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Monika Szikszai

Monika Szikszai
Associate, MSCI Research

Thomas Verbraken

Thomas Verbraken
Executive Director, MSCI Research

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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.

 

Will inflation rear its ugly head in the U.S.? Although the outcome of the U.S. elections might have lowered inflation expectations,1 investors may still wish to prepare for scenarios where inflation goes up.2 In this blog post, we examine three hypothetical multiperiod scenarios for inflation, corresponding to reflation, disinflation and stagflation regimes. In each scenario, market factors initially diverge but inflation reverses back to its long-term average in the long run, allowing markets to recover. Running such multiperiod stress tests, combining a shock and recovery path, can help long-horizon investors assess the trade-off between short-term drawdown and long-term returns.

 

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

 

 

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

 

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

 

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.

 

1Smith, C. and Rennison, J. "US election sucks air out of the reflation trade." Financial Times, Nov. 5, 2020.

2Tett, G. "Investors should take heed of the inflation chatter." Financial Times, 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.

4We 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

Stress Testing Inflation Scenarios

Will Interest Rates Surge? Evidence from Options Markets

US inflation: The market’s implied view

Regulation