Market Returns

This insight presents an outlook on USD-Denominated Emerging Market Bonds.

Highlights The recent decline in the US equity risk premium raises an important question for investors: are the structural risks facing the US or global stock markets higher or lower today than they were prior to the global financial crisis? A similar question may be asked for long-maturity US government bonds, given the recent decline in long-maturity yields. In this report, we discuss the measurement of risk premia for stocks and bonds and outline the key structural risks to a rise in both. It is unlikely that stock and bond risk premia will move significantly higher from current levels on a structural basis. However, some upward adjustment to both will likely be required, given several long-term risks to growth and inflation. 2023 is likely to be a year in which the equity risk premium rises for cyclical reasons. We would not be surprised to see the 10-year Treasury term premium fall, likely back into negative territory for a time, in lockstep with falling interest rate expectations. The key time for investors to assess the appropriateness of stock and bond risk premia will likely be in 2024, once the US recession that we expect to begin next year is over (or nearly over) and the US domestic policy and geopolitical outlook for the latter half of the decade becomes clearer. ​​​​​​​Feature Chart II-1Our Preferred Measure Of The US Equity Risk Premium Has Fallen Meaningfully Since The Summer Our Preferred Measure Of The US Equity Risk Premium Has Fallen Meaningfully Since The Summer Our Preferred Measure Of The US Equity Risk Premium Has Fallen Meaningfully Since The Summer We noted in our Annual Outlook report published last month that our preferred measure of the US equity risk premium has fallen significantly since the middle of the year (Chart II-1), which we argued was one sign that the US equity market was not priced for a US recession.1 Aside from the strangeness of the US equity risk premium falling in the face of mounting economic risks, the recent decline in the ERP was also notable because it reached levels not previously seen since before the global financial crisis. That raises an interesting question: are the structural risks facing the US or global stock markets higher or lower today than they were prior to the global financial crisis? A similar question may be asked for long-maturity US government bonds, given the decline in 5-year/5-year forward Treasury yields since mid-October (Chart II-2). Part of the rise in 5-year/5-year forward yields over the past year has reflected investor expectations of higher policy rates in the future, but part of the rise has likely reflected an increase in the “term premium”, the risk premium that investors should receive in exchange for accepting the uncertainty of the inflation outlook and the future path of real short-term interest rates. Complicating this question is the fact that the term premium is notoriously difficult to estimate, with some investors and market participants arguing that it is unquantifiable. Chart II-2Long-Maturity Bond Yields Have Also Recently Fallen Long-Maturity Bond Yields Have Also Recently Fallen Long-Maturity Bond Yields Have Also Recently Fallen In this report, we discuss the measurement of risk premia for stocks and bonds, and outline the key structural risks to a rise in both. We conclude that while stock and bond risk premia are not likely to move significantly higher from current levels on a structural basis, some upward adjustment to both is likely required. This is bad news for investors, as it suggests that future returns from both major asset classes are likely to be lower than they otherwise would be if stock and bond prices already incorporated these structural risks. Measuring Equity And Bond Risk Premia In academic settings, measurement of the equity risk premium has often occurred on an ex-post basis; i.e., what stocks have historically earned above-and-beyond short-term government bonds. When measured on an ex-ante basis, academic approaches to estimating the equity risk premium have tended to be based on some form of the Gordon Growth / Dividend Discount Model (DDM) and either the current yield available to investors from short-term government bond yields or some expected equilibrium yield. In its simplest form, the equity risk premium is derived from the Gordon Growth Model by adding one’s long-term dividend growth expectation to the 12-month forward dividend yield, and subtracting the risk-free interest rate. In practice, there are two main problems with a DDM approach to estimating the ERP. The first problem concerns the growth rate. For example, estimating the future growth rate of dividends for an equity index based on its historical growth may result in wildly different estimates depending on what period is used to calculate historical growth. This is due to shifts over time in the dividend payout ratio, labor’s share of income, and, if these calculations are performed in per share terms, the accretive/dilutive impact of changes in shares outstanding. There is also a complicated relationship between reasonable estimates of the future growth rate of earnings and the dividend payout ratio that may be difficult to model. Related Report  The Bank Credit AnalystHow Much More Pain? The second problem when using a DDM approach to estimating the ERP concerns the risk-free rate of interest. Academic estimates of the ERP frequently employ the yield on the 3-month Treasury bill as the risk-free rate of return, as it is typically viewed by global investors as the safest possible liquid financial asset available. However, one problem with this approach is that short-term interest rates fluctuate significantly over the course of the business cycle, meaning that the current 3-month T-Bill yield may not be, at any given point, a reasonable estimate of the risk-free rate of interest that will prevail in the future. Additionally, we would argue that using very short-term interest rates as the risk-free rate of interest ascribes too much maturity/duration risk to one’s estimate of the equity risk premium. The option-adjusted corporate bond spread (OAS) serves as an important analog to the equity risk premium in the fixed-income universe. It is noteworthy that OAS calculations are performed on a duration-matched basis. This is to avoid incorrectly ascribing yield differences between corporate and government bonds of differing maturities to credit/default risk. We believe that the same principle should apply when estimating the equity risk premium (i.e., investors should use long-maturity government bond yields as their estimate of the risk-free rate of interest). As an alternative to the DDM approach to estimating the equity risk premium, we tend to define the ERP as the difference between the earnings yield and the real 10-year government bond yield. This method abstracts from the complications related to the payout ratio, and it controls for some of the duration risk facing stocks that is not truly stock-specific. We use real rather than nominal government bond yields in this calculation because this adjustment allows us to account for some of the future growth in earnings (via inflation) without having to specify a precise long-term growth expectation for earnings or dividends. Table II-1 presents a variety of estimates of the ERP based on all possible combinations of earnings yield measures based on 1) trailing as reported earnings, 2) trailing operating earnings, or 3) 12-month forward earnings, and 10-year government bond yields deflated by 1) our BCA adaptive inflation expectations model, 2) 10-year CPI swap rates, or 3) TIPS breakeven inflation rates. For the sake of completeness, we also include one measure based on a dividend discount model approach. The table details the calculations and notes the historical percentile of each measure’s current value. Chart II-3 presents a time series based on the median these measures. Table II-1Current Percentile Rank Of Different S&P 500 Equity Risk Premium Measures* January 2023 January 2023 Chart II-3Our Composite Estimate Of The S&P 500 Equity Risk Premium Our Composite Estimate Of The S&P 500 Equity Risk Premium Our Composite Estimate Of The S&P 500 Equity Risk Premium Table II-1 and Chart II-3 reveal two important points about the equity risk premium. The first point is that, based on the median of the ten measures, the ERP is only slightly above its historical average. The second point is that measures of the ERP that employ our adaptive inflation expectations model to deflate nominal 10-year government bonds show a higher ERP because of lower implied real bond yields, which is likely due to the lagged nature of the model. Long-term household inflation expectations, which also tend to lag, have yet to break out, suggesting that ERP measures based on our adaptive expectations model are overestimating the ERP in the current environment. That means that the aggregate measure shown in Chart II-3 is also overestimated, and that equity investors are likely pricing in a risk premium that is below its long-term average. On the bond front, Chart II-4 illustrates the three main approaches that we use to gauge the term premium on 10-year US government bonds. The term premium is defined as the compensation that investors require for bearing the risk that interest rates may change over the life of the bond, and is not directly observable (meaning that it must be estimated). Chart II-4Our Best Estimate For The 10-Year Treasury Term Premium Our Best Estimate For The 10-Year Treasury Term Premium Our Best Estimate For The 10-Year Treasury Term Premium Two of the three term premium estimates shown in Chart II-4 are model-based. The two most cited models of the 10-year Treasury term premium are from Kim and Wright2 and Adrian, Crump, and Moench (ACM).3 A review of the mathematical/statistical details of these models is outside of the scope of this report, but both models attempt to price the term structure of interest rates based on a variety of factors. That allows a direct comparison of long-maturity Treasury yields to “fair value” yields based solely on expected future short-term interest rates, with the difference between the two representing the term premium. The third estimate of the term premium shown in Chart II-4 is survey-based. We subtract the current 10-year Treasury yield from the average of the median participant estimates of the 10-year average fed funds rate sourced from the New York Fed’s market participants and primary dealers surveys, backfilled with annual estimates from the Survey of Professional Forecasters. The chart highlights that all three measures generally trend together, but with significant variations in magnitude and occasional differences in direction. More recently, our survey-based measure is showing a large increase in the 10-year term premium, whereas the model values show significantly smaller – and still negative – premia. Panel 2 of Chart II-4 provides an average of all three of these measures, which we believe is the fairest estimate available of the 10-year term premium. The chart highlights that this aggregate measure of the term premium has risen significantly from its early-2020 lows, but remains slightly negative and at its 20th historical percentile. A negative 10-year term premium means that investors are paying to take interest rate risk over the life of the bond, which should rationally only occur due to the existence of regulatory constraints, strong bets by market participants on asymmetric volatility of interest rates, or the effective pricing by market participants of long-maturity government bonds as insurance. This latter explanation for a negative term premium sidesteps the arbitrage pricing framework for long-maturity bonds, and is especially likely to be present when a higher proportion of investors have a multi-asset framework, when investors have relatively short time horizons, and when stock prices and bond yields are positively correlated – which, except for this year, has been the case on average over the past two decades. Regardless of the cause, Chart II-4 underscores that the term premium on US 10-year Treasurys is probably not high, measured either in absolute terms or relative to its historical average. This points to the conclusion that equity and bond investors are currently not being compensated for the average level of risk that has historically impacted financial markets. As we explain below, there are several reasons to be concerned that the structural risks facing stocks and bonds will be above-average in the future, which could eventually raise stock and bond risk premia and weigh on future returns from both assets. Upward Structural Risks To The Equity Risk Premium Cyclically-speaking, the threat posed to the stock market from a higher equity risk premium is clear. As we noted in Section 1 of our report and in our recent Annual Outlook, we expect a US recession or a recessionary selloff in risky asset prices in anticipation of an eventual recession to occur next year. The question that we are addressing in this report is whether a higher equity risk premium is justified, abstracting from the cyclical outlook, as a result of above-average structural risks. We do not expect the next US recession to be a severe one, meaning that we certainly do not believe that the US equity risk premium will rise to its 2009-2012 levels. However, there are several risks to economic growth to which we would point, suggesting that the US equity risk premium should be higher than it was on average during the early-to-mid 2000s. This list is not meant to be exhaustive, and is presented simply to offer investors examples of how the current economic and political environment is vastly different than it was prior to the global financial crisis. Populist Policies And Hypo-Globalization We detailed the risks of populism for investors in our August 2021 Special Report.4 In a recent paper, Funke, Schularick, and Trebesch have compiled a cross-country database on populism dating back to 1900, defining populist leaders as those who employ a political strategy focusing on the conflict between “the people” and “the elites.” Chart II-5 highlights that the number of populist governments worldwide has risen significantly since the 1980s and 1990s, and Chart II-6 highlights that the economic performance of countries with populist leaders is clearly negative. Chart II-5Populism Has Been On The Rise For The Past 30 Years January 2023 January 2023 The authors found that countries’ real GDP growth underperformed by approximately one percentage point per year after a populist leader came to power, relative to both the country’s own long-term growth rate and to the prevailing level of global growth. To control for the potential causal link between economic growth and the rise of populist leaders, Chart II-7 highlights the results of a synthetic control method employed by the authors that generates a similar conclusion to the unconditional averages shown in Chart II-6: populist economic policies are significantly negative for real economic growth. Chart II-6Populist Leaders Are Clearly Growth Killers Even After… January 2023 January 2023 Chart II-7… Controlling For The Odds That Weak Growth Leads To Populism January 2023 January 2023     The risks of a renewed wave of populist policies in 2024 are clear if a US recession emerges next year and if Donald Trump wins the GOP nomination, as a recession would decrease the Democrats’ odds of retaining the White House to 30% at best. If Ron DeSantis is the Republican nominee there is a chance that additional populist policies will not be adopted, but it is not yet clear what areas of domestic and foreign policy would be prioritized under a DeSantis presidency. In addition, according to the Tax Foundation, the Biden administration “has kept most of the Trump administration tariffs in place, except for a five-year suspension of tariffs that were part of a WTO aircraft dispute and replacement of certain steel and aluminum tariffs with tariff rate quotas.”5 This means that our theme of “hypo-globalization” remains intact, as the maintenance of populist trade policies targeting China, or policies inspired by populism, have effectively become bipartisan in the US. This is negative for multinational firms with globally-sourced production, as relocating factories out of China to minimize the risk of potential supply-chain disruptions is likely to result in marginally lower operating efficiency and higher production costs. Future Geopolitical Conflict Strategic and trade friction between China and the US also significantly raises the risks of a damaging geopolitical conflict that could cause a similar impact to the global economy as Russia’s invasion of Ukraine did earlier this year. As noted in our Annual Outlook report, Western countries responded to Russia’s invasion with massive economic sanctions in lieu of war. The potential invasion of Taiwan by China over the coming few years substantially raises the risk of a similar outcome. Defining total trade as the sum of imports and exports, Chart II-8 highlights that the vast majority of countries around the world now trade more with China than they do the US. This argues in favor of the view that global sanctions (ex-US) against China in response to an invasion of Taiwan will be lighter than those levied against Russia because of their sheer cost to global economic activity. But Chart II-8 underscores how the economic response to an invasion, were it to occur, would be experienced globally and could result in an even larger supply-chain disruption than what has occurred over the past three years. Chart II-8An Invasion Of Taiwan Would Have Massive Global Consequences An Invasion Of Taiwan Would Have Massive Global Consequences An Invasion Of Taiwan Would Have Massive Global Consequences Soberingly, while our geopolitical strategists do not believe that China will launch a full-scale war against Taiwan next year, they do believe that war probably cannot be avoided over the long term, since the Taiwanese will not accept the loss of liberty and security. Beijing is also likely to impose punitive measures on Taiwan short of war, to undermine the ruling party ahead of Taiwan’s 2024 elections, which will keep tensions high. As noted above, the Biden administration has adopted the Trump administration’s efforts to constrain China’s military, technological, and economic growth, including through semiconductor export controls. If Biden starts to use secondary sanctions to insist that allies enforce these controls fully, then US-China conflict and Taiwan risk will rise sharply. Possible Economic Stagnation In China China has become the world’s second-largest economy, and is now one of the three pillars of global growth (along with the US and Europe). While the financial market assets that are directly linked to Chinese growth are somewhat limited in scope, China’s contribution to global growth is highly relevant for the emerging world as well as for the earnings of US and European multinational firms. Chart II-9China's Economy Looks Stagnant And Dependent On Credit Growth China's Economy Looks Stagnant And Dependent On Credit Growth China's Economy Looks Stagnant And Dependent On Credit Growth Chart II-9 highlights that the risks of secular stagnation in China are worryingly high, even without the aggravating factors noted above (belligerent US trade policy and the chance of outright Sino-US geopolitical conflict). The chart shows that China’s per capita GDP growth has exhibited a stagnant trend that, since 2009, has only been meaningfully inflected following episodes of a major acceleration in China’s credit impulse. This underscores that China’s progress towards becoming a high-income country is at risk given already elevated levels of private sector debt in China. Given an ongoing shift away from residential construction as a growth driver, and given the lack of a clear alternative “growth model” for the country, the risk of stagnation in China is not trivial. An economically-stagnant China would not necessarily negatively impact US growth prospects, but it would imply slower global potential growth which would be negative for internationally-focused US stocks. It would also mean that the global economy is likely to reach stall speed more frequently, implying higher volatility and more frequent growth slowdowns or recessions, and justifying a higher ERP. Potential Government Austerity We noted in our Annual Outlook report that interest rates closer to trend rates of economic growth mean that governments in the developed world will now finally have to contend with the rapid increase in government debt that began in 2008. In the US, Chart II-10 shows that net interest costs for the Federal government will exceed their early 1990s peak before the end of the decade if interest rates remain in line with trend nominal growth. Chart II-10Normalized Interest Rates Will Sharply Raise The US Government Debt Burden Normalized Interest Rates Will Sharply Raise The US Government Debt Burden Normalized Interest Rates Will Sharply Raise The US Government Debt Burden We wrote about the outlook for US government debt in a May 2021 Special Report,6 and my former colleague Martin Barnes recently wrote a guest piece for the Bank Credit Analyst that came to similar conclusions.7 It will take market pressures to force an inevitable change in US fiscal policies, and while that is very unlikely to occur in the coming 12-24 months, there are good odds of it happening by the end of the decade – as Chart II-10 highlights. Martin argued in his report that the “solution” to a market-induced US debt crisis will involve a mix of higher inflation, financial repression, increased taxes, and spending restraint. We are less convinced than Martin is that the Fed will allow higher inflation and keep interest rates low to accommodate the US government’s debt burden, but we fully agree that the US will be forced to engage in some kind of fiscal reform at some point over the next decade. Given the strong political aversion in the US to higher taxes, even if structured as a federal sales tax rather than higher income taxes as Martin suggested may occur, we suspect that the first attempt at fiscal reform will be to cut government spending, i.e., austerity. If public opposition to increased taxes is robust and persistent at the point that US federal government net interest costs are soaring, it is very possible that fiscal austerity will have a long-lasting impact on growth and US corporate profits. Upward Structural Risks To Government Bond Term Premia The primary risks to a structural rise in US long-maturity government bond risk premia are mostly related to higher inflation. While we defined the term premium above as the compensation that investors require for bearing the risk that interest rates may change over the life of the bond, typically this is due to a shifting inflation outlook rather than a structural shift in real interest rates. Prior to this year’s rise in long-maturity government bond yields, we had highlighted the risk of a structural rise in the real neutral rate of interest, or “R-star”. We argued forcefully against the secular stagnation / “new neutral” view that negative or near-zero real long-maturity bond yields had become a permanent feature of developed financial markets. We had also warned investors that a potential rise in the neutral rate of interest posed a risk to US stocks that had become increasingly dependent on low bond yields to justify lofty valuation ratios.8 However, 10-year US TIPS yields have risen roughly 250 basis points since the beginning of the year, bringing them much closer to the real potential growth rate of the economy (which is our best estimate for the real neutral rate of interest). As such, the forward-looking risk to a higher term premium would seem to stem more from inflation uncertainty than real interest rate uncertainty. There are two core arguments in favor of the view that US inflation will not just be structurally higher than it has been over the past decade, but structurally above the Fed’s target. The first argument is that globalization is no longer providing downward pressure on traded goods prices, which is the price consequence of our theme of “hypo-globalization.” Chart II-11 highlights that global export volume is no longer trending higher relative to global industrial production, and that import prices from China are no longer falling like they were from 2012 to 2020. Additionally, Chart II-12 shows that the pandemic effectively ended a 25-year period in which the US durable goods price deflator was falling. Chart II-11The World Is No Longer Becoming Increasingly Globalized The World Is No Longer Becoming Increasingly Globalized The World Is No Longer Becoming Increasingly Globalized Chart II-12The Pandemic Ended A 25-Year Period Of Durable Goods Deflation The Pandemic Ended A 25-Year Period Of Durable Goods Deflation The Pandemic Ended A 25-Year Period Of Durable Goods Deflation     It remains an open question how much of the import price effects that we have seen during the pandemic are likely to be permanent. Chart II-13 shows that shipping costs from China/East Asia to the West Coast of the US have already completely normalized. We expect that this will continue to have a negative impact on core goods prices – as we outlined in Section 1 of our report. Chart II-13Global Shipping Costs Have Normalized Global Shipping Costs Have Normalized Global Shipping Costs Have Normalized But it is certainly true that the world is no longer becoming increasingly globalized. We agree that re-shoring the production of some goods from China to the US or to other East Asian economies, either due to strategic considerations or due to supply-chain dependency concerns, is inflationary at the margin. The other core argument in favor of the view that US inflation is likely to be persistently above the Fed’s target is that demographic trends are turning increasingly inflationary. As we noted in our Annual Outlook report, Chart II-14 shows that the world support ratio is falling, which is defined as the effective number of workers to consumers. This suggests that output will decline relative to spending over the coming several years, which should have the effect of boosting prices at the margin. The Bank Credit Analyst service is less convinced than some investors are that these effects will push inflation significantly above the Fed’s target on a structural basis. More clarity on the likely structural effects of these factors, after controlling for the pandemic and its distortions on prices, wages, and the labor market, is only likely to emerge during the next economic expansion. Nevertheless, Chart II-15 highlights that 5-year/5-year forward market-based inflation expectations are lower today than they were prior to the global financial crisis or even during the early phase of the last economic expansion (when deflationary risks were clear). These expectations suggest that fixed-income investors may be complacent about the longer-term risks to prices and that the 10-year Treasury term premium has room to move higher. Chart II-14Demographic Trends Are Inflationary Demographic Trends Are Inflationary Demographic Trends Are Inflationary Chart II-15Are Investors Complacent About Longer-Term Risks To Inflation? Are Investors Complacent About Longer-Term Risks To Inflation? Are Investors Complacent About Longer-Term Risks To Inflation? Finally, our discussion of the US government's debt position and the likelihood of an eventual rise in federal net interest costs raises another risk to the 10-year Treasury term premium. If the Republican party wins both the Presidency and Congress in 2024, as would seem to be likely given our view that a US recession will probably begin over the next twelve months, there is a strong possibility that US policymakers will attempt to cut taxes as part of their economic agenda – especially if populism remains an important force in American politics. In the context of a likely future rise in interest rates, fixed-income investors are likely to respond negatively to any policy changes that threaten to widen the primary deficit. In late-September, the UK government witnessed the return of the “bond vigilantes” following the announcement of then Finance minister Kwasi Kwarteng, whose mini-budget included both a substantial energy support plan for households as well as large tax cuts. In response, GBP-USD fell to a new low, and UK 10-year government bond yields surged (Chart II-16). Chart II-16Fiscal Policy Can Push Term Premia Higher, Via A Fiscal Risk Premium Fiscal Policy Can Push Term Premia Higher, Via A Fiscal Risk Premium Fiscal Policy Can Push Term Premia Higher, Via A Fiscal Risk Premium A portion of the market’s response likely occurred due to the fact that the mini-budget combined a significant increase in spending with reductions in government revenue, and thus a similar response may not occur if US legislators cut taxes alongside some reductions in spending in 2025. But it underscores that budget announcements can cause a rise in long-maturity government bond yields, in the form of a fiscal risk premium – which is technically a component of the term premium, but is normally assumed to be zero when analyzing developed market government bond yields. Investment Conclusions Our discussion of the measurement of equity and bond risk premia, and the structural risks to both, outlines two key conclusions for investors. First, while stock and bond risk premia do not appear to be very high, it is unlikely that they will move significantly higher from current levels on a structural basis. The second point, however, is that some upward adjustment to both is likely required given the structural risks to growth and inflation that we have outlined. This is incrementally bad news for investors, as it suggests that future returns from both asset classes are likely to be lower than they otherwise would be if stock and bond prices already incorporated these structural risks. 2023 is likely to be a year in which the equity risk premium rises for cyclical reasons. We would not be surprised to see the 10-year Treasury term premium fall, likely back into negative territory for a time, in lockstep with falling interest rate expectations. The key time for investors to assess the appropriateness of stock and bond risk premia will likely be in 2024, once the US recession that we expect to begin next year is over (or nearly over) and the US domestic policy and geopolitical outlook for the latter half of the decade becomes clearer. Significant shifts in the direction of populist policies, belligerent trade actions, mounting geopolitical tensions with China, and/or suggestions of potential austerity under the next US administration may significantly alter our structural investment recommendations towards global stocks in the direction of a less constructive stance. Similarly, indications of lingering price pressures from the pandemic, and/or persistently elevated wage growth following what is likely to be a mild-to-average severity recession in the US, are likely to impact our structural duration recommendations within a fixed-income portfolio, biased in the direction of a short-duration stance. This topic is an area of ongoing research at BCA, and will likely be revisited at some point late next year or in early-2024. Stay tuned! Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1  Please see The Bank Credit Analyst "How Much More Pain?," dated November 28, 2022, available at bca.bcaresearch.com 2  Please see “An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates” by Don H. Kim and Jonathan H. Wright, Federal Reserve Finance and Economics Discussion Series (FEDS) 2005-33. 3  Please see Tobias Adrian, Richard K. Crump, and Emanuel Moench, "Pricing the Term Structure with Linear Regressions," Journal of Financial Economics 110, no. 1 (October 2013): 110-138. 4  Please see The Bank Credit Analyst "The Social Media Magnification Effect: Austerity, Populism, And Slower Growth," dated July 29, 2021, available at bca.bcaresearch.com 5  Please see Tracking the Economic Impact of U.S. Tariffs and Retaliatory Actions, Tax Foundation 6  Please see The Bank Credit Analyst "In COVID’s Wake: Government Debt And The Path Of Interest Rates," dated April 29, 2021, available at bca.bcaresearch.com 7  Please see The Bank Credit Analyst "Soaring Government Debt: A Crisis In Waiting?" dated October 27, 2022, available at bca.bcaresearch.com 8  Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com; The Bank Credit Analyst "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com; and The Bank Credit Analyst "Do Excess Savings Explain Low US Interest Rates?" dated March 31, 2022, available at bca.bcaresearch.com

Recession is not yet fully priced in, so markets have further to fall next year. But watch for a buying opportunity in the second half.

This week we present six key investment views for 2023.

In Section I, we note that while recent inflation developments point to some supply-side and pandemic-related disinflation, they also point to potentially stickier inflation over the coming several months. The inflation, monetary policy, and geopolitical outlook remains sufficiently risky that an overweight stance towards equities within a global multi-asset portfolio is not justified, and we continue to recommend a neutral stance for now. This month’s Section II is a guest piece written by Martin Barnes. Martin, who retired from BCA Research as Chief Economist last year after a long and illustrious career, discusses the outlook for government debt and the possibility of an eventual crisis.

This week’s report takes a look at risk-adjusted return opportunities in US spread product.

The Fed’s tone has taken a decidedly dovish turn during the past week and, despite September’s hot CPI print, there is mounting evidence that a period of disinflation is coming. This makes the case for a pause in the Fed’s tightening cycle in Q1 or Q2 of next year.

Our preferred tactical global fixed income trades for the rest of 2022 into early 2023 are all expressions of our views on relative monetary policy shifts within the main developed market economies. These involve bets on a relatively more hawkish Fed and Bank of England versus a relatively more dovish ECB and Bank of Canada, while also betting on additional selling pressure on Italian government bonds.

Long-after-the-fact revisions to reported income, spending and savings data do not alter our assessment that a flush consumer will continue to support the US economy and allow S&P 500 earnings to surprise the bearish investor consensus.

Investors should go long US treasuries and stay overweight defensive versus cyclical sectors, large caps versus small caps, and aerospace/defense stocks. Regionally we favor the US, India, Southeast Asia, and Latin America, while disfavoring China, Taiwan, Hong Kong, eastern Europe, and the Middle East.