August 14, 2023
Given the good economic news, should investors take on more risks ?
The likelihood of a recession increases as the job market deteriorates
ecent market developments have created a very special situation :
... the expected return on equities is no longer higher than on bonds

CHART OF THE WEEK: "The risk premium has fallen to zero"

Dear regular readers, please note that our next analysis will be published on 28 August.


In the first half of 2023, global economic activity rebounded slightly, the job market remained buoyant, and the rate of inflation fell sharply (see Fig. 2). This reassuring news has encouraged consumers and investors to become more optimistic (see Fig. 3), driving up bond yields and stock market indices. The latter are now approaching the all-time highs they reached in 2021. Are the conclusions of our econometric models too pessimistic? Are investors right to take risks?

Fig. 2 - Activity and inflation in the United States

Activity and inflation in the United States

Fig. 3 - Household confidence and equity allocation

Household confidence and equity allocation

On the economic front, the like lihood of a recession has not diminished. Around the world, leading indicators, and in particular purchasing managers' confidence, are showing a worsening outlook (see Figs.4 & 5). After a false start (W-shaped scenario) due to the strength of the services sector, companies are anticipating a contraction in activity by the end of this year.

Fig. 4 - Business confidence in the United States

Business confidence in the United States

Fig. 5 - Business confidence in the United States

Business confidence in the United States

The employment market, which seems to be resisting this deceleration, is a poor source of advice. Asalways, it is a lagging indicator of the economic cycle. For the record, it is only once demand has slowed,companies have stockpiled, and then stopped investing... that they lay people off. Looking at the details,the labour market is already starting to show signs of weakness. In the US, for example, jobless claims arerising, and their level is consistent with an unemployment rate of 4.2% in six months' time, compared with3.5% today (see Fig. 6). Using the housing market as a leading indicator, jobseekers could end uprepresenting 6% to 7% of the labour force within two years (see Fig. 7). Recent jobs figures should not therefore be seen as reassuring, nor should it be used to justify the recent bull market. They are the finalfireworks that marked the end of the previous cycle and which will be followed by complete silence.

Fig. 6 & 7 - Unemployment rate vs. jobless claims & new houses inventory in the US

Unemployment rate vs. jobless claims & new houses inventory in the US

Investors are not all optimistic about the economic cycle. Their perception is very different on the two main financial markets, equities and bonds. Basically, when economic activity picks up, earnings grow.The share prices of these companies will therefore rise, often with a time lag as valuations improve. At the same time, central banks will seek to control inflationary pressures by raising their key interest rates. As long yields rise in anticipation, the yield curve will steepen. Using these cause-and-effect relationships, it is possible to link economic activity to the rise in equities (see Fig. 8) and to the spread in bond yields (see Fig. 9).

Fig. 8 & 9 - Economic cycle vs. financial markets

Economic cycle vs. financial markets

Since 1er January, the global equity market has delivered between +4% for UK stocks and +32% for theNasdaq. Over the same period, the bond market has fluctuated between -3% for 7-10 year Gilts and +7%for US high yield corporate bonds. Thus, stock markets are currently expecting the US economy to grow by +4% over the next 12 months (cf. Fig. 8). In contrast, the bond markets are expecting US GDP to contract by -1.5% over the same period (cf. Fig. 9). The difference is all the more striking given that it was non-existent last year (see Fig. 10).

Fig. 10 - Performance of equities vs. bonds

Performance of equities vs. bonds

Fig. 11 - Expected return on equities vs. bonds

Expected return on equities vs. bonds

The ongoing slowdown in the global economy, the rise in central bank interest rates, and the recent outperformance of equities have created a unique opportunity for fixed income assets. The expected return on bonds is no longer lower than that on equities. This means that investors are no longer remunerated for the additional risk they take in holding equities. Some would say, cavalierly, that bounty hunters have become volunteers. This has not happened since the dot com bubble burst at the start of the millennium(see Chart of the Week).

Conclusion :

Traditionally, when the equity risk premium has fallen to zero, investors have corrected this market discrepancy over the following 12 to 24 months. To do this, fixed-income assets outperformed risky assets.If this relationship holds again, bonds could generate a relative performance of +35% compared with equities in 2024 (see Fig. 11). Investors will gradually seek to take advantage of this by increasing their allocation to bonds and getting more duration.


Financial Research