Exploring a broad viewpoint: is it possible for bonds and stocks to both be correct?
Discrepancy in Risk Premia Between Fixed Income and Equity Markets
Since April Fools' Day 2021, a notable discrepancy has emerged between the risk premia of fixed income and equity markets. This discrepancy can be attributed to several key factors, including differing market volatilities, macroeconomic conditions, and investor behavior during periods of uncertainty.
Volatility Differences and Market Dynamics
Fixed income markets and equity markets have fundamentally different risk profiles influenced by economic cycles. Fixed income securities typically have lower volatility but are subject to interest rate risks and credit risks. Equity markets tend to have higher volatility and risk premium due to growth expectations and higher sensitivity to economic conditions. Since April 2021, increasing volatility—amplified by rapid information dissemination and interconnected global economies—has affected these markets unevenly, contributing to diverging risk premia.
Monetary and Fiscal Policy Responses
Post-pandemic economic policy responses have varied across regions and asset classes. For example, the shift in fiscal policies such as stimulus packages in China (early 2025) and increased U.S. inflation concerns have influenced fixed income yields and equity valuations differently. Fixed income investors have had to price in changing interest rate environments and inflation expectations, which can widen risk premia when compared to equities, which may react more to long-term growth prospects.
Market Structure and Fund Management
Closed-end funds, which often invest in fixed income, have different liquidity features and leverage practices compared to open-end equity funds, impacting the perception and realization of risk premia over time. Fund flows and manager behavior, especially in volatile or uncertain markets, can amplify differences in returns and volatility patterns between these asset classes.
Risk Premia Forecasting Variation
Forecasts for equity risk premia have fluctuated over recent years reflecting changes in economic outlook, investor risk appetite, and alternative investments’ attractiveness. Since 2021, such shifts have likely contributed to a disparity in the risk premia estimates and realized returns for fixed income versus equities.
In the ongoing earnings season, earnings have handsomely beaten expectations in many parts of the world, with US Q2 EPS growth tracking at 9% year-on-year and European earnings at 4% representing an 8% beat. Despite this positive performance, the equity risk premia across major regions, excluding Japanese equities, are at or below the lowest 20th percentile of history, with the US being the most extreme.
For the 6-18 month investment horizon in active multi-asset client portfolios, a targeted approach has been taken to capture both robust earnings and attractive fixed income yields. In fixed income, long duration has been expressed via the belly of US TIPS, US investment grade credit bonds, and emerging market local bonds. In contrast to the past, equity premia have also been grinding lower this time, not higher, and are tightening from historically rich levels as optimism around future earnings has grown.
The most recent break, since April Fools' Day, is unusual because higher fixed income premia are not being driven by credit spreads but by government bond yields, both real and nominal. The inversion of the US sovereign curve continues to show traces of 'macro scepticism', with 42% of the US sovereign curve remaining inverted, although this is below the 70-80% typically associated with recession since the 1960s.
Being short the US dollar, and long gold, remain core positions in multi-asset portfolios. Attractive carry, potential rate cuts by the Federal Reserve, and solid credit fundamentals support both US and EM duration, particularly intermediate durations with inflation protection in the US.
In summary, the main drivers of the discrepancy are the differential impact of volatility and market dynamics on each asset class, policy-driven economic changes affecting fixed income and equity investments differently, and structural differences in fund management that influence risk and return characteristics. This discrepancy has been supported recently by factors such as weak US labor data, stickier inflation, tariff fears, and remarkably strong earnings for equities.
- The diverging risk premia between fixed income and equity markets can be attributed to differences in market volatilities and economic cycles, monetary and fiscal policy responses, and structural differences in fund management.
- For the 6-18 month investment horizon, a targeted approach in active multi-asset portfolios captures both robust earnings and attractive fixed income yields, with fixed income expressed via long duration bonds and equities exhibiting grinding lower premia, tightening from historically rich levels.
