At M&G’s Annual Investment Forum last week, Eric Lonergan of the Episode team discussed what he sees as the two big questions affecting investment today. Namely, ‘Why do equity markets appear to offer such high compensation for risk?’ and ‘Are we about to enter recession?’ Here is a video of his talk along with some accompanying notes and additions.
The state of equity risk premium
Equity risk premium (ERP) is a measure of how much compensation (implied by current prices) investors demand to own equities rather than supposedly risk free assets. As can be seen in figure 1, ERP remains elevated both relative to where it has been historically and to pre-global financial crisis levels. In particular, the chart demonstrates that investors appear to be being offered significantly more compensation for equity risk than for the risk of higher interest rates or wider credit spreads.
It is worth considering what these numbers imply. A 6% excess return equates to an outperformance over bonds and cash by some 80% over ten years, significant in its own right but especially considering that a number of fixed income assets are priced to deliver zero or negative returns.
ERP has good form as a predictive measure. For example, if you look at the turn of the century on the chart, equities were priced to give zero return and underperform Treasuries and credit. Over the subsequent decade, this turned out to be the case.
Why is the ERP so elevated?
Why do investors demand such a high level of compensation to own equities today? It may be that equity risks are higher than in the past. Is market pricing telling us that company profits are set to disappoint over the long term?
Let’s consider whether the facts justify this explanation for today’s equity valuations.
Do low cash rates suggest a growth problem?
A large part of why the equity risk premium looks elevated relative to history is the fact that risk free interest rates are at or around all-time lows. Most people have grown up with a model that real interest rates and real growth should be roughly the same and so assume that that low cash rates are telling us something about the growth environment.
However economic activity continues to grow around the world, particularly in the western world despite real interest rates having been negative ever since the financial crisis.
If one were only to listen to the theories of secular stagnation, which also tend to make the link between interest rates and growth (and which I have previously discussed here) the assumption would be that growth today is terrible. However, the evidence shows that this is not the case. We should take all such theories with a pinch of salt; last time secular stagnation gained popularity as a theory was in the late 1940’s, shortly before the greatest period for US growth in history
Are profits falling?
Again, when you look at the data, US companies are, on the whole, doing pretty well. Beyond normal cyclical variation there is little evidence of a structural deterioration in the corporate environment. In fact, as Dave wrote in a post last year the environment continues to look positive, with US profits having recovered strongly from the GFC lows and currently accounting for around 10% of GDP. So a worsening earnings environment does not appear to be justification for today’s elevated ERP.
Could valuations reflect a behavioural bias?
In my experience, investment opportunities arise when investors’ emotions impel them to separate the potential rewards available from an asset class away from the fundamental amount of risk they are taking on. I am convinced this is currently the case with equities.
It is clear to me that the reason investors remain wary of investing in equities is their past experience. Since 2000, investors have earnt virtually nothing from owning equities (see figure three). Instead, they have had to live with volatile returns that have barely kept up with inflation.
I believe that this is a strong determining factor of today’s equity valuation. Just as many investors did not want to touch UK gilts in the mid-1990s, or just as UK investors continue to believe that property is always the safest asset, our feelings of risk based on past experience can play a huge role. Opportunities arise when these feelings contradict objective assessment.
What about recession?
However, while the equity risk premium is an important predictive indicator to the potential returns from equities over the medium term, the return of recession would overcome valuation considerations for a meaningful period of time. It is worth noting that, while declines of 10% to 20% in the stock market can occur without an economic recession, it takes a recession to cause falls of 50% and it is these that can be most harmful.
Are we about to enter recession?
For most investors with diversified portfolios what matters are structural recessions, when all sectors of the economy struggle. By comparison, sectoral recessions are fairly commonplace and, indeed, the oil & gas industry is in recession at the moment.
In general, widespread recessions are associated with a combination of three factors: tight monetary policy, a high real oil price, and stress in the financial sector. These matter because they are a problem for all parts of the economy and when all three are present, there is a significant probability of recession.
Currently, it is clear that none of these conditions are in play. Indeed, central bank policymakers are about as accommodative as they have ever been (even in the US), the oil price is close to multi-year lows and the financial sector is arguably more robust, having been strengthened by government bailouts and consolidation.
US Industrial production
Most recession fears this year have stemmed from a weaker US industrial production number. This is an important measure but it is worth keeping in mind that US manufacturing is only 12% of US GDP. It is also worth noting while certain sectors of industry are suffering – and gaining all the attention, others are performing pretty well. Steven referred to this in a recent post, while Tim Duy and Josh Lehner have also drawn our attention to the chart below, which shows that the number of components of industrial production contracting at one time has typically been far higher in and around recessions.
Perhaps most importantly, I would point out that a recession in the energy sector is a stimulus to other areas of the economy. It is therefore not correlating but diversifying in its effects. In my opinion, getting worried about the lower oil price is an illogical reaction. A fall in the cost of their energy requirements should have a positive impact on consumers and the rest of the corporate sector.
It is worth noting that my discussions above centre on the prospects of recession in the western world, and the US in particular. It is not based on an optimistic case for resource production in the emerging market world or on China. China does face some very real challenges but the likely impacts of this on parts of the developed world seem to be overplayed; possibly due to investor experiences of the global nature of the financial crash in 2008. It is worth remembering that the US exports more to Canada and Mexico than it does to China by some margin, while the financial pass-through is also plausibly quite low, given the changes in the financial sector noted above.
Valuations suggest that there is a medium term opportunity for equity investors versus cash and some parts of the bond market. It seems that much of the valuation signal is not driven primarily by an objective view of the risks of equity, but by the experiences of ownership since the turn of the century (an experience that itself is entirely consistent with prevailing value signals in 2000). Moreover, the particular episode we are in today seems to represent an overly pessimistic view on the prospects for global growth, and could well represent a good entry point for exploiting that opportunity.