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Equity risk premium 100-200bps above long term average, says ING IM

Equity markets in every region of the world offer risk premiums between 100 and 200 basis points above their long term average, according to research from ING Investment Management (ING IM).

Europe offers the highest premium of 6.2 per cent, followed by Japan (5.5 per cent), the UK (5.1 per cent) and the US (4.1 per cent).
Patrick Moonen, senior multi asset strategist at ING IM, says: “Taking risk in equities is well rewarded: we expect that over the next one or two years, these risk premiums will gradually normalise. This will happen partly through higher bond yields but also partly thanks to rising markets as systemic and economic risks continue to fade. The level of the risk premium indicates that there exists a decent buffer against an increase in government bond yields.”
There are three risks to the assumption that the equity risk premium will decline. The first one is geopolitics. The tensions with Russia and in the Middle East may prove to be a lid on risk appetite, especially in Europe, which is more vulnerable to any negative impact of sanctions. A worsening news-flow out of China concerning defaults, the housing market or credit bubble is also a risk factor. However, recent cyclical data points towards stabilisation or even some improvement in the cyclical outlook. In the Eurozone deflation cannot be ruled out, although it is not a base case for ING.
ING IM has downgraded Europe from a small overweight to a small underweight and upgraded the US from neutral to a small overweight, based primarily on the rapid weakening of the former’s relative data. However, ING believes European earnings growth could still be higher than in the US over the next 18 months, if the recovery holds firm.
Moonen says: “The downgrade does not imply that all of a sudden we have turned bearish on Europe. The relative valuation argument is still intact. Europe’s equity risk premium is the highest in the developed world and recently, it has risen even further. Taking into account it is at an early stage in its earnings cycle and the ECB is prepared to do ‘whatever it takes’, the market will be driven by two factors: higher earnings and higher valuations. This stands in contrast to the US where we think valuations are more at risk in view of the gradual shift in monetary policy. Here, the market performance must come entirely from earnings growth. The strong Q2 earnings season in the US reveals that companies are delivering the needed growth to underpin the market.”

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