We recently released our Long Term Capital Market Assumptions (LTCMAs), which is a major piece of annual research involving over 40 people, three regions and around 9,000 research hours, producing 10-to-15 year risk and return forecasts for more than 200 major asset classes. Throughout this process, there were several recurring themes. An important one being we expect both government and corporate leverage to remain elevated. 
Aggressive central bank action suppressing interest rates over the last decade reduced the burden of carrying higher debt. Then, as the pandemic recession hit, central banks responded by easing further still and governments embarked on fiscal stimulus packages. The result is higher debt levels, but not necessarily a higher cost of debt servicing.
In our view, these conditions are likely to remain in place for an extended period. As policymakers adopt measures that lead to higher debt we expect economic systems to adapt to carry the larger debt load, and most importantly investors appear increasingly tolerant of growing debt levels.
Nevertheless, high and rising debt will affect many asset classes – across public and private sectors, and in both emerging and developed economies – and just how far investor tolerance of debt extends, remains to be seen.
What does this mean for sovereign bond returns?
A key change in this year’s LTCMAs is the extended path towards interest rate normalisation. This reflects the commitment of many central banks to “lower for longer” rate policy, as well as our belief that low and even negative real rates are necessary to sustain the high levels of debt expected over coming years. This reduces cash and government bond returns across major developed bond markets and in many cases, returns for long-duration government bonds are negative in real terms.
Higher debt levels increase the inflation risk premia we assume over our horizon for both developed and emerging market debt. Active use of fiscal policy should lead to greater differentiation among bond markets, especially in emerging economies. And even among developed market government bonds the long-standing co-movement of yields may now be at risk of dissipating over time.
After struggling with financial crises in the 1990s, many emerging market countries have implemented policy changes (including fighting inflation and issuing a larger share of debt in local currencies), leaving them more financially resilient. But this varies considerably across countries. During this crisis, emerging market central banks have started quantitative easing for the first time. Those with credible policy and strong institutions have been rewarded with developed market-like yield curve performance while others, slower to reform, have been penalised. Overall, we anticipate greater differentiation among emerging market debt markets to lead to dispersed returns across countries.
What are the implications of high debt for credit and equity?
US corporations levered up in the last cycle, and we do not expect this to reverse – at least, not in the early part of this cycle – as easy monetary policy responses are providing cheap bridge financing. However, over time, rising rates should ultimately lead to deleveraging of balance sheets as the cost of debt servicing starts to rise again. High leverage metrics have the greatest effect on our investment-grade spread assumptions, keeping credit spreads a little wider, on average, for a given level of leverage and credit rating. In turn, this leads to attractive returns for parts of the credit spectrum over the 10-15 year cycle period.
For equities, higher leverage should continue supporting high shareholder payouts – although at reduced levels vs. recent years – and this may be balanced by a drag on net margins. We expect revenue growth to be the key metric determining whether higher debt helps or hurts equity returns, and the jury is still out. We expect the most pronounced effects in the US market and the least in Japan. Higher debt but historically low bond yields also imply that equilibrium valuations may remain somewhat elevated.
In this environment, developed market equities increasingly become a vehicle for income rather than capital appreciation. Investors may have to turn to emerging market equities and alternatives for return on capital. It is also reasonable to expect that high starting points for indebtedness may exacerbate market volatility in future recessions.
Given today’s starting point of low interest rates, low inflation and considerable slack in the global economy, active fiscal expansion – that increases government indebtedness – will likely influence market performance for coming years. And for the first time in many years, monetary and fiscal policy will be generally pulling in the same direction. How this policy alignment plays out is still uncertain but we can see this as either potentially pulling up long term trend growth rates or ultimately increasing the risks of inflation down the road. Successful implementation of pro-cyclical and expansive fiscal policy can ultimately lead to steeper government bond yield curves to account for moderately higher medium-term inflation expectations. In turn, steeper curves might eventually help to sustain a rotation in equity markets towards value sectors and regions.
Thushka Maharaj is a global multi-asset strategist at JP Morgan Asset Management. The views expressed above are her own and should not be taken as investment advice.