How Inflation Could Affect Multi-Asset-Class Portfolios
- Dovish Federal Reserve monetary policy and the likelihood of unprecedented U.S. fiscal stimulus raise questions about inflation expectations.
- We analyzed four inflation scenarios, accounting explicitly for economic growth and movements in market-implied expected inflation as well as nominal and real rates.
- Return implications for a global diversified portfolio ranged from -17% to +8%, for the disinflation and reflation scenarios, respectively.
Recent Increases in Inflation Expectations Pushed Nominal Yields Higher
Four Scenarios for Inflation
- Reflation: While inflation runs slightly higher, fiscal and monetary stimulus are rightly sized to bring U.S. growth close to the pre-COVID trendline by year-end, and equity risk premia fall. In this scenario, the U.S. equity market gains, U.S. dollar strengthens, rates remain relatively stable and credit spreads tighten further.
- Disinflation: The economy fails to restart, and disinflationary forces emerge, resulting in increased uncertainty. In this bleaker scenario, nominal rates drop, the U.S. equity market falls significantly and credit spreads jump back to the levels of May 2020.
- Overheated economy: Inflation expectations pick up markedly, especially over the next few years, but then moderate over the longer term. With the economy running too hot and some damage to economic growth, there is increasing pressure on the Federal Reserve to scale back its dovish policy. In this scenario, the U.S. equity market drops, U.S. dollar weakens, credit spreads widen and nominal rates jump significantly.
- Stagflation: In this scenario, inflation jumps substantially and remains at higher levels, while economic growth slows and economic uncertainty rises, pushing equity risk premia higher. Nominal rates rise across all maturities, U.S. equities fall, credit spreads widen and the U.S. dollar weakens.
What We Assume in Our Scenarios
Scenario | Reflation | Disinflation | Overheated Economy | Stagflation |
|---|---|---|---|---|
Scenario BEI-rate shocks (basis points) | Reflation 2-year: +75 10-year: +40 | Disinflation 2-year: -175 10-year: -100 | Overheated Economy 2-year: +225 10-year: +100 | Stagflation 2-year: +225 10-year: +200 |
Scenario Treasury-rate shocks (bps) | Reflation 2-year: +10 10-year: +25 | Disinflation 2-year: -15 10-year: -70 | Overheated Economy 2-year: +35 10-year: +100 | Stagflation 2-year: +110 10-year: +225 |
Scenario Credit-spread shocks (bps) | Reflation Investment Grade: -15 High Yield: -45 | Disinflation IG: +100 HY: +230 | Overheated Economy IG: +25 HY: +60 | Stagflation IG: +100 HY: +230 |
Scenario US equity return (nominal) | Reflation +18% | Disinflation -29% | Overheated Economy -7% | Stagflation -24% |
Scenario EUR/USD shocks | Reflation -10% | Disinflation -5% | Overheated Economy +3% | Stagflation +12% |
Implications for Multi-Asset-Class Portfolios
To assess the potential impact on multi-asset-class portfolios, we created a stress test using MSCI's predictive stress-testing framework to propagate our main assumptions to all other risk factors impacting portfolio returns.4 Applying these scenarios to a hypothetical global diversified portfolio indicated that such a portfolio was hit hardest by the disinflation scenario (-17% return), whereas it gained the most in the reflation scenario (+8% return). While bond returns did offset equity gains or losses in the reflation and disinflation scenarios, respectively, this hedge disappeared in the overheated-economy and stagflation scenarios, leaving portfolios more vulnerable as both equities and bonds lost simultaneously. The exhibit below shows more granular results by asset class and region and for various base currencies.
The Scenarios' Potential Impact on Asset Classes
Loading chart...
Please wait.
U.S. Treasurys are represented by the Markit iBoxx USD Treasuries index. The U.S. equity market is represented by the MSCI USA Index and U.S. investment-grade (IG) bonds by the MSCI USD Investment Grade Corporate Bond Index. Private equity is represented by model portfolios. U.S. real estate is represented by the MSCI/PREA U.S. AFOE Quarterly Property Fund Index. U.K. real estate is represented by the MSCI/AREF UK Quarterly Property Fund Index. The composite portfolio is represented by the following weights: 50% global equities (35% public and 15% private), 10% U.S. Treasurys, 10% U.S. Treasury inflation-protected securities, 10% U.S. IG bonds, 10% U.S. high-yield bonds and 10% U.S. real estate. Based on market data as of Feb. 26, 2021. Source: IHS Markit, MSCI.
As the dovish monetary policy continues and Congress and the new administration plan to provide additional fiscal stimulus, market participants are increasingly focused on the future course of inflation. Our four updated inflation scenarios may help investors compare a variety of what-ifs and their potential impact on portfolios.
3In our analysis, market movements are not presumed to happen at a specific point in time. Instead, it aims to measure cumulative impacts up to the date when a specific scenario has been realized.
4The results are generated based on this methodology, using MSCI's BarraOne®, whereby we used current correlations to propagate the shocks to a hypothetical multi-asset-class portfolio. MSCI clients can access BarraOne® and RiskMetrics® RiskManager® files for these scenarios on the client-support site.
Further Reading
1Giles, C. “Joe Biden’s huge bet: the economic consequences of ‘acting big.’”s, Feb. 16, 2021.2Breakeven inflation is a market-implied measure of expected inflation. Breakeven-inflation curves, reflecting breakeven inflation at various tenors, are calibrated using prices on U.S. nominal Treasurys and U.S. Treasury inflation-protected securities.
The content of this page is for informational purposes only and is intended for institutional professionals with the analytical resources and tools necessary to interpret any performance information. Nothing herein is intended to recommend any product, tool or service. For all references to laws, rules or regulations, please note that the information is provided “as is” and does not constitute legal advice or any binding interpretation. Any approach to comply with regulatory or policy initiatives should be discussed with your own legal counsel and/or the relevant competent authority, as needed.