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Thomas Verbraken

Thomas Verbraken

Executive Director, MSCI Research

Daniel Szabo

Daniel Szabo

Associate, MSCI Research

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Stress Testing Inflation Scenarios


  • Although market-implied inflation expectations indicate modest levels of inflation, market participants fear the potential of deflation or inflation occurring.
  • We propose four scenarios, from deflation to reflation to two stagflation outcomes, accounting explicitly for the movement in breakeven inflation and nominal and real rates.
  • Implications for a diversified portfolio of equities and bonds could range from returns of -13% to +9% for the deflation and reflation scenarios, respectively.

Although market-implied expectations indicate modest inflation, aggressive actions by central banks and soaring government budget deficits have raised concerns among some market participants that inflation may significantly rise; however, others fear the prospect of deflation occurring.1 We discuss four potential scenarios for inflation: a reflation scenario in which monetary and fiscal policy successfully stimulates the economy, a deflation scenario where disinflationary forces overpower and two stagflation scenarios where runaway inflation hits the economy with various severities. Implications for a diversified portfolio of equities and bonds could range from -13% to +9%, in the deflation and reflation scenarios, respectively.

Although the 10-year breakeven inflation (BEI) rate2 dropped very steeply during the depths of the COVID-19 crisis, down to about 0.4%, it is now back to the moderate levels observed at the beginning of the year. The 10-year real rate,3 on the other hand, moved largely in the opposite direction, spiking during March but steadily decreasing thereafter to around -1% due to the run-up in breakeven inflation and stable and low nominal rates. In fact, a significant part of the equity-market rebound observed since April can be accounted for by the drop in real rates (together with a reversal in risk premia). We propose four hypothetical scenarios for inflation in which we explicitly account for the movements of nominal, real and breakeven inflation rates.4


10-Year Real Rate and Breakeven Inflation

Source: MSCI


Four Hypothetical Scenarios for Inflation

  • Reflation: In this first scenario, monetary and fiscal policy proves to be successful and the stimulus brings the economy closer to its pre-COVID long-term trend growth. Nominal rates remain relatively stable, breakeven inflation picks up to levels slightly above 2% and the U.S. dollar strengthens. This is good news for U.S. equity markets: With real rates and risk premia decreasing further, they could gain around 16%.
  • Deflation: A grimmer scenario is one where 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. The U.S. equity market could lose around 23% in this scenario, with growth stocks underperforming the market.5
  • Inflation Overheating: In this scenario, inflation picks up slightly more than planned, which leads to disrupted economic growth and increases in nominal rates as the Fed reacts to rising inflation. U.S. equities benefit moderately from decreasing real rates with growth stocks benefiting more from declining real rates.
  • Stagflation: This scenario is a more extreme version of the previous one, with inflation going up even more. However, this scenario assumes the U.S. is impacted more severely than other regions as a result of more aggressive fiscal and monetary stimulus, which could lead to significant pressure on the U.S. dollar. Although real rates decline, growth disruption and uncertainty take the upper hand, pushing U.S. equities into slightly negative territory, resulting in a positive bond-equity correlation.


Macroeconomic and Market-Scenario Assumptions

Scenario Reflation Deflation Inflation Overheating Stagflation
2-Year BEI (bps) +100 -125 +200 +300
10-Year BEI (bps) +50 -75 +100 +150
10-Year Treasury (bps) +0 -50 +20 +60
EUR/USD -3.5% +1.5% +1.5% +10%
Credit Spreads

IG: -21%

HY: -25%

IG: +77%

HY: +54%

IG: 0%

HY: -1%

IG: +33%

HY: +27%


Economic growth picks up, real yields drop, risk premia subside. Growth stocks continue to outperform moderately.



Significant disruption of economic growth, real yields bounce back, risk premia jump. Growth stocks mostly give back their recent outperformance against the overall market.


Slight economic-growth disruption, real rates plunge. Growth stocks continue to outperform the rest of the market.




More significant implications for economic growth and risk premia. Very low real rates, but limited positive effects on growth stocks.



US Equities (Nominal) +16% -23% +6%



Source: MSCI


Implications for Multi-Asset-Class Portfolios

To assess the potential impact on global 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.6 Applying these scenarios to a hypothetical 60/40 portfolio of global equities and bonds indicated that such a portfolio would be hit hardest by the Deflation scenario (-13%) whereas the Reflation scenario would benefit this portfolio the most (+9%), according to our model. Under the Inflation Overheating and Stagflation scenarios, nominal bonds would lose as a result of rising inflation. The global equity market could offset these losses, resulting in a positive portfolio return, albeit nearly zero for the Stagflation scenario.


Potential Implications for a Hypothetical 60/40 Equity/Bond Portfolio and Its Components

Portfolio impact of the scenarios as of Sept. 18, 20, U.S. Treasurys and high-yield bonds are represented by Markit iBoxx indexes. The equity market is represented by the MSCI ACWI Index and U.S. investment-grade corporate bonds by the MSCI USD Investment Grade Corporate Bond Index. Based on Sept. 18, 2020, market data. Source: IHS Markit, MSCI


After the sharp market recovery following the COVID-related downturn, market participants are increasingly focused on the future course of inflation. Our four inflation scenarios help investors compare a variety of what-if scenarios and their potential impacts to portfolios.


The authors thank Juan Sampieri for his contributions to this blog post.


1Stubbington, T. "Divided investors caught in inflation confusion." Financial Times, Aug. 24, 2020.

2Breakeven inflation rates are calibrated using prices on U.S. nominal Treasurys and U.S. Treasury inflation-protected securities..

3The 10-year real rate is computed as the 10-year nominal Treasury rate minus the 10-year breakeven-inflation rate.

4In our analysis, the impact on returns from the Federal Reserve’s monetary policy is not measured at a specific point in time. Instead, our analysis aims to measure the cumulative impact up to the date when the market perceives that a specific scenario has been realized. This process may take months, as market participants analyze economic data and assess the Fed’s behavior.

5Our stress test assumes that growth stocks react more strongly to changes in real rates because of the longer duration of their cash flows.

6The 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

Hedging Inflation: A Scorecard

US inflation: The market’s implied view

Believe the Hype Around the Fed’s Inflation Announcement? MSCI Perspectives Podcast