Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 107

Low rates and the equity risk premium

Over the course of the past year, RBA Governor, Glenn Stevens has bemoaned the low level of entrepreneurial risk-taking across Australia's corporate sector and implored businesses to invest for future growth prospects. ‘Animal spirits’ remain dormant in Australia and across most of the developed world thanks to persistent revenue headwinds and high discount rates that companies are assigning to expected future cash flows for potential new projects. The propensity for CEOs to lift dividend payouts rather than commit to new capital investment reflects a desire to cater to investors' insatiable appetite for income.

At first glance, the persistence of a high cost of capital is difficult to reconcile with the risk free rate or yields on sovereign bonds being at record lows. But in a wide-ranging speech delivered on 21 April 2015 (‘The World Economy and Australia’) in New York, Glenn Stevens acknowledged that lower returns on safe assets have not pulled down the cost of capital because there has been an offsetting rise in the equity risk premium (the return required to compensate investors for taking on the higher risk of the equity market). The Governor argued that the stability of earnings yields in the face of declining long term interest rates implies that the risk premium has lifted, reflecting more risk being assigned to future earnings and/or lower expected growth in future earnings (see Chart 1). He also highlighted anecdotal evidence of stickiness in hurdle rates used by corporate Australia when assessing projects.

Chart 1: Earnings and sovereign bond yieldsSF Chart1 010515

SF Chart1 010515

Investors have gravitated towards safe assets as they perceive a high level of risk in the world, despite the fact they are receiving record low interest rates. As Mr Stevens noted:

“Compensation in financial instruments for various risks is very skinny indeed. Investors in the long-term debt of most sovereigns in the major countries are receiving very little – if any – compensation for inflation and only minimal compensation for term.”

The risk premium and cost of capital

While lower rates have encouraged investment in ‘defensive’ sectors like banks and property trusts, stock multiples in cyclical sectors such as media and consumer discretionary are not receiving the assist from a lower risk free rate that might otherwise be expected due to caution about lower earnings and growth prospects.

There is a common misconception that record low interest rates should be associated with a re-rating of stocks. The risk free rate (the government bond rate) is directly observable on a daily basis, so our familiarity with low long term interest rates informs our mental framing of the cost of capital. But the equity risk premium is not directly observable, and so we are likely to neglect it as a source of variation in the cost of capital.

In fact, from the perspective of monetary policy, it is a key channel in which a central bank can influence the psychology of risk-taking, and hence the RBA Governor’s speech. If a central bank is seeking to revive ‘animal spirits’ in the corporate sector, it must do so by reducing the expected equity risk premium, as well as lifting expectations of revenue growth.

The defensive sectors in the Australian market are trading at a premium (based on dividend multiples) to their 10-year median estimates, while cyclical sectors are trading at or below their historical medians (see Chart 2). The higher equity risk premium has played an important role in driving a wedge in the multiples between defensive and cyclical stocks.

Chart 2: Defensive versus cyclical sectors and long term earnings multiplesSF Chart2 010515

High defensive stock valuations may persist

It might be tempting to think that either defensive stocks or high-yielding stocks with strong and sustainable sources of competitive advantage are exhibiting bubble-like valuations. But shifts in the risk premium and cost of capital matter for portfolio construction. This analysis suggests they have contributed to the relative rise in valuations for defensive (lower beta) stocks. Those high valuations may persist while the corporate sector's animal spirits remain dormant. The unwinding of the defensive trade will eventually happen abruptly, but that remains way off as long as output remains below potential, there is deficient aggregate demand, unemployment is well above the natural rate, and inflation remains subdued.

 

Sam Ferraro is founder and principal of the independent financial consulting firm, Evidente. This article is for general educational purposes and investors should seek professional advice about their personal circumstances.


 

Leave a Comment:

     

RELATED ARTICLES

Why valuation multiples fail in an exponential world

The world changes, then stays the same

Is this the end of the traditional term deposit?

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Meg on SMSFs – More on future-proofing your fund

Single-member SMSFs face challenges where the eventual beneficiaries (or support team in the event of incapacity) will be the member’s adult children. Even worse, what happens if one or more of the children live overseas?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

Policy proposals allow young people to access their super for a home bought from older people who put the money back into super. It helps some first buyers into a home earlier but it may push up prices.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.