- The optimism at the beginning of the year has shifted, as economists and investors increasingly fear a recession in 2023.
- Central banks find themselves in a difficult spot, having to balance financial stability and the fight against inflation.
- Our updated scenarios for the coming year include a “soft landing,” with a 3% gain for a diversified portfolio; “hard landing,” with a flat return; and “mild stagflation,” with a 6% loss.
In the wake of the banking turmoil, which continued earlier this week with the collapse of First Republic Bank, a “soft landing” seems less likely than at the beginning of the year. The minutes from the Federal Open Market Committee’s March meeting reveal the Federal Reserve’s projections included a mild recession starting later this year. We revised our four scenarios for 2023 to account for updated economic forecasts and recent market shifts. Under our “hard landing” scenario, a diversified portfolio of global stocks and U.S. bonds could stay flat over the next year, as equity losses offset bond gains. Instead, if a soft landing were still to be achieved, that same portfolio could gain 3%. Although the threat of entrenched inflation seems to have receded somewhat, it still poses a risk to portfolio returns, with potential losses of 6% over the next year under our “mild stagflation” scenario.
Between a rock and a hard place
The optimism investors felt at the beginning of the year has been replaced by realism, amid sticky inflation and turbulence in the banking industry. The International Monetary Fund stated in its April World Economic Outlook that the likelihood of a hard landing has risen sharply.1 Fed Chair Jay Powell suggested that tighter credit conditions following the banking turmoil could weigh on economic activity, hiring and inflation.2 The risk for policy mistakes is two-sided: overtightening the economy into a recession or not tightening enough and risking entrenched inflation. The exhibit below shows how bond-market-implied expectations are — perhaps excessively — optimistic, with inflation expectations for early next year close to the Fed’s target, while rate cuts are anticipated in the second half of this year. A group of economists polled by the Wall Street Journal have different expectations, however, suggesting that inflation may be stickier and that the Fed pivot may occur later than anticipated, at the start of 2024.3
Market-implied expectations point to Fed pivot
Market-implied expectations for the federal-funds rate and U.S. inflation are derived from the MSCI USD overnight-index-spread curve and MSCI USD breakeven-inflation curve, respectively. Data as of May 3, 2023.
Against this background of quickly shifting macroeconomic expectations, we revisited and slightly updated the four narratives outlined in our previous blog post:4
- Soft landing: Interest rates remain high as inflation comes down in line with the Fed’s expectation. Economic growth in the U.S. and eurozone is weak but slightly positive. No additional global downside risks materialize. The U.S. dollar slightly depreciates.
- 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. The Fed’s pivot in response to the recession weakens the U.S. dollar.
- Mild stagflation: Central-bank policy does not efficiently tame inflation, eroding central banks’ credibility, and inflation becomes entrenched. High prices and interest rates weigh on growth for an extended period. The U.S. dollar strengthens, putting pressure on emerging-market economies.
- Strong rebound: Inflation is under control and falls more than economists’ consensus expectation, while economic growth surprises on the upside. Current global headwinds get resolved and supply-chain issues ease.
Four paths for US growth and inflation
We used the MSCI Macro-Finance Model to develop different trajectories for the U.S. economy outlined in the exhibit above. Apart from shifting one quarter in time and incorporating updated economic and market data, the most significant change compared to the previous set of scenarios is that the “hard landing” scenario now reflects a slightly deeper recession. The full scenario definitions, complemented with other regional and asset-class assumptions, is shown in the exhibit below.
Our scenario assumptions
Scenario assumptions are informed by the MSCI Macro-Finance Model, analysis of historical data and subjective judgment. These are not forecasts, but hypothetical narratives of how the macroeconomic scenarios could affect multi-asset-class portfolios over the horizon of one year. Breakeven inflation (BEI), bond yields and credit spreads measured in basis points (bps).
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.5 For such a portfolio, the impact of a soft landing was a 3% gain. Under the more bearish hard landing, the portfolio’s returns stayed flat, which may seem counterintuitive for what is considered a bad scenario. However, the bonds in the portfolio rally because of the significant decrease in nominal rates, while equities do not take a large hit.6 The “mild stagflation” scenario, with high interest rates and inflation, proved worse for our portfolio, with a 6% loss, as bonds and equities are hurt at the same time. The exhibit below shows more-detailed results.
Impact across asset classes under our scenarios
Portfolio impact of the scenarios based on market data as of April 26, 2023. Note that the stress-test results capture the effect of repricing of the assets, not the income component. U.S. Treasurys and Treasury inflation-protected securities are represented by Markit iBoxx indexes. 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.
Mind the risks
Stubbornly high inflation, uncertainty about the path forward for monetary policy and potential financial instability are all contributing to portfolio risks. The four scenarios outlined in this blog post cover a range of plausible outcomes and could help investors assess the impact to their portfolios.
The authors thank Raman Subramanian and Dora Pribeli for their contributions to this blog post.
1“A Rocky Recovery.” IMF World Economic Outlook, April 2023.
2“Transcript of Chair Powell’s Press Conference.” Federal Reserve, May 5, 2023.
3Gabriel Rubin and Anthony Debarros. “Economists Turn More Pessimistic on Inflation.” Wall Street Journal, April 15, 2023.
4We renamed the previous “baseline” scenario “soft landing” to avoid the perception that we consider this scenario the most likely outcome.
5The 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.
6The relatively mild equity loss can be explained by three things: 1) The recession we assumed in our scenario is not very deep; 2) the return horizon of the scenario is one year, after which the worst of the recession is behind us and the recovery ahead; and 3) the decrease in interest rates, caused by the Fed pivot, and lower inflation also support equity prices.
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