The stock market and the paradox of declining risk premiums?

The stock market and the paradox of declining risk premiums?


Philippe Trainar


“Examining the decline in stock values ​​since the beginning of the year in the light of these economic theory lessons, it turns out that this decline is relatively modest and that three sources of important uncertainty that could continue require much stronger stock valuation adjustments or even a stock crash. market. ”(Photo: Adobe Stock -)

Decline since the beginning of the year on both sides of the Atlantic, financial markets are living in times of war in Ukraine and rising interest rates. In this context, Philippe Trainar deciphers the impact on risk premiums

From the lowest point at the beginning of March 2009 to the highest point at the beginning of January 2022, the value of shares in Europe rose by 143% (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 by 19% in the United States. Economic theory teaches us that the value of a stock equals the present value of its expected dividends (the so-called Gordon-Shapiro formula). It increases when the market expects higher future dividends, when the risk-free interest rate falls and when the risk premium, which depends on both current uncertainty and aversion to market risk, falls.

Examining the decline in stock values ​​since the beginning of the year in light of these lessons from economic theory, it turns out that the decline is relatively modest and that three sources of considerable uncertainty could ultimately justify a much stronger stock valuation correction or even a stock market crash. Two of these factors are well known to Boursorama readers. We will therefore quote them only for the sake of order.

In fact, the decline in shares correlates exclusively with rising interest rates, especially with rising real components. The purely nominal component, which reflects inflation expectations, has remained broadly unchanged over the period and assumes perfect central bank credibility as real inflation continues to decline beyond their forecasts. As regards real component growth, it remained modest, at around 0.7 to 0.9 percentage points at 30-year rates, with markets betting that central banks would manage to control inflation with negative or weakly positive real interest rates… a challenge.

Stock return risk premium

The third factor is less known. This is a risky premium component of stock returns. It has tended to decline since the beginning of the year and at least partially counteract the effects of rising interest rates. This decline in the risk premium is doubly unexpected. On the one hand, the prospect of a less accommodative and credible monetary policy should have encouraged investors to reallocate their investments from risky to non-risky assets, which should have contributed to an increase in the risk premium.

On the other hand, the increase in geopolitical tensions in the world and the war in Ukraine, which have significantly increased economic uncertainty, as all available indicators on the subject show, should have resulted in an increase in the risk premium. The decline in the risk premium since the beginning of the year was probably only possible because the market has doubts about the size of future interest rate increases and prefers to wait and delay the movement of portfolio reallocations towards risk-free assets. .

These factors pose a significant risk to equities, the valuation of which is not only above the risk fundamentals, but is also at the mercy of reassessing the credibility of central banks. At best, if this credibility is confirmed, the risk premium will increase with the reallocation of portfolios towards risk-free assets and the market correction will remain appropriate. In the worst case, if central banks do not manage inflation under the conditions expected by the market and lose their credibility, inflation explodes and with it the level of the risk premium explodes.

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