Pricing equity risk amid tariff uncertainty

For multi-asset investors, the balance of risk and returns between equities and bonds is critical. In today’s volatile equity markets, and with bond yields recording multi-year highs, that relationship is being tested. Key to any reassessment should be equity risk premium (ERP), or the additional return that investors can expect for accepting stocks’ volatility over the relative certainties of government bonds. The higher the ERP, the more asset allocators are compensated for equity risk taking.

Historically, this forward-looking, or implied ERP has widened during periods of macroeconomic or policy uncertainty. This is because investors demand greater returns for the higher risk of owning equities. In recent years, the Global Financial Crisis and the Covid pandemic both recorded a spike in ERP. Over the last decade, the expected US ERP has instead fallen as investors were willing to pay higher prices for the growth underpinning the strong performance of American stocks.

In contrast, Europe and emerging markets (EM), recorded a higher ERP, partly due to their lower growth outlooks and profitability. In 2024, US ERP saw a steep fall to a near-historic low as a result of both pricey equities and higher bond yields, before ticking higher this year. Europe’s ERP instead remained consistently higher, mirroring less expensive equities and lower bond yields. The level of ERPs hence implies better equity compensation over bonds in Europe, as compared to the US, where bonds have emerged as alternatives to equities.

With trade tensions foremost in investors’ minds, the US ERP has risen

ERP also serves as a barometer of general confidence. The higher the risk, the more investors seek compensation for it, and vice-versa. With trade tensions foremost in investors’ minds, the US ERP has risen. Trade policy, when deployed as aggressively as today’s US tariffs, reshapes corporate profit expectations, recalibrates equity valuations, and drives changes to interest rates. These factors feed directly into the ERP, and are now doing so differently across regions. Everywhere there is a potential erosion of investor confidence in forward earnings, and subsequently a rise in risk aversion.

At the end of 2018, during the first Trump administration, the ERP surged as equities devalued in response to  sustained monetary policy tightening by the Federal Reserve. It is worth highlighting that US earnings per share (EPS) actually increased 24% in 2018, supported by tax cuts.

Despite improvements, US ERP remains below average

In 2025, despite being well signalled during Mr Trump’s campaign, US tariffs caught financial markets by surprise as far as their levels and breadth were concerned. In contrast to 2018, valuations were more demanding and bond yields higher at the start of 2025. The outlook for the Fed is for continued easing, unlike in 2018, and we expect lower Treasury yields. The implied ERP on the S&P 500 increased from 1.7% to over 2.7% year-to-date. This is a meaningful improvement but remains below the implied US historical average of 4.7%. Some further increase may happen if US Treasury yields fall as expected below 4%.

The spread to other regions has narrowed and earnings reports in the weeks ahead will determine how much additional narrowing can be expected. European equities including German automakers and French luxury brands have both felt the impact of US tariffs. Still, European stocks have shown some resilience in 2025 thanks to a fiscal policy shift promising infrastructure investments and a renewed focus on industrial self-reliance. Switzerland’s ERP remains above the European levels as the country benefits from ultra-low bond yields.

…for multi-asset investors, this risk environment demands careful geographic and asset class diversification

Despite improvements, ERP levels across the board are still below their implied historical averages, and for multi-asset investors, this risk environment demands careful geographic and asset class diversification. In our asset allocation, we hold equity portfolio positions at strategic levels, as we expect policy responses and trade negotiations to support a gradual rebound. Our updated average annual expected returns over the next 10 years are relatively similar across all key regions. For example, for US equities, we now estimate average 10-year annual returns of 7.2%, compared to 7.6% for European equities, or 7% for Japanese equities. Taking their respective volatilities into account, risk-rewards are balanced, except for the UK, which stands out as more positive. In fixed income, we are overweight investment grade corporate and sovereign bonds, and have neutralised our exposures to high-yield bonds.