Via Damien Boey at Credit Suisse:
Most of the headlines are still about the coronavirus, and its potentially severe impact on economic growth. But the underlying signal to monitor is volatility. We are witnessing a surge in equity market implied volatility, which could have some non-linear, and negative consequences in the short term.
2020 was always going to be about a widening spread between equity risk premium and risk free rate. No matter what one thinks about near-term cyclical growth prospects, material movements in discount rate components will always overwhelm changes to short term cashflow assumptions in any discounted cashflow valuation model. More specifically, a rise in the equity risk premium relative to the risk free rate disproportionally benefits defensives over cyclicals, because of lower beta. We proxy the change in the equity risk premium using the change in market implied volatility, and the change in the risk free rate using the percentage change in bond yields.
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