As early October optimism fades, equities rely on risk premium

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LONDON The dark clouds of a slowing global economy and weak corporate earnings are gathering again over world stock markets, but rock-bottom bond yields leave few attractive alternatives and may sustain investment flows into equities.

After one of the worst quarters for global equities in four years and the lowest year-to-date investment returns since 2008, early October saw a sharp rebound that confounded economists now warning of another global economic recession next year.

That rocket has fizzled as data showing China's economy weakening deals another blow to commodities and emerging markets and the third-quarter earnings season gets off to a poor start, leaving the question of where to invest a tricky one.

But at least some of the factors that have sustained one of the longest equity bull markets since World War Two remain.

Measures of the so-called equity risk premium remain well above historic averages, as they have for most of the post-credit-crash years, and show little sign of shrinking. If anything, they've turned higher over the volatile summer months.

The equity risk premium is the extra return investors can earn from a combination of dividend yields and earnings-driven stock price projections compared with yields on low-risk government bonds.

"Measures of the so-called equity risk premium remain well above historic averages, as they have for most of the post-credit-crash years, and show little sign of shrinking"

According to Goldman Sachs, this fundamental driver will be one of the most important of very few boosters left for stocks over the coming year, during which it sees a roughly 15 percent total return globally.

"At some point low bond yields no longer support equities because they flag a risk to corporate cash flows, questioning to some extent an already very weak recovery," said Christian Mueller-Glissmann of Goldman's portfolio strategy and asset allocation team in London.

"But a high equity risk premium makes equities appealing and indicates that they are still an attractive investment in the longer term, in particular relative to bonds."

Persistently depressed bond yields are often a direct result of weak economic growth, which will also ultimately damage corporate earnings.

There is no uniform formula for calculating ERP and analysts put different weightings on its differing inputs, but there is broad agreement the collapse of global bond yields since the 2008 crisis has altered the picture drastically.

The standard model is dividend yield, plus the long-term growth rate, minus the 10-year bond yield. Goldman's model also takes into account company cash flows deviating from long-term trend due to differing stages of the economic cycle.

The ERP of European shares is currently around 8 percent, among the world's highest and way above a pre-crisis average of 2.7 percent and even the post-crisis average of 7 percent, Mueller-Glissmann said.

That reflects a yield of just 0.55 percent for 10-year German government bonds, with shorter maturities paying less than zero, and bets that yields could fall further if the European Central Bank extends its asset purchases as expected.

FLASHING RED

The Bank of Japan is also seen injecting more stimulus into its faltering economy. Some say ECB and BOJ quantitative easing could continue for years.

Japan's ERP is just under 7 percent, compared with pre- and post-crisis averages of 4.7 and 5.4 percent respectively, according to Goldman.

"The biggest premiums relative to local bonds can now be found in QE-ingesting continental Europe and Japan," Citi's equity strategy team wrote in their quarterly market outlook last week.

The pick up offered by U.S. stocks is smaller, with an ERP of 5.9 percent for Wall Street's S&P 500 -- still well above the pre- and post-crisis averages of 2.9 and 5.6 percent.

That is because bond yields are higher, the Federal Reserve is contemplating raising interest rates, the stock rally is more mature and a strong dollar is eroding corporate profitability.

These are good reasons to be wary, said Nick Lawson, managing director at Deutsche Bank in London, adding that the ERP is only one factor investors should consider when deciding what stocks to buy.

"Indebtedness is higher because of lower interest rates, earnings may still be too high and market liquidity is a worry," he said. "There's a lot of flashing red at the moment."

A higher ERP makes equity financing more expensive and so encourages companies to raise debt, which provides a fillip for stock prices in the short run but has questionable longer-term benefits, analysts say.

U.S.

"The equity risk premium is the extra return investors can earn from a combination of dividend yields and earnings-driven stock price projections compared with yields on low-risk government bonds"blue-chip firms are expected to post earnings growth of barely 1 percent this year, while estimates for their euro zone peers have been cut to 12 percent from a whopping 20 percent seen in early summer.

British blue-chips, which have greater exposure to collapsing commodity and energy prices, are expected to see earnings plunge by 13 percent.

But Citi, which predicts global stock market gains of 20 percent over the coming year, says only three of 16 factors that flashed "sell" at previous major global market peaks are currently in danger territory. ERP levels aren't one of them.

The global average ERP is currently around 5.4 percent, compared with 4.9 percent before the market correction that started in March 2012 and 2.6 percent before the sell-off that began in mid-1998.

The bear markets -- a deep and sustained decline -- in stock prices that unfolded in March 2000 and October 2007, started with EPRs of 1.0 percent and 3.3 percent respectively, Citi said.

(Editing by Catherine Evans and Mike Dolan)