Is Equity Risk Worth the Reward in a World of Higher Bond Yields?

27 November 2023

4 min read

Robert Milano| Senior Investment Strategist and Global Co-Head—Equity Business Development

Walt Czaicki, CFA | Senior Investment Strategist—Equities

David Wong| Senior Investment Strategist and Global Co-Head—Equity Business Development; Co-Chair—Responsible Investing Steering Committee, Asia-Pacific

Equities have an important role to play in a diversified allocation today, to help hedge against inflation and to navigate a lower-growth environment.

Higher bond yields are presenting tough questions for equity investors. While the risk/reward trade-off for equities might be less favorable than in the past, historical return patterns suggest that US stocks can still do well in this environment.

Making investment decisions about any asset is a function of risk versus reward. For investors in stocks, the equity risk premium (ERP) is a common way to measure the risk/reward trade-off. Simply put, the ERP is the excess return that investors expect to earn over a risk-free rate. It measures the compensation that investors expect for investments in stocks, which are generally seen as riskier assets than bonds or cash. A higher ERP signals that investors can expect a relatively greater reward from stocks than they would in a lower-ERP environment, and vice versa.

Is Today’s Lower ERP a Bad Signal for Stocks?

This year, the ERP for US stocks has declined. Our ERP metric shows the earnings yield of the S&P 500 minus the yield of the 10-Year US Treasury note, a proxy for the risk-free rate. That spread declined to 1.2 percentage points at the end of October, from an average of 3.1 percentage points between 2009 and 2022 (Display). The ERP has narrowed because rising interest rates lifted the Treasury yield from near-zero levels to 4.9% at the end of October.

US Stocks Have Performed Well in Lower ERP Environments

Bar chart compares the S&P 500 equity risk premium with the market return from 1993 to 2008, 2009 to 2022 and in 2023.

Past performance does not guarantee future results.
Equity risk premium (ERP) is measured by the S&P 500 earnings yield minus the 10-Year US Treasury note yield. Returns for periods from 1983 to 2008 and 2009 to 2022 are shown as annualized averages. ERP for those periods is shown as a simple average.
As of October 31, 2023
Source: Bloomberg and AllianceBernstein (AB)

To equity investors, that sounds worrying. After all, the ERP is likely to be lower in the coming years, as bond yields won’t be suppressed by low inflation, ultralow interest rates and the Federal Reserve’s quantitative easing programs that prevailed from the global financial crisis through the COVID-19 pandemic. From 2009 to 2022, when the ERP was much higher, US stocks returned 13.1% annualized on average. So does that mean the lower ERP is a warning sign for equity investors?

Not necessarily. We’ve experienced periods of lower ERPs in the past, and stocks have done relatively well. For example, from 1983 through 2008, the ERP was also low at 1.0%. Yet during that period, the S&P 500 returned an annualized average of 10.2%. Future conditions may well be different than in the past, and the lower ERP does set the bar higher for equities. Still, history suggests that stocks can still deliver solid returns in higher-bond-yield environments.

Equities Can Help Portfolios Cope with Inflation

Yes, we understand that bond yields of close to 5% these days are an attractive proposition for investors and offer a sense of safety in an unstable world. Yet we believe stocks and bonds both have important roles to play in a diversified investment portfolio today.

In particular, we think stocks offer a good hedge against inflation. Our research suggests that in periods of moderate annual inflation of between 2% and 4% between 1948 and the third quarter of 2023, the S&P 500 returned 2.5% per quarter. That’s a solid real return, which helps protect the purchasing power of portfolios if inflation stays relatively high, as we expect.

Equities can also offer a rising stream of income via increasing dividends. We measure equity income by using the free-cash-flow (FCF) yield, which calculates the excess cash that a business generates after deducting all operating costs. Our research suggests that the FCF yield of US stocks should rise over time, above the Fed’s long-term inflation target of 2%.

This contrasts markedly with a popular investment strategy these days—cash. Interest rates on cash are very attractive now, but they may not be for long if the Fed cuts rates, as many investors expect (Display). If yields do decline, investors who stay too long in cash would miss out on the potential for increasing dividends and the prospect of share-price appreciation along the way.

Equities vs. Cash: Rising Income Potential Trumps Falling Interest Rates

Bar chart shows the annual estimated S&P 500 Free-Cash-Flow Yield vs. the yield on cash from 2023 through 2030.

Past performance does not guarantee future results.
*Assuming investing on July 31, 2023; using consensus free-cash-flow (FCF) forecast for 2023 and 2024, while assuming free cash flow grows at 7% annually afterward. Cash rates use fed funds rate as proxy; 2023 and 2024 fed funds rate forecasts are based on future implied rate, while 2025 and onward are based on Fed dot plot (2025, 2026 and long-run) forecasts.
As of September 30, 2023
Source: Bloomberg, US Federal Reserve and AB

Selectivity Is Crucial When the Hurdles Are Higher

Bonds and stocks can and should coexist in a diversified investment allocation. In fact, if rates continue to fall over time, the ERP would rise, providing another impetus for equity returns.

For now, equity investors must be particularly selective to navigate a low-ERP environment. It’s especially important to identify quality companies with strong balance sheets that benefit from sources of consistent growth potential and cash-flow generation, and with share prices that trade at reasonable valuations. When carefully curated in an active equity portfolio, companies like these can help provide equity investors with both resilience and the ability to deliver return potential in a world of higher macroeconomic and market hurdles.

Grant Banko, Equities Product Manager, contributed to this analysis.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams, and are subject to change over time.

About the Authors

Robert Milano

Robert Milano is a Senior Investment Strategist and Global Co-Head of Equity Business Development. He is responsible for partnering with global sales leadership to set strategic priorities and goals for the AB Equities business, develop new products, and engage with clients to represent the market views and investment strategies of the firm. Previously, Milano served as head of EMEA Equity Business Development, and prior to that held roles as a senior investment strategist supporting AB’s Select US Equity and US Growth Portfolios. He joined the firm in 2013 as a product analyst on our Fixed Income Business Development team, where he supported the firm’s taxable and municipal funds for the US Retail market. Milano holds a BS in finance from Manhattan College. Location: London

Walt Czaicki, CFA

Walt Czaicki serves as a Senior Vice President and Senior Investment Strategist for Equities at AB. He rejoined the firm in 2015 and has been in the investment-management industry since 1986. Czaicki's roles have ranged from a fundamental equity research analyst and portfolio manager to chief investment officer. Prior to rejoining AB, he worked on the buy side for a Regions Financial predecessor organization, as well as at Commerce Trust Company and Bank of America. Czaicki holds a BSBA in finance and an MBA, both from Saint Louis University. He is a CFA charterholder. Location: Dallas

David Wong

David Wong is a Senior Vice President, Senior Investment Strategist and Global Co-Head of Equity Business Development, and Co-Chair of AB’s Responsible Investing Steering Committee in Asia-Pacific. He joined AB in 2015, bringing two decades of experience in global equity markets to the firm. Prior to joining AB, Wong was a partner at Janchor Partners, a Hong Kong–based long/short equity hedge fund with US$2 billion in assets under management (AUM). Before that, he set up the Hong Kong office for GMT Capital, an Atlanta-based long/short equity hedge fund with $5 billion in AUM, where he served as portfolio manager and head of Asian investments. Over Wong’s eight years at the two hedge funds, he was responsible for global investments in technology stocks and served as a generalist portfolio manager for the Asia-Pacific region, including Japan. He was also the founder and managing director of Mobile Adventures, a pan-Asian wireless content company. Wong started his career as an equity research analyst at Bankers Trust and Deutsche Bank; at Deutsche, he managed a team of five associates as the firm’s regional semiconductor analyst. He holds a BA in political science from Yale University. Location: Hong Kong

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Is Equity Risk Worth the Reward in a World of Higher Bond Yields?

Is Today’s Lower ERP a Bad Signal for Stocks?

Equities Can Help Portfolios Cope with Inflation

Selectivity Is Crucial When the Hurdles Are Higher

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