Macro Scenarios in Focus: Higher Rates for Longer
Key findings
- A survey of economists suggests that the U.S. could avoid recession in the next 12 months while rates are expected to stay higher for longer. This forecast is aligned with our soft-landing scenario.
- According to the MSCI Macro-Finance Model, expected returns for U.S. fixed income under the soft landing are significantly larger than its historical expected-return estimates in the past 25 years.
- The value of a diversified portfolio of global equities and U.S. bonds could gain 4% under the soft-landing scenario, while a hard landing or mild stagflation might lead to losses of 1% and 9%, respectively.
In a survey of economists,[1] most forecast that the U.S. federal-funds rate would rise by another 25 basis points, with cuts coming only in the third quarter of next year, while the U.S. would dodge a recession in the coming 12 months. This forecast is aligned with our "soft landing" scenario, under which the value of a diversified portfolio of global stocks and U.S. bonds could gain 4%. Downside risk scenarios, such as a "hard landing" and "mild stagflation," however, could hurt that portfolio's value — with 1% and 9% losses, respectively.
Higher rates for longer
Consistent with the economist survey, interest-rate futures markets now imply that policy rates across regions will remain elevated until the middle of next year. Policymakers are indeed increasingly debating a preference to hold rates at higher levels for longer.[2] As discussed in "Markets in Focus: Narrow Yield Spread and High Crowding Pressure Equities," this may have implications for bond-equity allocations in multi-asset-class portfolios.
Implied one-month forward rates point to rates remaining elevated until mid-2024
Market-implied expectations for central-bank policy rates are derived from the respective MSCI overnight-index-spread curves. As of Oct. 2, 2023.
We revised our four scenarios for 2023, accounting for updated economic forecasts and recent market shifts, with our soft landing most closely aligned with current macroeconomic expectations. Under this scenario, interest rates remain high as inflation comes down in line with the Federal Reserve's expectation, the U.S. economy avoids recession and no additional global downside risks materialize.
We used the MSCI Macro-Finance Model to assess one-year expected returns under the soft landing and compared that to historical model-implied baseline expected returns. The exhibit below shows that U.S. fixed income would have significantly larger expected returns under the soft landing relative to those estimated in the past 25 years. Furthermore, U.S. equities' expected returns are close to their 25-year average, but the gap between equities and bonds has narrowed substantially.
One-year expected returns for major US asset classes under the baseline soft-landing scenario
Expected returns are generated by the MSCI Macro-Finance Model, as of August and June 2023. The blue bars represent the average and one-sigma bands of historical estimates of the asset classes' expected returns between 1998 and 2023.
Besides the expected returns under the soft landing, we also updated the market-risk-factor shocks for three scenarios, two reflecting downside risk and one upside risk:
- Hard landing: Overaggressive monetary policy effectively curbs inflation, and the Federal Reserve maintains its credibility, at the cost of a U.S. recession in 2023.
- Mild stagflation: Central-bank policies do not efficiently tame inflation, eroding central banks' credibility, and inflation becomes entrenched. High prices and interest rates weigh on growth for an extended period.
- Strong rebound: Inflation is under control and falls more than economists' consensus expectation, while economic growth surprises on the upside.
Our scenario assumptions
Scenario assumptions are informed by the MSCI Macro-Finance Model, analysis of historical data and judgment. Breakeven inflation (BEI) is measured in basis points (bps). These are not forecasts, but hypothetical narratives of how the macroeconomic scenarios could affect multi-asset-class portfolios over a horizon of one year.
Potential implications for financial portfolios
To assess the scenarios' impact on multi-asset-class portfolios, we used MSCI's predictive stress-testing framework and applied it to a hypothetical global diversified portfolio, consisting of global equities and U.S. bonds and real estate.[3] This portfolio's value gained 4% under the soft landing. Under the more bearish hard landing, the portfolio's value dropped by 1% as rallying bonds offset the selloff in equities. The mild-stagflation scenario, with high interest rates and inflation, hurt the portfolio most, with a 9% loss, as bonds and equities sold off simultaneously. The exhibit below shows more-detailed results.
Impact to portfolio values under our scenarios
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Portfolio impact of the scenarios based on market data as of Sept. 26, 2023. Note that the above stress-test results capture the effect of repricing the assets, not the income component. Treasury inflation-protected securities are represented by the iBoxx TIPS Inflation-Linked Index provided by S&P Dow Jones Indices. U.S. Treasurys, equities and corporate bonds are represented by MSCI indexes. Private equity is represented by model portfolios. U.S. real estate is represented by the MSCI/PREA U.S. AFOE Quarterly Property Fund Index. The composite portfolio is 50% global equities (35% public and 15% private), 10% U.S. Treasurys, 10% U.S. Treasury inflation-protected securities, 10% U.S. investment-grade bonds, 10% U.S. high-yield bonds and 10% U.S. real estate. Source: S&P Global Market Intelligence, MSCI
Summing up
The 2023 economy has so far been resilient to the rising-rate environment. Investors still face risks, including economic overheating and the potential for lagged impacts of policy to induce a recession. Alternatively, the resilience seen so far could be a sign of increased productivity to come. Investors can use this blog post's scenarios to help assess these uncertainties for their portfolios as we look toward 2024.
The authors thank Dora Pribeli for her contributions to this blog post.
1 Colby Smith and Eva Xiao, “Economists expect Fed to defy investors with more interest rate rises,” Financial-Times, Sept. 17, 2023.2 Krishna Guha, “Central banks debate: can 'high for longer' substitute for rate rises?” Financial-Times, Sept. 13, 2023.3 The results are generated by using model correlations to propagate shocks to the portfolios, using MSCI's BarraOne®. MSCI clients can access BarraOne and RiskMetrics® RiskManager® files for these scenarios on the client-support site.
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