Barclays Global Investors Canada Ltd. today announced new research in support of long-term equity investing. This research estimates a Canadian equity risk premium of approximately 3.5% over the next 10 years.
The ERP is the extra return investors can earn from taking on the higher risk of investing in stocks versus 10-year Government of Canada bonds. BGI is currently projecting an ERP for the United States market that is also in the 3.5% range. Although the estimates for both countries are considerably less than the 5.4% ERP that prevailed in the U.S. from 1926 to 2001, they are in keeping with the prevailing mood of lowered expectations for stock market returns.
“We have carefully considered all sources of the equity risk premium, and found support for a middle ground between ‘irrational exuberance’ and excessive pessimism. We believe equity markets will reward investors for risk with reasonable returns,” explained Rajiv Silgardo, chief investment officer of BGI Canada, in a news release. “While this is good news for equity investors, this expectation is still lower than the historical experience in the US.”
According to BGI Canada, the Canadian equity risk premium has averaged 3.3% over the past 75 years-and only 2% in the last half of the century. However, BGI research has identified some structural changes in the Canadian capital markets and economy that support a higher ERP going forward. The changes an equity benchmark that has a lower weighting in commodities and more exposure to growth than in the past. On the economic front, a sharp decline in inflation expectations and an overall increase in fiscal prudence has led to an outlook for interest rates that is much lower than the average level during the last three decades.
BGI’s study is based on several key assumptions. Over the next 10 years:
- Inflation is targeted to remain in the 2%-3% range
- The dividend yield will average close to 2%
- Canadian corporate earnings will grow at a 3.5% real rate, and
- Canadian real economic growth will average 3% a year.