"Stock Investment Appeal Declines" US Stock Risk Premium Hits Lowest in 20 Years

Investors' incentives to invest in U.S. stocks instead of bonds are diminishing. The so-called 'risk premium,' which investors could enjoy by taking on additional risk through stock investments, has fallen to its lowest level in about 20 years. Some worry this could pose a threat to the recent rally in the New York stock market.

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The daily Wall Street Journal (WSJ) reported on the 31st (local time) that the 'equity risk premium,' which shows the gap between the S&P 500 index's rate of increase and the 10-year Treasury yield, dropped to around 1.1 percentage points last week. This is the lowest level since 2002. The gap with the 10-year Treasury Inflation-Protected Securities (TIPS) yield, which reflects the real interest rate excluding inflation, narrowed to 3.5 percentage points, the lowest since 2003. Some experts prefer the TIPS-based results, considering that corporate earnings are adjusted according to inflation.

The decline in the equity risk premium suggests that recently, stocks have been less attractive as an investment compared to bonds, which are considered representative safe assets. WSJ stated, "The equity risk premium shows how much compensation investors receive for the risk of holding stocks," adding, "Currently, that compensation is not very large." The outlet also noted concerns that the New York stock market rally may be difficult to sustain as the equity risk premium falls to a 20-year low.

The equity risk premium began to decline in the second half of last year. At that time, while bond yields strengthened due to the Federal Reserve's (Fed) interest rate hikes, stock prices stabilized after early-year sell-offs. Furthermore, this year, expectations of a soft economic landing have grown, sustaining the New York stock market rally. The large-cap-focused S&P 500 index has risen about 19% since the beginning of the year. The tech-heavy Nasdaq index's gains approach 37%.

Currently, most experts believe the equity risk premium will not remain low for an extended period. They also point out that a low equity risk premium does not necessarily mean the recent New York stock market rally will end soon. Historical cases, such as the late 1990s dot-com bubble when the equity risk premium was much lower than now, support this view. WSJ explained, "Historically, the equity risk premium tends to revert to the mean over time," adding, "This is generally because corporate earnings outlooks are bleak, not because investors are scared." Brian Jacobson, chief economist at Annex Asset Management, said he has not found a strong statistical relationship between the 10-year Treasury yield and future earnings yields.

Considering that bond yields have been falling recently, unlike stock prices, there are expectations that the equity risk premium will normalize soon. This decline in bond yields aligns with hopes that the Fed's rate hikes may end this month. According to the Chicago Mercantile Exchange (CME) FedWatch, the federal funds (FF) futures market this morning reflects a 79% probability that the Fed will hold rates steady at the next September FOMC meeting. Although the Fed's June dot plot suggests one more rate hike could occur this year, the market strongly favors a hold scenario through year-end. Most Fed officials predicted in June that real interest rates would stabilize at a level not significantly exceeding 0.5%.

Jacobson, who previously recommended expanding bond investment portfolios instead of stocks, forecasted that the 10-year TIPS yield could fall to 0.75% or 1% over the next 12 to 18 months. This means investors would receive greater compensation for holding stocks even if stock prices do not rebound significantly. He said, "Looking at interest rate cycles since 1989, every time rates peaked, the bond market showed strength (bond yields fell). It seems we are at least close to that point."

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