Tariffs Raise the Specter of Stagflation: Three Macro Scenarios

Economists have cut growth forecasts and raised inflation expectations since the U.S. tariff announcement on April 2.^[1] For multi-asset-class investors, the key question is how shifting macroeconomic expectations could affect asset prices — and how that effect compares to the recent sell-off. Under our worst-case scenario of an inflationary recession — a sharp economic contraction coupled with surging inflation — equity-market losses from before the April 2 tariffs announcement could amount to nearly 35%. The decline for a diversified portfolio of global equities, U.S. bonds and real estate — measured from that same date — could reach 19%.

Three forward-looking macroeconomic scenarios

We define three macroeconomic scenarios relative to the start-of-year baseline of robust U.S. growth and declining inflation:^[2]

• In the stagflation scenario, economic growth falls to 0% while inflation rises by 200 basis points, amid supply shocks and trade fragmentation. To combat high inflation, the central bank raises rates, which weighs on growth longer term.
• The recession scenario assumes an economic contraction of 3%, while slowing demand reduces inflationary pressures. The Federal Reserve has room to cut interest rates, and growth recovers faster than in the stagflation scenario.
• Our worst-case scenario combines a recession and high inflation. Despite a sharp economic contraction, persistent trade disruptions sustain inflationary pressures and push interest rates up, like the oil-price shocks during the stagflation of the 1970s, when recessions coincided with high inflation.^[3]

Growth and inflation under our scenarios

The charts below compare the scenarios’ market impact to recent market performance. Despite the recent sell-off, equity markets may face significant further losses — particularly in our worst-case scenario — while government bonds may decline in our scenarios with inflationary pressures. The macro scenarios capture repricing based on shifting macroeconomic expectations, but do not account for the currently elevated U.S. equity-market valuation relative to history. A valuation-driven drawdown could further amplify equity losses.

Room for further losses under our macro scenarios

Impact on multi-asset-class portfolios

To assess the scenarios’ impact on multi-asset-class portfolios, we used MSCI’s predictive stress-testing framework and applied the shocks from the table below to a hypothetical global diversified portfolio, consisting of global equities, U.S. bonds and real estate.^[4]

Broad US market shocks under our scenarios

The portfolio lost 19% in our worst-case “recession and high inflation” scenario, as growth shocks weigh on equities while increasing interest rates hurt bonds, typical for a stagflation environment, as discussed in our previous blog post. The stagflation scenario resulted in a similar, but milder loss of 13%. By contrast, in the recession scenario, rallying bonds offset equities, reducing the portfolio’s loss to 9%. This underscores that bonds can help limit losses during recessions — but only when inflationary pressures are absent.

Changes to portfolio values under our scenarios

Is there any upside?

Our adverse scenarios are framed relative to the baseline macro scenario at the start of the year, which featured robust growth and declining inflation. In contrast, an optimistic scenario may assume a return to the baseline macroeconomic outlook. The chart below shows the potential impact of a reversal from April 15 to the Feb. 19 market peak. We compare this with the additional losses that could occur under our macroeconomic scenarios, accounting for market movements during the same period.^[5]

What a market reversal could mean — and the room for further losses

We illustrated a framework to help investors understand how shifting macroeconomic expectations could affect portfolios. In particular, the combination of declining growth with surging inflation — at a time when there may not be a “Powell put” — could hurt multi-asset-class portfolios.

The authors thank Will Baker and Leo Fischler for their contributions to this blog post.