-year Treasury yield.

This downward trend suggests that investors have lesser incentives to invest in riskier stocks as safer assets offer similar rewards.

Nevertheless, UBS strategists, led by Nicolas Le Roux, expressed that the ERP might rise in the face of an "era of deglobalization, limited policy space, and higher geopolitical risks," potentially leading to increased economic volatility.

Despite this, UBS data indicates that the S&P 500's ERP has been shrinking over recent years and is currently at levels last observed nearly two decades ago. "This signals mediocre equity returns ahead," the analysts commented.

Identifying the key drivers behind ERP is considered one of the most challenging questions in modern finance. However, the analysts noted five potential catalysts: cyclicality, variance in economic data, lack of profit sharing, central banks' quantitative easing programs, and leverage.