The potential of US equities is being tested by the compression of the risk premium.
As the turbulence stirred up by Donald Trump begins to settle, attention is refocusing on fundamentals. The environment is once again conducive to an academic reading of the risk premium – a gauge of the return equity investors demand over the risk-free rate. Against a backdrop of persistently high interest rates, stretched valuations, and falling earnings growth expectations, one observation clearly stands out: the upside potential of US equities is being challenged by the erosion of the risk premium.
Risk compensation at historic lows
Since the end of the pandemic, the risk premium on the S&P 500 has steadily compressed. Investors are thus willing to pay ever higher prices for American corporate earnings growth, drawn by profits superior to those in other regions. The heavy weighting of the ‘Magnificent 7’, whose earnings are relatively insulated from economic cycles, gives the index better visibility on future results. Neither trade tensions, nor doubts about the sustainability of US debt, nor even geopolitical uncertainty, seem to have harmed this momentum. Yet, a closer look reveals a warning sign: a historically low risk premium amid high interest rates could cast a shadow over the continuation of the S&P 500 rally.
Valuations disconnected from expected earnings trajectory
During this period, the US market’s price-to-earnings (P/E) ratio has steadily risen to 21.5 times earnings. Recently, Donald Trump’s policies have weakened the earnings momentum of US companies while fuelling inflation expectations. The ‘Made in America’ profit engine is showing signs of weakness: earnings growth forecasts fell from 14% in 2024 to 12% at the start of this year, and were revised down further to 9% in May. Our calibration shows that the profit-to-valuation ratio has worsened against the 10-year yield, which reached 4.5% in early June.
Back to a diversified asset allocation
The combination of a shrinking risk premium and falling earnings suggests limited upside for equities, despite investor confidence betting on US economic stability and an upcoming round of monetary easing. For the stock market rally to continue, positive news on one of the determinants of the risk premium – either earnings or interest rates – will be necessary. Conversely, a disappointment on the earnings front could swiftly destabilise the momentum in equities.
Interpreting the market this way has led us back to a diversified asset allocation among income-generating assets capable of absorbing potential shocks. The attractiveness of equities will depend on companies’ ability to generate profits and restore an attractive risk premium.
The opinions expressed herein are correct as at 6 June 2025 and are subject to change without notice. Any forecast, projection or target, where provided, is indicative only and is not guaranteed in any way.
