Equity risk premium: Reflective of the current environment?

Quick takes on capital markets

September 1, 2023 | 2 min read

Elevated stock market valuations, coupled with higher bond yields, have driven the equity risk premium to near 20-year lows.1 The lofty valuations, while not contagious to the entire equity market, don’t seemingly reflect heightened recession risks. Rather than be potentially under-compensated for taking additional equity risk, investors today might consider increased high- quality bond allocations, which can hedge their portfolios toward a more stable income stream.

1 The equity risk premium is the excess return that investing in the stock market provides versus the risk-free rate.

S&P 500 equity risk premium
Basis points, 2008–present

Line graph showing S&P 500 equity risk premium by basis points from 2008-2023

Source: S&P Dow Jones, Federal Reserve, Bloomberg, Principal Asset Management. Data as of August 30, 2023.

In the coming quarters, many equity analysts expect robust corporate earnings recoveries; an optimistic outlook that has been supportive of strong year-to-date stock performance. However, the current economic backdrop is fraught with uncertainty, and investors may not be appropriately pricing in the strong likelihood of recession in the next 6-12 months.

Today, global central banks remain broadly hawkish, and many leading economic indicators are already in contraction. Europe is teetering on a stagflationary recession, while the world’s growth engine, China, is experiencing deflation. Although U.S. growth appears buoyant for now, its future, and the current global picture, leave earnings resilience far from assured.

Therefore, given the economic uncertainties, and with the S&P 500 risk premium at its lowest level in nearly two decades, investors are rarely getting adequate compensation in the equity market. In fact, future earnings disappointments seem to be so underappreciated that price-to-earnings multiples remain close to their pre-Fed hiking highs in early 2022—hardly reflective of the current environment and associated risks.

Despite recent U.S. economic resilience, investors should remain alert to an upcoming recession. Increasing allocations to high-quality credit may be appropriate, as bonds now provide an even more valuable portfolio hedge, offering income, capital stability, and diversification, as well as potentially sizeable capital gains once recessionary markers become more conspicuous.

Disclosure

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Fixed‐income investment options are subject to interest rate risk, and their value will decline as interest rates rise.

The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice.

Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.

Securities are offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers.

Principal Asset Management leads global asset management at Principal.®

For Public Distribution in the U.S. For Institutional, Professional, Qualified and/or Wholesale Investor Use only in other permitted jurisdictions as defined by local laws and regulations.

© 2023, Principal Financial Services, Inc. Principal Asset ManagementSM is a trade name of Principal Global Investors, LLC. Principal®, Principal Financial Group®, Principal Asset Management, and Principal and the logomark design are registered trademarks and service marks of Principal Financial Services, Inc., a Principal Financial Group company, in various countries around the world and may be used only with the permission of Principal Financial Services, Inc.

3093398