Honey, the Fed Shrunk the Equity Premium

AQR

Thomas Maloney

Research

18 Pages

AQR Capital Management examines how higher interest rate levels affect equity risk premia and strategic asset allocation. Drawing on nearly a century of data, the article shows that when cash yields are higher, equity and private market excess returns tend to shrink, while bonds and certain liquid alternatives hold up better. It finishes with a case study on rebalancing toward cash plus diversifiers.

Date published: September 5 2023

Source: Global Financial Data, Federal Reserve, Bloomberg and AQR. Results shown are the average across the three rules described previously, and the average across 1-, 12- and 36-month horizons. Cash is U.S. 3-month T-Bill. For U.S. IG Credit, chart A shows excessof-Treasury return and chart B shows credit excess return plus corresponding Treasury return.

Key Takeaways

Equity premium shrinks: Higher cash yields line up with slimmer equity excess returns and less need to lean on stocks.
Mixed asset responses: Private assets behave like equities, while bonds and cash plus liquid alternatives benefit more from higher rates.
Allocation rethought: Higher rate world supports greater diversification away from equities toward income assets and liquid diversifiers.
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