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December 21, 2012 at 07:00 PM
Despite tough conditions, equity markets squeezed out decent gains in 2012. As we move into 2013, what can investors expect? The global economy faces significant challenges but we are positive on the outlook. Investors must, however, position themselves for a new kind of investment environment.
Markets Still Pricing in Bad News
The equity risk premium (ERP)—or the spread between the expected return on stocks over the risk-free rate—is close to multi-decade highs (see Figure 1, left). The ERP has eased back in recent months as the eurozone sovereign debt crisis calmed, but it remains abnormally high. This suggests high risk-aversion, resulting in extreme valuations that should provide opportunities for long-term equity investors.
We advise caution when interpreting the risk premium: An elevated ERP only tells us that either equities are cheap or bonds are expensive. Still, the ERP is a useful indicator of relative valuation over time. Today, it tells us that equities are extremely cheap versus bonds.
Low interest rates have pushed the price of many government bonds to a point where returns to maturity are no longer attractive. The open-ended nature of the current round of central bank action will also support equities as investors will have to accept the current low level of yields as the new norm. Despite last year’s equity rises, markets are still pricing in substantial bad news. So while 2013 has challenges, small positive macro developments should translate into decent equity gains.
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