UK equities are much riskier now than they have been for most of the last 30 years. That’s the message of the equity risk premium.
This premium is the gap between expected returns on equities and on bonds: it’s the excess return on equities that investors expect as a reward for taking equity risk. Formally, it’s defined as the dividend yield, plus expected growth, minus bond yields. Sadly, we can’t see expected growth. But we can see the gap between the dividend yield on the All-Share index and the yield on 10-year index-linked gilts. This is now almost 5.4 percentage points, close to the biggest gap since linkers were first issued in 1981. This is only very partly due to the recent rise in the dividend yield: even before the recent sell-off in stock markets, the yield gap was far above its long-term average.
Now, it’s likely that the gap is high in part because investors need a higher yield than in the past to compensate for a lack of expected growth.
This, though, is probably only a small part of the story. The most reasonable assumption to make about long-run share price growth is that it’ll be the same as dividend growth which in turn we might reasonably expect to grow in line with GDP. Given that long-run growth is reasonably stable, it’s unlikely that prospective growth has fallen by more than two percentage points since the 80s.
The inference, then, is clear: the equity risk premium is probably now twice what it was in the 1980s and 90s – probably well over six percentage points compared with around three percentage points then.
Why might equities be so much riskier now than then to justify such a high risk premium?
The question is a tricky one because in one important sense the economy seems safer now than it was then.
One reason for this is that companies have stronger balance sheets: they have less debt and more cash.
Also, in 1981 and 1990 the UK suffered recession as policy-makers raised interest rates to reduce inflation. But Eric Lonergan at M&G points out that for the last 20 years inflation has been remarkably stable. It is, he says, no longer a source of cyclical risk. With one source of risk removed, the equity risk premium should be lower now than it was then.
So why isn’t it?
One reason is that inflation is only one of countless possible causes of recession. And while the probability of a recession is perhaps no higher now than usual, it is a nastier prospect. Central banks responded to past recessions, or even the chance of them, by cutting interest rates thereby cushioning share prices. At near-zero rates, such cuts aren’t so feasible and so this cushion is missing.
A second explanation is a scarring effect. The tech crash of 2000-03 reminded us that shares are not necessarily a great long-term investment: the FTSE 100 only returned to its 2000 peak in 2015. And the 2008 crisis killed off talk of a “great moderation” and has made us more sensitive to all kinds of risk.
Thirdly, there’s creative destruction risk. The UK is not like the US: Antonio Fatas at Insead points out that the risk premium there has fallen in recent years. One reason for this might be that US companies have enjoyed increasing monopoly power whereas UK ones haven’t. They have stronger moats – ways of fending off competition. UK companies thus face a greater danger that future technical change or competition from new companies will bid away their profits.
There’s a precedent for this. Boyan Jovanovic at New York University says that one reason why shares fell so much in the 1970s was that investors rightly anticipated that the beneficiaries of the IT revolution would be as-yet-unquoted companies while the losers would be the incumbents. The fear that a similar thing might be true of the AI revolution justifies a high risk premium today.
A fourth possibility is distribution risk – the danger of a shift from profits to wages as a result of near-full employment or (maybe more likely) a political backlash against present-day capitalism. Utilities have done badly recently despite having supposedly bond-like qualities because of political risk. They might not be alone.
Perhaps, though, there’s another explanation.
The story of the rise in the equity risk premium is not so much about equities as bonds: the dividend yield is similar to what it was in the 80s and 90s but bond yields have trended downwards since then. The question, then, is why the dividend yield didn’t fall as bond yields did?
One possibility lies in the fact that the purpose of investing is not to predict reality but to predict others’ opinions of it. If you believe that others believe that the dividend yield should be between 3 and 4 per cent you’ll not want to buy at low yields. If enough people believe this, the yield will therefore stay in this range.
Put it this way. The only way we could have what looks like an equity risk premium of three percentage points with index-linked yields at minus 1.5 per cent and expected growth of 1.5 percentage points would be for the dividend yield to be zero. Would you really want to buy shares near such levels? Would you expect others to?
Such an explanation might seem intuitively simple. But it has a devastating implication. It suggests there’s no equity risk premium. There are yields on bonds and on equities, but no connection between them.
This isn’t wholly absurd. It’s consistent with the fact that there are in many cases no trade-offs between risk and return – defensive stocks, for example, do better than high beta ones. In such cases, the notion of a risk premium makes no sense.
All this gives us a dilemma. One possibility is that shares really are riskier than in the past. This suggests that they might well outperform bonds by more than in the past, but only as a reward for taking unusually great risks. The other possibility is that conventional economics is wrong and that the notion of a risk premium makes no sense. Either view is a very radical one.
