Recession-Hard/Soft Landing

Highlights Market expectations for Fed rate cuts later this year reflect either an extremely mild US recession, or a nonrecessionary scenario in which inflation falls rapidly back toward the Fed’s target. In the case of a true recession, even a historically mild one, the Fed will likely cut interest rates meaningfully below what is priced into the OIS curve – to 1% or lower. It is plausible that the Fed could ease monetary policy this year before the US economy begins to contract, because the Fed wrongly believes that the neutral rate of interest is just 2.5% – well below the current policy rate. Monetary policy rules also point to interest rate cuts even if the Fed’s current inflation and unemployment rate forecasts for this year come to fruition. However, several conditions would need to be met for the Fed to consider easing monetary policy, meaning that the prospect of nonrecessionary rate cuts this year is possible but not especially likely. Given that US monetary policy is currently tight, a high bar for the Fed to cut rates supports a defensive stance. Investors should remain underweight stocks versus bonds in a multi-asset portfolio over the coming 6-12 months. Feature Chart II-1The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year The Market Expects The Fed To Cut Interest Rates In The Second Half Of The Year Based on the shape of the OIS curve, investors are projecting that the Fed will cut interest rates in the latter half of this year. Chart II-1 highlights that the OIS curve peaks at 4.9% as of this summer, falling to 4% by the end of this year. The common interpretation of this is that the OIS curve reflects investors’ expectations of a mild recession. However, an alternative explanation is that financial markets are priced for a soft-landing scenario, in which the Fed cuts rates back toward its neutral rate estimate in response to declining inflation before the US economy tips into a recession. In this report, we explore what it will take for the Fed to cut interest rates in both a recession and non-recession scenario for this year. In the case of a true recession, the Fed will not only cut the fed funds rate, they are also very likely to cut it meaningfully below what is priced into the OIS curve – to 1% or lower. And, while it is plausible that the Fed could ease monetary policy this year before the US economy begins to contract, it does not seem particularly likely, given that several conditions would need to be met. For now, our conclusions continue to support a defensive stance, arguing that investors should remain underweight stocks versus bonds in a multi-asset portfolio. Fed Rate Cuts: The Recession Scenario The most obvious scenario in which the Fed cuts interest rates is one in which the US economy slips into a recession, which we believe is more likely than not to occur at some point over the coming year. Chart II-2 highlights that the Fed has always eased monetary policy following the onset of recession in the post World War II (WWII) environment. Many investors would argue that the recession scenario is effectively what is being priced into financial markets: 12-month forward earnings have modestly declined, consensus economic forecasts call for at least one quarter of negative growth in 2023 and a rise in the unemployment rate to 4.8%, and the OIS curve is now pricing in 225 basis points of interest rate cuts from Q2 2023 to Q2 2024 (Chart II-3). Chart II-2The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur The Fed Would Certainly Ease Monetary Policy Were A Recession To Occur Chart II-3Consensus Economic Forecasts Call For An Extremely Mild Recession This Year Consensus Economic Forecasts Call For An Extremely Mild Recession This Year Consensus Economic Forecasts Call For An Extremely Mild Recession This Year   As such, some argue that, based on these apparent expectations of a very mild recession, earnings are not likely to decline significantly from current levels and the equity market has already priced in upcoming economic weakness. Effectively, the consensus view is pricing in what the Fed is projecting in its most recent Summary of Economic Projections. We think that is not a likely occurrence for the following reasons: Following WWII, the US unemployment rate has never risen less than 2% during a recession (Chart II-4). What the market is calling a “mild recession” would actually be the mildest recession in US history, by a nontrivial amount. Peak-to-trough declines in earnings during recessions are typically between 10-20% (Chart II-5), versus the 3-4% decline that has occurred over the past year. And while it is true that 12-month forward EPS only recorded a single-digit decline during the 1990-91 recession, that decline occurred against the backdrop of meaningfully lower profit margins compared to the present day; there was thus less of a risk to earnings at that time from margin compression. Chart II-4The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History The Market's Small Expected Rise In The Unemployment Rate Has Never Occurred In Post-War US History Chart II-5US Earnings Per Share Do Not Reflect A Recession US Earnings Per Share Do Not Reflect A Recession US Earnings Per Share Do Not Reflect A Recession       The equity risk premium has fallen, rather than having risen, as monetary policy has become tight (Chart II-6). Within the bond market, the level of interest rates priced into the OIS curve following the onset of rate cuts is very likely too high for a recession scenario. 1-year/1-year forward bond yields currently trade at roughly 3.7%, which is barely stimulative based on our view of the neutral rate of interest and still tight based on the Fed’s neutral rate view as well as the market’s. As we wrote in our September Special Report,1 the historical experience of recessions suggests that the Fed will cut the policy rate close to the zero lower bound (Chart II-7). That is based on the historical level of interest rates relative to potential growth or average realized nominal GDP growth. It is possible that the Fed will cut rates closer to 1%, but we suspect that this would most likely only occur in a scenario wherein core inflation was slower to return to target levels than the Fed expects. Absent another supply-side shock over the coming 12-18 months, we believe that the combined effect of waning pandemic-related and supply-side driven inflation, decelerating house prices and rental rates, and weak aggregate demand in the case of a recession is more likely than not to bring core inflation back to, or even below, target levels. Chart II-6The US Equity Risk Premium Is Too Low Given Recessionary Risks The US Equity Risk Premium Is Too Low Given Recessionary Risks The US Equity Risk Premium Is Too Low Given Recessionary Risks Chart II-7The Fed May Have To Cut To Zero During The Next Recession, But Probably Not Into Negative Territory February 2023 February 2023 The historical experience of Fed rate cuts during recessions shown in Chart II-7 is also supported by two monetary policy rules when considering the Fed’s current neutral rate assumption. Chart II-8Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession Monetary Policy Rules Suggest The Fed Funds Rate Will Fall To Between 0-1% In A Recession The most well-known monetary policy rule is the Taylor Rule, but FOMC officials have more commonly spoken about another rule called the balanced-approach rule with shortfalls (which is, itself, a version of the original Taylor Rule). In this version of the rule, the policy rate is equal to the Fed’s inflation target, plus the real neutral rate of interest, plus the inflation gap (times a multiplier), plus the output gap when the gap is negative. This one-sided consideration of the output gap is somewhat compensated for by an inflation gap multiplier that is larger than 1 (typically 1.5, versus 0.5 in the Taylor Rule). In short, compared to Taylor Rule, the balanced-approach with shortfalls rule will produce a policy rate that is the same as that produced by the Taylor Rule for any given level of inflation when the unemployment rate is at NAIRU, but less than the Taylor Rule as the unemployment rate deviates from NAIRU in either direction. As such, the balanced-approach rule with shortfalls is a strictly more dovish monetary policy rule than the Taylor Rule. Assuming a recession scenario in which core PCE inflation falls to 2% and the unemployment rate rises to 5.5%, the balanced-approach rule projects a -0.5% policy rate (Chart II-8). Using the same assumptions for the Taylor Rule and deriving the output gap through Okun’s law, the policy rate is projected to be 1%. A simple average of these two approaches is 0.25%, which is effectively the Fed’s lower bound. This underscores that investors should shift heavily into a long duration stance in response to concrete signs that the US economy is indeed veering into recession, which we expect to become evident in the labor market over the coming few months. Fed Rate Cuts: The Nonrecessionary Scenario As noted above, the view of most investors is that financial markets are pricing in the likelihood of a US recession, and that the OIS curve reflects what investors believe is the likely recessionary interest rate path. Chart II-9According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight According To The Fed's Neutral Rate View, Monetary Policy Is Already Extraordinarily Tight Another possibility is that investors expect nonrecessionary rate cuts, as the Fed responds to easing inflation by lowering the policy rate closer to its estimate of neutral – what the Fed and many investors refer to as a “soft landing”. That would still be consistent with our interpretation of the yield curve that we noted in Section 1 of our report, and the muted decline in 12-month forward S&P 500 EPS. The core basis for the nonrecessionary rate cut view is the fact that the Fed believes the neutral rate of interest is just 2.5%, which is well below the current policy rate (Chart II-9). In fact, as we have highlighted in past reports, monetary policy is the tightest it has been since the 1980s based on the Fed’s neutral rate view. We strongly disagree with the Fed’s estimate of the neutral rate. But from a strategy standpoint, it is important to predict how the Fed will act, rather than how it should act. Unless the Fed revises its neutral rate estimate higher, it is possible that they will choose to lower interest rates before a recession has begun, in response to an “immaculate disinflation” scenario in which inflation decelerates rapidly back toward its target. The key question is how low inflation would need to fall before the Fed becomes comfortable easing policy. Charts II-10 and II-11 highlight what the balanced-approach with shortfalls rule would imply in view of the Fed’s most recent forecasts from the summary of economic projections, as well as in a true soft landing scenario wherein the unemployment rate rises to just 4% and inflation returns completely back to the Fed’s 2% target. In the first case, the balanced approach rule prescribes a policy rate of 3.6%, close to 160 basis points below what the Fed’s policy rate projection for the end of this year. In the second case, given a closed inflation gap and an unemployment rate at NAIRU, the rule prescribes a policy rate that is in line with the Fed’s neutral rate estimate of 2.5%, approximately 260 basis points below what the Fed projects for this year. Even the Taylor Rule would point to rate cuts in both scenarios, projecting a policy rate of 4.1% and 2.5%, respectively. Charts II-10 and II-11 make it clear that the Fed has stated plans to maintain very high policy rates compared to what typical monetary policy rules would advise. Why is this the case? There are three possible answers. Chart II-10Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed’s Economic Forecasts Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed's Economic Forecasts Monetary Policy Rules Prescribe Lower Interest Rates Than The Fed Is Forecasting Given The Fed's Economic Forecasts Chart II-11A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed’s Neutral Rate View A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed's Neutral Rate View A True Soft Landing Scenario Would Imply Significantly Lower Interest Rates, Given The Fed's Neutral Rate View     The first is simply that monetary policy rules are not part of the Fed’s reaction function and have no bearing on monetary policy. This is possible, but not a particularly likely explanation given that Fed officials occasionally refer to them and that they are structured in a way that at least theoretically captures the Fed’s reaction function. The second possible answer is related to the fact that the fed funds rate significantly undershot what monetary policy rules would have prescribed in 2021. It may be that the Fed is attempting to compensate for this deficit when setting interest rates over the coming year, especially given how significantly some measures of inflation expectations have risen. In fact, this perspective is theoretically supported by the idea of the modern-day Phillips Curve. We noted in our January 2021 report that if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero.2 Given that the output/jobs gap is fundamentally determined by the stance of monetary policy, the Fed may see its failure to raise rates in 2021 as having contributed to too long a period of very strong employment, which needs to be balanced by a period of “too-high” interest rates. Chart II-12There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking There Is Good Evidence So Far That Long-Term Inflation Expectations Are Forward Looking Additionally, recent work from the IMF on the risk of a wage-price spiral has shown that the magnitude of the monetary policy response required to prevent such a spiral is determined by whether long-term inflation expectations are primarily backward or forward looking.3 Chart II-12 provides good evidence that long-term inflation expectations have recently been forward looking, but the Fed may believe (reasonably so) that this is less likely to be true the longer that inflation remains above its target level. Finally, the third possible answer explaining why the Fed’s rate projections this year are so much higher than monetary policy rules would prescribe is that the Fed is simply jawboning. The goal of jawboning the market would be to convince economic agents to set lower prices and accept lower wage growth to ensure that inflation does indeed return to target, such that the Fed either does not actually need to raise short-term interest rates to the level they are projecting, or must quickly lower them once their unemployment rate and core PCE inflation projections materialize. As we noted in Section 1 of our report, we do not think that the latter scenario is likely. However, if it does occur, it could enable the US economy to avoid a recession in 2023, and would likely alter our current asset allocation recommendations in the direction of increasing risky asset exposure on a 6-12 month time horizon. R-Star Wars? Chart II-13The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking The Secular Stagnation Narrative Is Now, Wrongly, Embedded In The Fed's Thinking As noted above, the core basis for a nonrecessionary rate cut view is the fact that the Fed (wrongly) believes the neutral rate of interest is meaningfully below the potential rate of nominal economic growth. This view has been heavily influenced by the revival of the theory of secular stagnation by Larry Summers in the fall of 2013 (Chart II-13). Thus, the expectation of some investors that the Fed will ease monetary policy before a recession begins will be undercut if the Fed were to raise its expectations for the neutral rate, or were to act as if it believed that R-star might be higher, even if those beliefs were not reflected in the FOMC’s Summary of Economic Projections. While the Fed has made no indication that this is the case, recent comments from Summers himself during a recent interview suggest that the Fed’s longer-run interest rate projections may increasingly come under pressure: “The thirty-year story has been declining interest rates and the idea that we're moving into an era of low interest rates. That was certainly the thesis that I was pushing with the idea of secular stagnation prior to COVID; that has been the basis for a large amount of economic thinking. The idea that we are going to return to [that environment] is a kind of orthodoxy baked into markets. You see it when the Fed predicts a half a percent neutral real rate, you see it in breakevens on inflation in the low 2s, you see it in a 10-year rate in the 3.7% range. And that might be how things play out. The forces of secular stagnation – demography, inequality, lower priced capital goods – all of that are strong. But my guess is that just as those who during the Second World War predicted that when the war ended we would return to secular stagnation and a sluggish low interest rate economy turned out to be wrong, that is going to be true this time around. I think we are in a new era of much higher government debt ratios. We are in an era, including because of national security spending, of substantially larger budget deficits. We are in an era of much higher investment demand because of resilience investment and reshoring, and because of green energy transformations that are going to happen all over the world. At the same time, the disinflationary shock of billions of people in emerging markets joining the global labor pool and applying disinflationary pressure – that is surely not going to continue at the same rate [as over] the last several decades. And it may, given developments in China, actually go into reverse. There is going to be [an increase] in uncertainty and I think [that is] likely to translate into increased term premiums. So my guess is that this is going to be remembered as a “V” year, when we recognized that we were headed into a different kind of financial era with different kinds of interest rate patterns.” Larry Summers, Bloomberg TV, January 6, 2023 Some of Summers’s comments relate to the belief that nominal interest rates will be higher in the future because of structurally elevated inflation, but some of what he expects would relate to a higher real neutral rate, particularly the idea that global investment demand will be stronger because of increased defense spending, resilience investment / reshoring, and green energy projects. A broader discussion of whether the factors that Summers raised are likely to materialize will likely be the subject of future BCA Research reports. But for now, the key point is that the idea of a low neutral rate of interest may become increasingly controversial over the coming months and years, implying that investors cannot necessarily rely on the Fed’s low neutral rate view to act as a strong basis for significant rate cuts over the coming year outside of the context of a recession, even if inflation slows significantly. Investment Conclusions We noted above that there are two scenarios in which the Fed could cut interest rates over the coming year. The first scenario involves a recession, which we think is the most likely economic outcome over the coming year. However, were a recession to occur, it is likely to be more severe than investors currently expect, because what the market is calling a “mild recession” would actually be the mildest recession in US history, by a nontrivial amount. Based on the historical experience of recessionary interest rate cuts, as well as what is implied by monetary policy rules, we expect the Fed to cut the fed funds rate to 1% or lower in a recessionary scenario. This underscores that investors should shift heavily into a long duration stance in response to concrete signs that the US economy is indeed veering into recession, which we expect to become evident in the labor market over the coming few months. The second rate cut scenario involves the Fed easing monetary policy before the economy veers into contractionary territory. This is a plausible scenario given that the Fed believes the neutral rate of interest is just 2.5%, meaning that the current stance of monetary policy is extremely tight according to the Fed’s view. Monetary policy rules point to interest rate cuts even if the Fed’s current inflation and unemployment rate forecasts for this year come to fruition. The latter underscores that the Fed could cut interest rates this year in a nonrecessionary context if all of the following conditions are met / become true: Core PCE inflation falls below the Fed’s 2023 forecast of 3.5% Inflation expectations remain well anchored or decline from current levels The Fed does not believe that it needs to compensate for “too-low” interest rates in 2021 with a period of “too-high” interest rates The Fed does not upwardly revise its real neutral rate view or set monetary policy as if R-star were higher than the FOMC currently projects Were this nonrecessionary rate cut scenario to materialize, it would likely cause us to change the investment recommendations that we outlined in our 2023 Annual Outlook. Evidence that the Fed is shifting toward rate cuts prior to the onset of a recession would still cause us to recommend a long duration stance (as the Fed would be lowering short-term interest rates), but we would likely recommend increasing exposure to risky assets back to overweight. Falling long-maturity bond yields would support equity multiples, and the avoidance of a recession would almost certainly point to positive earnings growth, the combination of which would likely lead stocks to outperform bonds over a 6-12 month time horizon. For now, however, we do not find the prospect of nonrecessionary rate cuts to be especially likely, meaning that interest rates are likely to fall later this year because of a recession rather than in the context of a “soft landing”. This supports a defensive stance, indicating that investors should remain underweight stocks versus bonds in a multi-asset portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst “The Fed Funds Rate, Bond Yields, And The Next US Recession,” dated August 25, 2022, available at bca.bcaresearch.com 2  Please see The Bank Credit Analyst “The Modern-Day Phillips Curve, Future Inflation, And What To Do About It,” dated December, 2020, available at bca.bcaresearch.com 3  “Wage Dynamics Post–COVID-19 and Wage-Price Spiral Risks,” International Monetary Fund World Economic Outlook, October 2022

Heading into a black hole, you pass a point of no return known as the ‘event horizon’ after which your impending oblivion is sealed. US recessions also have an event horizon, which we are fast approaching. We reveal a leading indicator of this event horizon, and what it means for investment strategy.

Fed Governor Lael Brainard delivered an important speech last week in which she laid out the intellectual justification for the Fed to soon pause its rate hike cycle. This week’s report reviews her arguments and explains how they inform our monetary policy and investment views.

Global investors should sell Chinese assets on strength this year and diversify into other emerging markets. American investors should limit China exposure. Short CNY-USD.

Hopes of a soft landing for the US economy will intensify over the coming months, allowing equities to rally. However, even if an equilibrium of high employment and low inflation is reached, it will be difficult to keep the economy there. Investors should remain tactically bullish on stocks but look to turn defensive in the second half of 2023.

The crucial question for 2023 is: will the US and UK Beveridge Curves shift back inwards to their pre-pandemic versions, ushering in a soft landing? Or, will we slide down the new post-pandemic Beveridge Curves into recession? Plus: we reveal the most important chart for Europe and the most important chart for China in early 2023.

Relative to beaten-down expectations, global growth will surprise on the upside in 2023. Investors should overweight equities for now but look to turn more defensive in the second half of the year.

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

In this, our final report of a tumultuous year, we summarize our policy outlook for the “Big 4” central banks – the Fed, the ECB, the Bank of England (BoE) and the BoJ – and the associated bond market implications for 2023.

This week we present our outlook for the Fed in 2023.