Investing.com -- A key indicator of the attractiveness of stocks compared to bonds may be about to inflect, according to analysts at UBS.
The equity risk premium (ERP) attempts to measure the excess returns investors demand from stocks over risk-free government bonds. According to the UBS analysts, the gauge has "strong predictive power for equity performance."
The analysts noted that ERP has been falling in recent years, touching the 15th percentile of a 100-year distribution -- meaning equities have been that expensive relative to bonds only 15% of the time over the past century. The latest ERP mark has historically translated to a mere 1.32% average 12-month additional reward from the S&P 500 over the benchmark 10-year Treasury yield, according to the analysts.
The move lower, which was also seen over much of last year, signals that investors have less incentive to plug their capital into riskier investments because typically safer assets are offering similar rewards.
But in a note to clients, the UBS strategists led by Nicolas Le Roux argued that the ERP could be due to climb higher ahead of an "era of deglobalization, limited policy room and higher geopolitical risks" that could lead to more "macro[economic] volatility."
Still, data compiled by UBS shows that the ERP of the S&P 500 has been narrowing over the last few years and currently sits at a level last seen almost two decades ago.
"This points to mediocre equity returns lying ahead," the UBS analysts said.
The analysts flagged that identifying the main drivers of ERP is "one of the toughest questions in modern finance," but they identified five possible catalysts: cyclicality, variance of economic data, a lack of profit sharing, quantitative easing programs by central banks, and leverage.