US stock risk premium hits lowest level since 2002; JPMorgan Chase: Rising interest rates will have a more painful impact than in the past two decades.

US stock risk premium hits lowest level since 2002; JPMorgan Chase: Rising interest rates will have a more painful impact than in the past two decades.

The excess return of stocks relative to bonds has shrunk to a historic low, and the buffer that protects US stocks from interest rate shocks has been almost completely exhausted.

According to a recent research report by JPMorgan Chase, the S&P 500 Equity Risk Premium (ERP) has fallen to approximately 2.1%, not only more than 100 basis points lower than the historical average but also the lowest level since 2002. This trend is particularly noteworthy against the backdrop of a recent sustained rise in real bond yields. JPMorgan Chase's global market strategy team has thus warned that in an era of low risk premiums, the stock market's sensitivity to interest rate changes will increase significantly, and the impact may exceed investors' general expectations over the past two decades.

Analysts point to a three-pronged effect: First, the stock market's sensitivity to bond yields will systematically increase; second, long-term investors will have a stronger incentive to rebalance their assets from stocks to bonds; and third, the positive correlation between stocks and bonds that has existed since the 2022 inflation shock will be further strengthened. For risk parity strategies that rely on bond duration to hedge stock risk, these changes constitute a persistent headwind.

The risk premium fell to 2.1%, a new low since 2002.

JPMorgan Chase uses the Dividend Discount Model (DDM) framework, which substitutes the current price of the S&P 500 index into the discounted cash flow equation, reverses the equity discount rate, and then calculates the difference between the discounted cash flow rate and the real yield of 10-year U.S. Treasury bonds to obtain an estimate of the equity risk premium.

Strategist Nikolaos Panigirtzoglou and his team estimate that the S&P 500 equity risk premium is currently around 2.1%, about 100 basis points below the historical average. This indicator has fallen below the cyclical low of 2.4% in the third quarter of 2007; the subsequent sustained rise in the stock market, coupled with further increases in real bond yields, has pushed the risk premium down even further.

Historical data shows that between 1974 and 1998, equity risk premiums were also low, a period encompassing high inflation and the subsequent decline in inflation. JPMorgan Chase points out that during that time, stock returns were significantly more sensitive to bond yields, sometimes moving almost in tandem. The current risk premium has fallen back to a comparable range, meaning a similar linkage mechanism may repeat itself.

Pressure to rebalance stocks and bonds has increased, with investors overweighting stocks to their highest level since 2002.

The narrowing risk premium has a second implication regarding asset allocation. JPMorgan Chase's calculations of the implied allocations of global non-bank investors show that the current overweighting of equities relative to bonds is the highest since 2002; separate statistics on G4 pension and insurance companies (covering the US, UK, Eurozone, and Japan) also reach the same conclusion.

The report points out that the current low-risk premium situation could theoretically continue—if AI-related productivity gains can continue to drive profit growth, the low premium level has fundamental support. However, if real interest rates rise further from current levels, the narrowing gap between expected returns on stocks and bonds will provide multi-asset investors with an incentive to increase their bond holdings, and the scale of rebalancing flows from stocks to bonds may exceed recent levels.

The positive correlation between stocks and bonds is strengthening, putting pressure on risk parity strategies.

JPMorgan Chase points to the third implication of narrowing risk premiums as the correlation between stocks and bonds.

Following the inflation shock of 2022, the correlation between daily yields on global stocks and bonds has turned positive. The bank believes that the current low-risk premium environment will further solidify this positive correlation through two pathways: first, the valuation channel—the stock market is more sensitive to bond yields; second, the macroeconomic mechanism channel—if inflation volatility remains relatively high, the probability of stocks and bonds moving in the same direction will remain high.

These changes pose a systemic challenge to risk parity trades, which rely on bond duration as a hedge against equity risk. The positive correlation between stocks and bonds weakens this hedging effect. JPMorgan Chase anticipates that demand from multi-asset investors for direct hedging tools such as stock options will likely increase accordingly.

Rising real interest rates: Optimistic growth or term premium?

The recent rise in real bond yields has sparked discussions about its driving factors. JPMorgan Chase believes that this upward trend cannot be simply attributed to a single factor.

The bank used the Federal Reserve's D'Amico, Kim, and Wei (DKW) model to decompose the 10-year real Treasury yield. Data shows that the sharp repricing of real interest rates in 2022 was mainly driven by expectations of real short-term interest rates, consistent with a significant tightening of monetary policy. Since late February of this year, the rise in real yields has been roughly evenly distributed between expected real short-term interest rates and the term premium.

JPMorgan Chase points out that this breakdown is consistent with a slight upward revision of market expectations for long-term potential growth rates, which may be driven by growth optimism stemming from the AI investment cycle. Meanwhile, persistently high fiscal deficits and the continued quantitative tightening (QT) by other developed market central banks are also significant contributing factors. Data from Consensus Economics shows that long-term real growth expectations have begun to improve since the end of 2023, but compared to the downward trend from the 2008 financial crisis to the COVID-19 pandemic, the current rise in real interest rates is still significantly greater than the improvement in growth expectations.

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