India's equity risk premium has gone up from 2.9 percent in November this year to 3.4 percent in the first week of December
No one would expect to make a 10-12 percent return by buying a lottery ticket for the simple reason that it is a highly risky instrument. A lottery ticket will probably feature at the extreme end of the risk and return curve and thus, will demand a very high return. On a relative basis, equity investors would have lower expectations, but they will still be higher than the expectations harboured by bond investors.
This simple demarcation in expectations of returns keeps on fluctuating based on the perception of risk, including at the country level. Indian and foreign equity investors have started factoring in many such risks like elections next year, interest rates, commodity prices, and fiscal situation, which are now getting reflected in the equity risk premium (excess return expectations).
It is simple that if the money gets dearer the desire to invest in equity is less because the bonds are giving you better yields that in turn suggest a lower PE multiple. Moreover look at the earnings growth of the last five years it does not make sense to give higher multiple at this juncture. This year the earnings outlook is subdued. I do not see a major recovery in earnings in the medium term," said Saurabh Mukherjea, Founder, Marcellus Investment Managers.
Bond vs equity: A risk worth noting
India's equity risk premium has gone up from 2.9 percent in November this year to 3.4 percent in the first week of December. It is perceived that this premium has only gone up after the state election results. The other important data point that investors can gauge the increased risk in is the widening spread between bond yields and the Nifty's earnings yield.
In January 2018, this difference was 2.1 percent (refer to the illustration below). It has now widened to 2.4 percent. The increase in earnings yield compared to bond yields indicates that stocks have become cheaper as investors are looking for higher risk-adjusted returns. Considering the elections next year, particularly in light of the adverse outcome of the state elections recently, investors are weighing risks differently.
Impact on inflow
There is little doubt that the perceived risk has increased as far as the Indian stock market is concerned. Foreign investors would factor in all these risks and add to the overall expectations. India's risk premium benchmarked against the US, calculated by countryeconomy.com, suggests that the risk premium has increased from a low of about 390 points.
When premiums increase, a foreign investor would typically evaluate India along with other markets. With the corresponding increase in risk, his or her expectations would increase in terms of the returns and thus, they would expect stocks to be a lot cheaper so as to generate the additional return expectations, which increase because of the higher perceived risks.
One direct fallout this would be on foreign portfolio allocation to India and by extension, foreign inflows. And this possibly could be one reason FIIs are net sellers in the Indian market right now. After the state elections, FIIs have sold close to Rs 3,700 crore worth of Indian stocks and and Rs 4,469 crore worth of Indian debt securities so far.
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