Analysis: Equity risk premium set to shrink

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Analysis: Equity risk premium set to shrink

By Simon Jessop and Clare Kane

LONDON (Reuters) - The extra return demanded by holders of European equities over safe-haven sovereign debt is set to retreat from record highs unless investors' worst fears over global growth come true.

That return, known as the equity risk premium, is a measure of relative value between stocks and bonds and stands at twice its long-term average, Thomson Reuters data showed. While various measures of earnings growth and bond yields will produce slightly different figures, the trend remains the same.

One part of the risk equation relies on stock prices, which many think have fallen too much, while the other rests on the yield offered by countries such as the United States, the UK and Germany on their debt, and here things are far from normal.

Central bank stimulus efforts in the first two countries and safe-haven flight to German debt by investors seeking to preserve capital in the euro zone crisis, have driven returns on bonds to record or multi-year lows.

Against this backdrop, analysts said share prices have taken too big a hit - double-digit declines in 2011 - and so should begin to adjust, leading to a paring in the hefty premium over the coming weeks and months.

"I would take this as a mispricing and I take it to be a buying opportunity for equities," Tom Elliott, global strategist at JPMorgan Asset Management, said.

Euro zone blue chips (.STOXX50E) fell 17 percent last year, largely on macro-economic concerns, but dividends are healthy, companies are cash-rich and many can tap into growth around the world, analysts said.

That makes them attractive in income terms for investors shopping around and finding a negative real return on UK gilts, U.S. Treasuries and German Bunds when inflation is factored in.

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For a graphic comparing regional equity risk premia, click here: http://link.reuters.com/mum95s

For asset performance in 2012, click here: http://link.reuters.com/nyw85s

For global government bond yields, click here: http://link.reuters.com/ser95s

For S&P equity earnings yield vs 10-yr Treasury yield (live graphic), click here: http://link.reuters.com/sed23s

For developed country comparison (live graphic), click here: http://link.reuters.com/ved23s

For global sector comparison (live graphic), click here: http://link.reuters.com/bud23s

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POLITICAL RISK

The risk premium can vary depending on the measure of equity value and what is considered "risk-free" - a notion eroded by the debt crisis.

"The concept of risk-free appears to be under attack across financial markets," Jonathan Stubbs, European equity strategist at Citi, said. "Credit risk is rising across many sovereign bond markets."

That risk recently saw France's credit rating downgraded along with those of eight other euro zone sovereigns.

Using Bunds, traditionally seen as Europe's risk-free rate and now offering rock bottom yields, the euro zone's ERP stands at 11.1 percent, but in Italy, where the rate on government bonds has spiked in recent months, the ERP is 9.4 percent.

Unlike at the height of the financial crisis when banks' balance sheets were in focus and the risk premium rose as stocks fell, investors are now more inclined to price in political risk, which has contributed to the inflated ERP.

"Investors are much more aware this time of the capacity for credit events to severely impact global economic growth and therefore earnings," Ian Scott, global head of equity strategy and quantitative research at Nomura, said.

That said, the outlook for stocks is not a one-way bet.

In spite of a positive start to the year, with global shares .MIWD00000PUS up 5 percent, Garry Evans, global head of equity strategy at HSBC, said in a note he expected 2012 to be a volatile year that ends flat.

"The news that France and others had their credit ratings cut and the near-failure of the Greek negotiations should remind investors that risks still lurk."

GLOOMY MARKETS

The degree to which equities are undervalued depends on the growth outlook, but while global growth is still being revised down, with the World Bank just the latest to do so, data shows stock markets are even more bearish.

Germany's DAX (.GDAXI), the leading euro zone index by market capitalization, is priced as if compounded earnings per share growth will fall 5 percent every year for five years, StarMine data showed

Peter Oppenheimer, chief equity strategist at Goldman Sachs, said that at current levels of return on equity and expected growth, the STOXX Europe 600 (.STOXX) should be trading at around 420 points. It traded close to 255 points on Friday.

Signs the global industrial cycle is bottoming out, "which tends to be supportive for equities," could help close the gap, Oppenheimer said.

If that feeds into equity market sentiment and market pessimism wanes, the equity risk premium will be trimmed even if the other key input - bond yields - stay low.

Nomura's Scott said he would be looking for the ERP to come down over the first half of 2012 "unless we see things in the euro zone deteriorating considerably."

(Additional reporting by Pratima Desai, graphics by Scott Barber and Vincent Flasseur, editing by Nigel Stephenson)