Recently one of the mostly-followed corporate finance and valuation professor Aswath Damodaran has updated his metrix of the so called Equity Risk Premia (ERP) for countries around the globle. Unlike in recent year, this year the change in ERPs in some countries has been very significant.
This is mostly because of the new phenomena that we’ve experienced YTD including:
– general retreat of risk capital, which impacts a substantial repricing of risk assets not only within one country, but also across geographies
– Russian invasion on Ukraine impacing Counrty Risk Premia (CRP) for many other countries in the region.
To the details now…what impacts CRP? there’s 4 major drivers:
1. political structure (more/better democracy = lower CRP )
2. corruption (higher corruption = higher CRP)
3. war/violence (more exposure to war = higher CRP)
4. legal&property rights (better rights = lower CRP).
CRP is naturally a part of the ERP for a certain country, as a country you live/invest in (impacted by all the points 1-4 above to its own specific extent) naturally and to much extent determines the risk on equities you own in that country. Very simplistically an ERP for country A will equal the ERP for the most safe country (usually US is taken as a benchmark, also for the fact that it has such a big equity market, also called Mature Market Premium) + additional Premium impacted by the CRP.
Damodaran has a very specific procedure for setting ERPs, based on on country-specific spreads on sovereign bonds or covereign CDS spreads or ratings tables (presented in the video on slide 13). In general the ERPs have risen quite significantly all around the globe over the recent 12 months. As you can clearly see in the video the countries, which saw the biggest rise in ERPs are those that are most exposed to the Rus-Ukr conflict both politically as well as geographically. Here’s the list of those countries (also in the video slide 15): Russia, Ukraine, Belarus, followed by some African countries.
The US market ERP is 6.01% now (benchmark worldwide).
Now to finish off, please pay attention to slide 20, which clearly shows just by how much the Cost of Capital (risk free rate plus ERP for equity financing and risk free+CDS spreads*(1-corporate tax) for debt financing) for companies around the world has risen over the last 6 months. As you can see for US companies only the CoC (a mix of equity and debt cost or the WACC) went to 8.97% from 5.77%, for global companies to 9.7% form 6.37% – this is a MASSIVE change and it to much extent explains why equities have sharply fallen by 20-30% on average across the world.
The next big move in equities will be driven not by the higher CoC, causing discounted future cash flows being worth less then before (and hence driving prices of equities lower), but by the forecasted EPS of companies. If we get a recession, the consensus analyst expectations will take their forward EPSs lower from here, automatically causing rising PEs again, and hence driving equities yet lower, so that PEs (on a forward basis) can adjust lower again. But if this time around the Fed does manage a soft landing for the economy, we’re possibly in a sweet spot to be buying equities now. The big unknown is whether the economy is strong enough to withstand the turbulences. Meanwhile positioning should remain cautious in an investors portfolio, until we get more clarity on inflation tendencies. My portfolio remains underweight equities (40-50% allocation) and well skewed toward Value stocks, which are much less impacted by the recent changes in ERPs.
Yours, GlobalAlphaS
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