Are equity risk premiums really still attractive?

By Ed Smith, Rathbones

Added 6th October 2016

Consensus suggests it is a struggle to find value in equities, but despite political uncertainty in the UK, US and Europe, there are still plenty of opportunities globally

Are equity risk premiums really still attractive?

Key economic indicators are forecasting a very low risk of recession in the coming months; 1987 aside, bear markets do not occur without one. Global indicators have risen, and our measure suggests global growth will end 2016 at about 3% in real dollar terms, around the 30-year average.

There are three key risks to the equity markets: a clean sweep by Republicans or Democrats in the US presidential election could herald an era of protectionism; the Italian referendum and banking bailout could spark renewed political uncertainty in Europe; and Brexit may cause a greater slowdown than anticipated.

That said, equity risk premiums offer investors considerable compensation in the UK and the US, but not enough in the eurozone.

Prior to the EU referendum in the UK, our analysis suggested a Brexit vote would shake confidence and the shock would slow growth to as good as zero, but that a recession was not guaranteed. Post-referendum, we upgraded our outlook for domestically focused equities, as many stocks were pricing for a far higher probability of recession than was suggested by our analysis.

After some immediate jitters in the UK economy, indicators do not suggest a recession is on the horizon. Consumer confidence and purchasing managers’ index (PMI) surveys even suggest mild growth.

Within the FTSE 100, those stocks that are most exposed to the UK are yet to recover but the more domestically geared FTSE 250 has rebounded strongly, though valuations remain depressed, especially relative to large caps. Looking at valuations relative to global equities, the FTSE 250 still provides a large cushion against macroeconomic shocks.

The performance of the FTSE 100 relative to global equities seems consistent with the devaluation of the pound, the recovery in the price of oil and better Asian macroeconomics. However, the first of these is unlikely to offer a tailwind from here on. At this juncture, volatility is unlikely to resume until the UK parliament triggers Article 50.

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