The tariffs announced by the Trump administration on April 2 have increased market volatility, creating both risks and opportunities. Long-horizon investors may seek to exploit short-term views without straying too far from their long-horizon allocation.
In this blog post, we review alternative macro scenarios and establish a framework that allows investors to make allocation shifts in liquid assets based on the scenarios’ short-term expected returns, while limiting deviations from their long-term strategy. We take a total-portfolio approach that assesses all asset classes holistically and accounts for shared drivers of risk and return across public and private markets.
Assessing macroeconomic scenarios
After the announcement of the Trump administration’s tariffs package, economists revised their macroeconomic forecasts, cutting projected U.S. growth and raising inflation expectations. We model a stagflation scenario in which U.S. growth declines to 0% and inflation rises to 4.5% in 2025, in line with revised forecasts.[1] We also consider a recession scenario in which the U.S. economy contracts by 3%, and inflation falls slightly from 2.7% to 2.5% in 2025, with further drops in subsequent years.
The chart below shows expected one-year return by asset class under both scenarios.[2] In the stagflation scenario, inflation-linked bonds offer the most attractive return, while equity and real-estate assets sell off most sharply. U.S. equities — with stretched valuations — decline more than global-ex-U.S. equities. In the recession scenario, Treasurys, Treasury inflation-protected securities (TIPS) and investment-grade (IG) fixed-income assets deliver the highest returns, driven by rising prices as yields fall.
Short-term expected returns under our alternative macroeconomic scenarios
Implementing scenario-driven allocation shifts
To assess potential tactical shifts, we run two optimizations — one for each scenario — in which we maximize short-term expected return and minimize active risk (tracking error) relative to the original total-portfolio allocation, as shown in the chart below.[3] We keep the weight of illiquid asset classes fixed and apply a constraint on the average active-weight deviation of all other asset classes to prevent excessive reallocation and high portfolio turnover.[4]
Hypothetical long-horizon allocation
The chart below shows the trade-off between the incremental one-year return from the tactical shift and the tracking error relative to the long-horizon allocation. For illustration, we highlighted the point on the efficient frontier corresponding to 100 basis points (bps) of tracking error relative to the long-horizon allocation. Potential added return from tactical shifts to high-grade fixed income under the recession scenario is 2.0% for this level of active risk. On the other hand, because both nominal bonds and equities are forecast to experience flat or negative returns in the stagflation scenario, the potential gain from a tactical shift is lower, at 1.5%, for the same level of active risk.
Trade-off between additional expected return and tracking error
Next, we looked at the resulting tactical allocation changes for 100 bps of active risk. In the stagflation scenario, U.S. equity is cut sharply to fund shifts to international equity, IG credit and TIPS. In the recession scenario, exposure to equity and investment-grade credit is reduced to fund an increase in TIPS and Treasurys. The allocation shifts are broadly in line with the scenario’s expected returns. The reallocation from equities to fixed income leads to a reduction in total portfolio volatility, from 10.3% for the initial allocation to 9.6% for both the recession and stagflation allocations.[5]
Changes in allocation weights under the two scenarios for 100 basis points of tracking error
We outlined a process for shifting long-horizon allocation weights to address alternative macro scenarios and their potential impact on short-term expected returns. We took a total-portfolio approach and used the MSCI Multi-Asset Class Model to capture common drivers of risk and return across public and private markets. The initial long-horizon allocation serves as a benchmark, enabling tactical shifts while maintaining consistency with long-term objectives. This process offers a potential path for investors to position their multi-asset-class portfolios for short-term volatility, while staying close to their long-term asset allocation.
The authors thank Will Baker for his contributions to this blog post.