US Equity Risk Premium Reaching Inflection Point

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Rising US Treasury yields are putting pressure on US equity risk premiums, and if 10 year yields go up any more the ERP will fall below its historic average, making stocks look relatively expensive, and bonds may already look better than stocks in the UK and Europe.

US equity risk premium attractive

“While the US equity risk premium is still in attractive territory, if government bond yields continue to rise as expected by our economists, it will soon move below its long-term average,” writes Societe Generale analyst Alain Bokobza. “As bond yields rise, USTs will gradually appear more attractive relative to equities.”

Bokobza expects UST yields to approach 3.75 by the end of the year, at which point US ERP will start to look unattractive, all else being equal.

Rising yields aren’t always bad for equities

But the impact of rising yields may not be felt right away. “Rising bond yield is not necessarily a negative for the US equity market and we expect it to remain supported in the near term. We still expect the shift in Fed monetary policy to cause a correction in the S&P 500 (INDEXSP:.INX), only later,” writes Bokobza.

The correlation between bond yields and the stock market is only negative in an inflationary market, and the correlation has actually been positive since 2008. Bokobza writes that the correlation usually turns positive when there are deflationary fears, as can be seen from the sharp jumps in reaction to crises of the last few decades. It’s this combination of rising bond yields and a return of the negative correlation that most people expect that will really put pressure on equities, but that probably won’t come together immediately.

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Japanese stocks still relatively cheap

A similar trend can be seen in the UK and the Eurozone, where the ERP is already below its historical average, but Japan is on a different track altogether. Even though Japan’s ERP has fallen from a recent high, the fact that it is still well above the historical average reinforces the idea that, aside from the similarities of accommodative monetary policy, Japan’s recovery is proceeding along different lines and should be analyzed separately from the West.

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