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The equity market and the paradox of a falling risk premium?

The equity market and the paradox of a falling risk premium?
Written by madishthestylebar

Philippe Trainar

“When we examine the decline in equity values ​​since the beginning of the year in the light of these lessons from economic theory, it emerges that this decline is relatively moderate and that three sources of important uncertainties that could go forward warrant a much stronger correction in equity valuations or even a crash in the equity market.” (Photo credits: Adobe Stock – )

Down since the beginning of the year on both sides of the Atlantic, the financial markets live at the time of the war in Ukraine and the rise in interest rates. In this context, Philippe Trainar deciphers the impact on risk premiums

From the low point in early March 2009 to the high point in early January 2022, the value of stocks has increased by 143% in Europe (Eurostoxx 50 index) and by 608% in the United States (S&P 500 index). Since then, the value of shares has fallen by 17% in Europe and 19% in the United States. Economic theory teaches us that the value of a share is equal to the present value of its anticipated dividends (the so-called Gordon-Shapiro formula). It increases when the market anticipates higher future dividends, when the risk-free interest rate falls and when the risk premium, which depends on both current uncertainties and market risk aversion, falls. .

When we examine the fall in the value of equities since the beginning of the year in the light of these lessons from economic theory, it emerges that this fall is relatively moderate and that three sources of significant uncertainty which could ultimately justify a much stronger correction in equity valuations or even a crash in the equity market. Two of these factors are well known to Boursorama readers. We will therefore only quote them for the record.

The fall in equities is in fact exclusively correlated to the rise in interest rates, and more particularly to the rise in its real component. The purely nominal component, which reflects inflation expectations, has hardly changed over the period and assumes that central banks have perfect credibility when actual inflation continues to slide beyond their forecasts. As for the rise in the real component, it remained modest, around 0.7 to 0.9 points for 30-year rates, with the markets betting that central banks will succeed in controlling inflation with negative or weakly positive real interest rates… a challenge.

Equity return risk premium

The third factor is less familiar. This is the risk premium component of equity returns. This has tended to fall since the beginning of the year and to counteract, at least partially, the effects of the rise in interest rates. This fall in the risk premium is doubly unexpected. On the one hand, the prospect of less accommodating and credible monetary policies should have encouraged investors to reallocate their investments from risky assets to non-risky assets, which should have contributed to an increase in the risk premium .

On the other hand, the rise of geopolitical tensions in the world and the war in Ukraine, which have greatly increased economic uncertainties, as shown by all available indicators on this subject, should have resulted in an increase in the risk premium . The fall in the risk premium since the beginning of the year has probably only been possible because the market harbors doubts about the magnitude of the interest rate hikes to come and prefers to play wait and delay the movement of reallocation of portfolios towards risk-free assets.

These factors pose a significant risk to equities, whose valuation is not only above risk fundamentals but is also at the mercy of a reassessment of the credibility of central banks. In the best-case scenario, if this credibility is confirmed, the risk premium will rise with the reallocation of portfolios towards risk-free assets and the market correction will remain reasonable. In the worst case, if the central banks fail to control inflation under the conditions anticipated by the market and lose their credibility, inflation will explode and the amount of the risk premium will explode with it.

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