Scenario analysis can prepare investors for uncertain times by providing the necessary signals when considering a large number of possible market outcomes after a given period of time. As the global outlook remains clouded by geopolitical uncertainty, energy shortages and persistent global inflation, the charts could fall in several sequential ways, which will have broad implications for skittish asset markets that seek to extrapolate these developments, powered by algorithms and based on momentum. funds.
Results are in a few powerful hands
In our recent writings, we have spoken of the “stages of grief” for investors – who have been forced to accept a world without multiple policy support, as governments and central bankers aim to kill the inflation monster that fed on the pandemic.
We also hinted that the US Federal Reserve (as the world’s first central bank) would not “pivot” policy easily or quickly when financial market participants return to work after a scorching summer vacation in South America. North and Europe. The global outlook remains highly volatile, with several possible trajectories for asset markets all having reasonable probabilities.
A few influential people hold powerful cards for these outcomes (Putin, Xi, OPEC, Biden, Powell) and the sequence in which they can play these hands can have powerful effects in an economic and macro environment that will likely continue to slow more and more. more restrictive. policy until the end of the year.
Asset allocation based on scenario analysis
Thus, we view asset allocation as a series of scenarios with different probabilities. 2022 turns out to be such a complex year that it is not impossible for the low probability “tails” to occur simultaneously, which gives the scenario analysis table a very complex third dimension. It’s beyond the scope of this article for now, but consider the world in two dimensions on the five scenarios tabulated below – starting from our most likely and central case with possible outcomes (good and bad for the assets), then the extremes, low-probability events but high-impact contingencies for the markets.
Scenario analysis on a 12-month outlook
Source: Jamieson Coote Bonds
Intermediate scenario, the central case
Starting with the central scenario most expected by the markets, this assumes that energy will find a new valuation and a new trading range, which helps to mitigate inflationary effects as prices remain higher than in previous periods, but do not continue to rise (inflation is a concept of rate of change) . Goods inflation is moderating as supply chains continue to recover – this is already happening across the global economy – but the services side of inflation remains sticky from a market perspective. inflation, which prevents year-over-year inflation readings from moderating any faster.
Things like “rent” often have a mechanical legal contract component driven by past higher headline inflation readings that become somewhat self-perpetuating, making it imperative that central bankers kill inflation quickly by destroying inflation. demand in the economy via higher interest rates.
This result is currently being assessed by the markets, which expect inflation to moderate, with the US Federal Reserve continuing to hike rates towards the 3.75% zone before providing mild support with some rate cuts. in 2023.
We expect most assets to be range bound in this scenario, with a drift towards more “anti-risk” pricing as the economic picture continues to weaken from the previous policy adjustment that has not yet hit the economy due to its lagged effect (rate hikes typically take 6-12 months to show up in economic data). In this scenario, we assume most assets are already well priced, inflation remains well above mandate but declining, the US Federal Reserve continues to climb but at a slower pace, equities, credit spreads and bond yields reflect higher risk premia and volatility remains above historical backdrops.
Scenarios 2 and 4, the possibilities
On either side of this central scenario are “possible” outcomes, one better for asset prices and one less favorable.
It depends on energy pricing and its impact on inflation outcomes and therefore how much further tightening is needed to moderate demand in order to rebalance the economy. If we have additional exogenous shock events that drive up energy prices (e.g. Putin cuts off Russian gas during European winter or OPEC severely restricts oil flows), then the impact on the Inflation will force central banks to raise interest rates into restrictive territory, crushing asset values in the process and wiping out demand, causing a severe recession.
If central banks stay the course as inflation fighters, it would be unpleasant for bonds, as short-term bonds continue to move towards higher yields (lower prices). However, we would assume that long-term yields are becoming sticky and that bond total returns could hold up fairly well relative to other asset classes, as much of this has already been priced in for bond markets, helped by the current yield of 3.60% to maturity across the Australian Government Bond Asset Index.
This would be terrible for credit spreads as companies already facing weaker demand will be forced to refinance outstanding debt securities at much higher yields (costs) and in a low confidence market all companies less highly rated will not be able to effect such refinancing. . We would expect an increase in credit defaults, which in turn would rattle the equity complex. As we know, bonds would lead this process initially, but as we saw earlier this year, when other markets catch up, it can be quite violent.
Conversely, without an exogenous energy shock, the mirror image could be expected. Lower energy prices as supply comes online, reducing demand from already active monetary tightening, contributing to a faster moderation in inflation, allowing central bankers to pause and d to do “less”, which would be favorable to all asset classes.
In this case, we expect government bonds to post the lowest yields, while corporate credit and equities would benefit from less restrictive policies and volatility could moderate under more default assumptions. weaker than previously feared.
Scenarios 1 and 5, the extremes
At the extremes of our scenario analysis, we consider low-probability but high-impact possibilities.
First, a resolution of the Russia-Ukraine conflict would generate a powerful bullish move for assets, expecting lower volatility, abundant energy supply, lower inflation, and more. In this case, a full risk allocation would be the preferred outcome. Growth stocks and crypto assets are expected to rise. Credit would also benefit from this environment with an expected tightening of spreads and bonds would also perform, albeit subdued relative to other expected asset returns.
Second, at the other extreme, we assume a geopolitical flashpoint between the United States and China in the Taiwan Strait. This would likely cause panic and a strong “flight to quality” reaction from markets, which are generally very supportive of government bonds (especially US Treasuries) and volatility. Unfortunately, all other asset classes would be expected to perform poorly if we were to endure the scary prospect or global war. We don’t think it’s likely, but the probability is not zero.
Ability of government bonds to play an anchor role
With a lot of uncertainty ahead, diversified portfolio allocations seem to be navigating through a multitude of possible scenarios. With the restoration of yield in government bond markets, they will continue to play an anchor role through these uncertainties ahead and an important role in four of our five scenarios.
Charlie Jamieson is Managing Director and Chief Investment Officer of Jamieson Coote Bonds (JCB). This article contains general information only and does not take into account the situation of an investor.
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