CICC: Why is the risk premium of US stocks so low?

Since the advent of ChatGPT at the end of 2022, leading the AI wave, the U.S. stock market has consistently outperformed in the global market and has repeatedly reached new highs. This is supported by a positive feedback mechanism strengthened by three major "macro pillars" (i.e., AI technology, fiscal expansion, and global capital rebalancing). Even though the U.S. has faced challenges in the first quarter of this year, including technology (DeepSeek at the end of January), fiscal (DOGE layoffs and spending cuts in February while Europe increased fiscal efforts), and global capital reallocation (the impact on confidence in dollar assets as safe assets after reciprocal tariffs), leading to a temporary "triple kill" of stocks, bonds, and currencies and capital outflows, the U.S. stock market quickly recovered lost ground and continuously set historical highs.

Chart: The three macro pillars of U.S. fiscal policy, AI, and capital rebalancing have been impacted since the beginning of the year, with a low point at the end of April.

Recent performance of the U.S. stock market and the dollar also confirms our viewpoint, which does not fully endorse the overly crowded and long-term grand narrative of "de-dollarization," but rather suggests that the dollar may strengthen slightly, and the U.S. stock market may outperform again. Accompanied by the rebound of the U.S. stock market and continuous new highs, the equity risk premium (ERP, which measures the risk compensation required by investors for investing in stocks relative to risk-free assets) has also reached new lows, even falling into negative territory, especially since May 2023, when the risk premium for Nasdaq has remained negative, only briefly turning positive in early September last year and after reciprocal tariffs.

Chart: The U.S. stock market's risk premium has continued to decline and even turned negative after 2022, especially for Nasdaq.

One question that has troubled investors in recent years is why the risk premium of the U.S. stock market can be so low, even negative? To put it simply, why can investors rush to buy U.S. stocks without requiring any risk compensation? After all, the last time the U.S. stock market had such a low risk premium was before the tech bubble burst in 2000, when the S&P risk premium turned negative from the end of 1998 and continued until the tech bubble burst in 2001. Based on this, there have been constant pessimistic views in the market over the past year or two suggesting that the U.S. stock market will face bubble and pullback risks, but all attempts to short the U.S. stock market have ended in failure.

This article aims to explore whether there are other factors behind this phenomenon that explain this seemingly "abnormal" situation. By identifying the underlying causes, we can find the key that supports the "exceptionalism" of the U.S. stock market, thus answering the core of the U.S. stock market's performance and its subsequent evolution.

1. What is risk premium? The additional risk compensation required by investors, with the U.S. stock market continuously negative and significantly lower than other markets.

The so-called equity risk premium refers to the additional compensation that investors require when investing in equity assets compared to the risk-free rate. The risk-free return plus the risk premium equals the expected return for investors, and its reciprocal is the valuation that investors are willing to assign to stocks. Therefore, the calculation of the risk premium is the reciprocal of the P/E ratio minus the risk-free rate (usually represented by the nominal yield of 10-year government bonds) If we use this conventional calculation method, the current risk premium of the US stock market is far lower than that of other major markets in the world. The risk premiums for the S&P 500 and Nasdaq are 0.36% and -0.6%, respectively, while the risk premiums for other major global markets, such as the European Stoxx 600 and Nikkei 225, are 4.0% and 3.6%, respectively. The risk premiums for the CSI 300 and Hang Seng Index reach 5.6% and 5.9%, respectively.

Chart: The current risk premium of the US stock market is far lower than that of other major global markets

We note that the significant decline in the US stock market's risk premium began after the Federal Reserve's rapid interest rate hikes in 2022. In March 2022, the Federal Reserve started raising interest rates to combat high inflation (the US CPI rose sharply from 1.7% in January 2021 to a peak of 9.1% in May 2022). Over the following 16 months (with the last rate hike in July 2023), a total of 525 basis points were added, corresponding to the 10-year US Treasury yield rising from 2.1% before the rate hikes in March 2022 to nearly 5.0% in October 2023. On the surface, the most direct reason for the decline in the risk premium is the rapid increase in interest rates. Although valuations have also risen (during the same period, the S&P 12-month forward P/E expanded from 19.0x before the rate hikes in March 2022 to the current 21.8x), the decline in the risk premium is primarily attributed to the increase in interest rates (which contributed 72%). If we assume that the 10-year US Treasury yield remains unchanged at 2.1% before the rate hikes, then relying solely on valuation increases would only reduce the risk premium from 3.2% in March 2022 to 2.4%, which is still much higher than the current 0.36%. In other words, the performance and valuation of the US stock market over the past few years have essentially "ignored" the significant rise in the risk-free rate.

Chart: After the Federal Reserve began raising interest rates in March 2022, US Treasury yields rose rapidly, corresponding to a quick decline in the risk premium of the US stock market

II. Is the risk premium inherently miscalculated? The seemingly low figure may not be so low, and the issue mainly lies with the risk-free rate

Many investors question how the risk premium of the US stock market can be so low. However, before questioning the reasonableness of the risk premium itself, should we take a step back and consider whether the risk premium calculated using this conventional method was flawed from the beginning?

It is indeed possible, and the issue lies with the use of the risk-free rate. Typically, we use the nominal yield of the 10-year US Treasury to represent the risk-free return in the US, which is generally acceptable under normal circumstances. However, two new changes have emerged in the US in recent years: first, the significant rise in inflation post-pandemic has led to a clear divergence between nominal rates and real rates, while the natural rate of return (the neutral rate r*, the equilibrium level of real rates, which can be approximated as the overall return rate of the economy) has risen, meaning that the relative rate (defined as real rate - natural rate) has not widened. This can be understood as costs rising, but returns have also increased accordingly; Secondly, under the AI market, a large influx of global funds into U.S. stocks has made them the preferred choice in a global "asset shortage" environment. In light of these two changes, we propose the following two reflections and improvements regarding the risk premium of U.S. stocks when considering the risk-free interest rate.

► First, should we directly use the nominal interest rate? The risk-free return measures the cost of risk-free capital. Normally, using the nominal yield of 10-year government bonds is reasonable, as the trends of nominal interest rates and real interest rates (adjusted for inflation) generally align when growth and inflation are stable. However, this situation has undergone systematic changes post-pandemic. Due to high inflation in the U.S. after the pandemic, nominal interest rates are high, but real interest rates are not. Furthermore, even if real interest rates are high, the natural rate of return is also rising, which means the gap has not widened significantly.

We found that the trends of nominal interest rates, real interest rates, and relative interest rates (real interest rate - natural interest rate) were generally consistent during the stable inflation period from 2000 to 2020, but began to diverge significantly after inflation surged in 2021. Nominal interest rates rose sharply from 1% at the beginning of 2021 to a peak of 5% in October 2023, while real interest rates remained negative until May 2022. Subsequently, due to a decline in inflation (CPI fell from a peak of 9.1% in May 2022 to a low of 3.0% in May 2023), real interest rates rose again to the current 1.7%, indicating that the actual cost is not that high. Meanwhile, post-pandemic fiscal stimulus and the new trend of AI have also raised the natural rate (the Richmond Fed's LM model estimates the natural rate increased from 1.0% in Q1 2020 to a peak of 2.2% in Q1 2024). The gap between real interest rates and natural rates has not widened significantly, compared to the nominal interest rate which has widened by 320 basis points from 1% at the beginning of 2021 to the current 4.2%. During the same period, the increase in relative interest rates was only 205 basis points (from -2.09% at the beginning of 2021 to the current -0.04%).

Chart: After the significant rise in inflation in 2021, the trends of U.S. nominal interest rates, real interest rates, and relative interest rates began to diverge.

When the trends of the three diverge, relative interest rates, rather than nominal interest rates themselves, can better reflect the relative "opportunity cost" in the real economy, thereby affecting valuation pricing. Historical experience shows that the negative correlation between U.S. stock valuations and relative interest rates is more pronounced.

Chart: The 12-month dynamic P/E of the S&P 500 shows a positive correlation with nominal interest rates.

Chart: The 12-month dynamic P/E of the S&P 500 shows a negative correlation with real interest rates, but the correlation is very low

Chart: The 12-month dynamic P/E of the S&P 500 shows a negative correlation with relative interest rates (LM model), and the correlation is higher than with actual interest rates.

From this perspective, we find that the S&P risk premium measured by relative interest rates (under the LM model) is 4.6% (with a mean of 6.2% since 1997), which is still significantly higher than the 1.5% during the 2000 internet bubble. Therefore, the seemingly "high" interest rates (nominal rates) are not as high (actual rates vs. relative rates), and the seemingly "low" risk premium (calculated using nominal rates) is also not as low (calculated using relative rates).

Chart: The current S&P risk premium measured by relative interest rates (under the LM model) is 4.6%, still a considerable distance from the low point of 1.5% during the 2000 information technology revolution.

► Second, should we only use U.S. interest rates? This question seems puzzling at first; if U.S. stock valuations do not use U.S. interest rates, what other market rates should be used? In fact, it should be so. The equity risk premium is the risk compensation that investors require for investing in stocks, and the financing costs and risk-free returns faced by investors in different regions vary. Normally, this difference is not significant, but since 2021, the gap in risk-free rates among major global economies has widened significantly. For example, the U.S.-China interest rate spread has increased from around 0% at the beginning of 2022 to 3.1% at the beginning of 2025, widening by 310 basis points.

Chart: The gap in 10-year government bond yield spreads between the U.S. and other major countries has widened since 2022.

Considering the global "asset shortage" in recent years, with a general lack of attractive investment opportunities, a large amount of global capital has flowed into U.S. stocks. According to the Federal Reserve's data (as of the first quarter of 2025), the scale of U.S. stocks held by overseas investors has increased by $5.2 trillion since the end of 2022. According to the U.S. Treasury TIC data (as of May 2025), this scale has reached $6.6 trillion, contributing 39.1% of the increase in U.S. stock market value during this period. Meanwhile, the proportion of U.S. stocks held by overseas investors relative to the total market value of U.S. stocks [1] has risen from 27.4% at the end of 2022 to 32.1% (as of May 2025). Considering that different overseas investors face different risk-free returns when investing in U.S. stocks, we believe that the risk premium should be calculated based on a weighted rate of the incremental structure of investors rather than simply using the nominal rate of U.S. Treasury bonds, just as mainland investors' required risk compensation for investing in the Hong Kong market should consider the weighted average of risk-free rates in both China and the U.S Among overseas investors in the US stock market, Europe accounts for the largest share (49%), followed by Canada (10%) and Japan (6%). Since the end of 2022, Europe and Canada have collectively increased their holdings in US stocks by USD 4.1 trillion, contributing 62% to the increase in US stock holdings by overseas investors. Based on the contribution ratio of the increase in overseas investors' holdings since the end of 2022, we estimate the weighted risk-free rate to be 3.7%, lower than the 4.2% yield on US 10-year Treasury bonds. The equity risk premium for the S&P calculated from this is 0.9%, higher than the 0.36% calculated using only the US Treasury yield.

Chart: Europe accounts for 49% of overseas investors in US stocks, followed by Canada (10%) and Japan (6%)

Chart: Since the end of 2022, Europe and Canada have collectively increased their holdings in US stocks by USD 4.1 trillion, contributing 62% to the increase in US stock holdings by overseas investors

Chart: The current weighted risk-free rate in the US is 3.7%, lower than the 4.2% yield on US 10-year Treasury bonds

Chart: The S&P risk premium calculated using the investor-weighted rate is 0.9%, higher than the 0.36% calculated using the nominal rate

In summary, if we consider the relative interest rate levels of costs and returns, or the weighted risk-free rate of overseas investors' incremental contributions, the risk premium of US stocks is not as low as it seems.

Therefore, as long as the growth and industrial trends in the US remain valid (corresponding to an upward natural interest rate), and the relative advantages of US stocks continue amidst a global "asset shortage," lacking alternative assets to US stocks, the low risk premium of US stocks can still persist. This is also why the emergence of DeepSeek at the beginning of the year, European fiscal expansion, and the impact of tariffs on the safety of dollar assets have significantly impacted US stocks, raising doubts about the "irreplaceability" of US stocks.

III. Structural differentiation within US stocks: Driven by AI trends and leading stocks, structural differentiation is evident; leading stocks contribute most of the downward risk premium

In addition to the macro factors analyzed above, the low risk premium of US stocks is also influenced by significant internal structural differences, primarily driven by AI trends and leading technology stocks. Since the end of 2022, the "Seven Sisters" of US stocks have risen by 174%, far exceeding the overall increase of 62% in the S&P. From a valuation perspective, the 12-month forward P/E of the "Seven Sisters" has risen from 22.9 at the end of 2022 to the current 30.6, an expansion of 33.6%, while the valuation of the S&P excluding the "Seven Sisters" has only expanded by 22%. If we break down the S&P 500 into the 20 stocks with the largest increases since the end of 2022 (mostly leading technology stocks) and the remaining 480 stocks, It can be found that this "structural market" is more extreme.

► From the performance perspective, since the end of 2022, the top 20 stocks in the S&P have risen by 620%, while the remaining 480 stocks have only risen by 41%. The recent market recovery has also mainly benefited from the contribution of these top 20 stocks, which have risen by 68% since the market bottom in late April, far exceeding the 19% rise of the remaining 480 stocks.

Chart: Since the end of 2022, the top 20 stocks in the S&P have risen by 620%, while the remaining 480 stocks have only risen by 41%

► From the perspective of risk premium, the risk premium of the top 20 stocks since the end of 2022 (currently -0.8%, calculated based on the weighted interest rate of overseas investor structure, the same below) is significantly lower than that of the other 480 stocks (1.2%) and the overall level of the S&P 500 (0.9%). After adjusting for equivalent tariffs, the risk premium of these 20 stocks compared to the S&P 500 continues to widen (the difference from the S&P risk premium has expanded from the April 3 peak of -0.8% to the current -1.6%), while the risk premium of the remaining 480 stocks relative to the S&P 500 has significantly increased (the difference from the S&P risk premium has risen from the April 3 low of 0.1% to the current 0.3%), proving that the recent recovery of the risk premium in the U.S. stock market mainly comes from the contribution of these 20 stocks.

Chart: Since the end of 2022, the risk premium of the top 20 stocks is significantly lower than that of the other 480 stocks

Chart: After adjusting for equivalent tariffs, the risk premium of the top 20 stocks since the end of 2022 continues to decline relative to the S&P 500, while the remaining 480 stocks are on the rise

It can be seen that the leading individual stocks in the U.S. market have contributed to most of the decline in risk premium and the rise in the index. In other words, as long as the advantages of the leading individual stocks in the U.S. market, especially the AI leaders, can be sustained, even without the "support" of other sectors, the U.S. market still has the "capital" of low-risk premium. The main driver of the new highs in the U.S. stock market since April also comes from this.

Chart: In the first quarter of 2025, accelerated investment in AI-related fields, with the year-on-year growth rate of information technology equipment rising to 21%

Chart: Corporate financial reports also show accelerated growth in capital expenditures, with the year-on-year growth rate of technology leaders maintaining above 60%

Four, what should a reasonable risk premium be? Under baseline conditions, the risk premium still has slight room for decline, corresponding to the S&P 500 level of 6200~6400 So, how do we determine a reasonable level of risk premium? As analyzed above, the core reason for the low risk premium in the U.S. stock market lies in the rising actual returns, as well as the investor enthusiasm for U.S. stocks under the AI market structure and the global "asset shortage." Below, we will analyze the reasonable risk premium and valuation level of the S&P 500 from these two perspectives:

► Method One (Adjusted for Relative Interest Rates): In the baseline scenario, the Federal Reserve is still expected to cut interest rates this year (《》), coupled with the implementation of the "Great Beauty" Act, which will gradually restore the already strong U.S. credit cycle. The risk premium still has slight room for decline. If the S&P risk premium calculated under the relative interest rate (LM model) slightly declines from the current 4.6% to the average before the announcement of this year's equivalent tariffs (4.4%) and the average after the "512 tariff downgrade" (4.5%), considering the impact of tariffs and fiscal policies on profits, the corresponding S&P 500 level would be between 6200 and 6400. In an optimistic scenario, if the S&P risk premium calculated under the relative interest rate (LM model) declines to the low point of 4.2% at the beginning of the year, it could push the S&P 500 to around 6700.

► Method Two (Calculated by Adjusting for Investor-Weighted Interest Rates and Measuring Structural Differences Separately): One possible change after the implementation of tariffs is that some overseas investors may reduce their allocation to U.S. stocks due to concerns about the safety of U.S. assets (the so-called "de-dollarization"). This would cause the weighted risk-free rate to rise closer to U.S. Treasury rates. For U.S. Treasury rates themselves, assuming the Federal Reserve still has two 25bp rate cuts this year, the term premium would decline to around 50bp after the peak of bond issuance, corresponding to a central point of the 10-year U.S. Treasury rate at around 4.2%. For overseas investors, if the contribution of domestic funds to the total market value of U.S. stocks increases from the current 61% to 70%, then the investor-weighted risk-free rate may rise slightly from the current 3.7% to 3.8%.

From a structural perspective, the AI market is not significantly impacted, and the traditional U.S. credit cycle is gently restored under the Fed's rate cuts. Assuming the risk premium of the top 20 stocks (representing tech leaders) maintains the average since the "512 tariff downgrade" (-0.7% vs. current -0.8%), while the risk premium of the remaining 480 stocks (representing traditional cycles) recovers to early February levels (0.8%~1%, vs. current 1.2%), the overall risk premium of the S&P 500 would slightly decline. Considering the impact of tariffs and fiscal policies on profits, the corresponding central point of the S&P 500 would be between 6200 and 6400. In an optimistic scenario, if the risk premiums of both top stocks and traditional cycles decline to the low points at the beginning of the year (corresponding to -0.94% and 0.75%, respectively), the overall risk premium of the S&P 500 (based on investor-weighted rates) may further decline from the current 0.9% to 0.5%, corresponding to a central point of the S&P 500 around 6600.

Chart: S&P central point 6200~6400 under baseline scenario (risk premium of top stocks maintains average since tariff downgrade, traditional cycle declines to early February)

Chart: In an optimistic scenario (where the risk premium of leading stocks maintains the current level and the traditional cycle reverts to the low point at the beginning of the year), the S&P central point is around 6600.

Considering the two methods of estimating risk premiums adjusted for the risk-free rate mentioned above, the central point of the S&P 500 in the baseline scenario is 6200-6400, and in the optimistic scenario, it is 6600-6700.

► In terms of rhythm, there are still disturbances in the third quarter. The significant downward revision of the July non-farm data triggered a decline. Against the backdrop of substantial floating profits and hovering at historical highs, the market's first reaction was to worry about "recession" and profit-taking, while interest rate cuts are not coming quickly and may even be pulled back repeatedly. Additionally, the liquidity "drain" from fiscal bond issuance in August and September (with a net bond issuance of $140 billion in July and an expected monthly issuance of around $400 billion in August and September) and disturbances from tariff negotiations cannot be ruled out, which may amplify concerns. However, pullbacks will also provide better buying points and reallocation opportunities; otherwise, it will be difficult to operate continuously at high levels. We have previously pointed out that chasing at previous highs was not cost-effective, and it is better to wait for these "several hurdles" to pass.

[1] Here, the market capitalization of U.S. stocks is measured by the total market capitalization of U.S. exchanges as reported by Bloomberg.

Authors: Liu Gang, Xiang Xinli, Source: Kevin Strategy Research, Original Title: "Why Can the Risk Premium of U.S. Stocks Be So Low?"

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