Stress Testing Multiperiod Inflation Scenarios
- We propose three hypothetical multiperiod scenarios for inflation corresponding to reflation, disinflation and stagflation regimes.
- For long-horizon investors, there may be a trade-off between short-term drawdown and long-term returns to be considered. Risk-averse investors may seek to avoid short-term drawdowns, but may surrender potential market runs in the long term.
- Multiperiod scenarios, which include both the initial shock and the longer-term recovery, allow investors to better assess this trade-off.
Three Multiperiod Scenarios for Inflation
We looked at three hypothetical 10-year-long multiperiod scenarios for inflation. The scenarios are based on the narratives used in our previous blog post:
- Reflation: Monetary and fiscal stimulus bring the economy back to its long-term growth trend. Nominal rates remain relatively stable, and 10-year breakeven inflation rises to levels slightly above 2%. U.S. equity markets are assumed to gain 15% in the next year, after which they grow at approximately the long-term average trend.
- Disinflation: A grimmer scenario in which disinflationary trends get the upper hand despite the Federal Reserve's keeping yields of all maturities close to zero. With economic growth impaired and increased uncertainty, this is bad news for U.S. stocks, which are assumed to lose around 14% in the first year, after which equity markets recover.
- Stagflation: Inflation picks up more than anticipated, leading to disrupted economic growth and increased risk premia. Nominal rates increase as the Fed reacts to rising inflation, and equities are assumed to lose about 7% in the first year.
Stress-Test Assumptions for Main Risk Factors
Loading chart...
Please wait.
Scenario Implications for Various Allocation Strategies
We focused our analysis on hypothetical portfolios of U.S. equities and bonds. The base case was the traditional 60/40 allocation to equities/bonds, with the bond portfolio consisting of 50% U.S. Treasurys, 37.5% U.S. investment-grade corporate bonds and 12.5% high-yield corporate bonds.3 In addition, we considered more aggressive 80/20 and more defensive 20/80 allocations to equities/bonds. We assessed the performance of each allocation under the various scenarios, with cash flows reinvested back into the portfolio. Each year, we also assumed the portfolio was rebalanced to the original target allocation across asset classes and that the bonds were rolled into newer issues to maintain the original time to maturity.4
Portfolio Impact Under Various Multiperiod Scenarios
Loading chart...
Please wait.
Impact of the scenarios on hypothetical portfolios of U.S. stocks and bonds. U.S. Treasurys and high-yield bonds are represented by Markit iBoxx indexes. The U.S. stock portfolio is proxied by the MSCI USA Index and U.S. corporate bonds by the MSCI USD Investment Grade Corporate Bond Index. Based on Nov. 5, 2020, market data. Source: IHS Markit, MSCI.
The above exhibit illustrates the trade-off between short-term drawdown and long-horizon return. In the disinflation scenario, for example, initially the return of the defensive (20/80) allocation dropped about 6 percentage points less than the 60/40 allocation, but it also significantly underperformed that same 60/40 portfolio over the full 10-year horizon.
Is the Potential Return Worth the Drawdown?
Under our assumptions in the disinflation and stagflation scenarios, the more aggressive allocations to equity incurred greater drawdowns but higher long-horizon returns. The exhibit below shows this trade-off explicitly for various allocation strategies and illustrates how much long-horizon return may need to be sacrificed in order to reduce the drawdown under a given scenario. For example, in the disinflation scenario, the drawdown could have been avoided by fully going into bonds (0/100 allocation) although this would have reduced the long-horizon return significantly. In the stagflation scenario, however, the drawdown was unavoidable: Bond yields increased, and equities fell during the early stages of the investment horizon. This is also the reason why the maximum drawdown is much more comparable across the various asset allocations in this scenario.
Trade-Off Between Drawdown and Long-Horizon Return for Various Allocations
Loading chart...
Please wait.
For long-horizon investors, there's a trade-off between short-term drawdowns and long-term returns. Risk-averse investors may seek to avoid short-term drawdowns, but may also be giving up potential market runs in a long-term scenario. Multiperiod scenarios, including both the initial shock and the longer-term recovery, allow investors to better assess this trade-off.
We used MSCI's BarraOne® Multi-Period Stress Testing module to propagate the shocks on the main risk factors to the entire portfolio. This allows us to model the impact of a scenario that plays out over time as opposed to a single-period or instantaneous shock. BarraOne also incorporates the reinvestment of income, rolling and rebalancing to the target allocation.
Further Reading
1Smith, C. and Rennison, J. "US election sucks air out of the reflation trade." Nov. 5, 2020.2Tett, G. "Investors should take heed of the inflation chatter." , Nov. 12, 2020.3U.S. Treasurys and high-yield bonds are represented by Markit iBoxx indexes. The equity market is represented by the MSCI USA Index and U.S. investment-grade corporate bonds by the MSCI USD Investment Grade Corporate Bond Index. Based on Nov. 5, 2020, market data.
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.