If I were to take Bloomberg, for example, as a rough estimate, almost 100% of interviews focused on the economic environment are devoted to rates. Risk premiums are roughly zero. At the same time, premiums are much more relevant for stocks than central bank rate settings. But they have one drawback – they are not talked about as simply as rates. At the same time, they are probably extremely low now. What could this mean?
Equity risk premiums cannot be observed directly, so they are derived in various, sometimes somewhat misleading ways (difference between inverse PE and risk-free rates). At the same time, their development can also be indirectly derived from shifts in risk spreads on the bond markets. The risk on stocks is not the same as the risk on bonds, but there should still be some connection. The following graph shows how the risk spreads of corporate bonds with a very low rating (their yields relative to the yields of bonds with a high rating) have developed:
Source: X
Current premiums are extremely low. Which, by the way, together with a similar period before 2007 and 1999, shows that there is nowhere near the need for extraordinary monetary expansion, quantitative easing and the like for a similar decline in spreads and risk appetite. It is quite obvious from the graph that after periods of extremely low premiums comes their quite sharp growth. That is, markets do not tend to slowly readjust to higher risk aversion, rather they jump to it.
At the same time, according to the graph, these jumps historically do not match the growth of the stock market. He doesn’t need extremely low premiums to go up, he just needs to go down. However, their sharper growth, even from very low levels, does not bode well for him. At current premium levels, it would be quite extraordinary if they were to go significantly lower. If history is any guide, it’s “just” a question of how long they’ll stay at current values before taking a leap higher. As soon as a shock comes to the market or a sudden reassessment of the situation even without a shock.
Of course, history doesn’t have to repeat itself. And in this context, it may be worth considering briefly why premiums should be so low now. There is constant talk of Fed rate cuts. However, on the whole, monetary easing is not expected to be imminent (easing, yes). And there is the question of why this alone should push premiums extremely low. In terms of fundamentals, we have mainly structural visions about the potential of artificial intelligence.
If it should really raise productivity in the wider economy, it could also affect the ability to pay back the debt of many companies. So somehow AI could be combined with lower premiums. A significant upward jump in premiums would then be due to a massive reassessment of the potential of AI in stocks and bonds. And of course premiums also have a significant cyclical element. But a recession does not seem to be in sight now, even though the warnings about it are constantly being sounded.