The International Monetary Fund[1] suggests that “the global economy is poised for a soft landing,” despite regional disparities and the weaker or negative growth observed in Europe and Japan. Equity markets have performed strikingly well in the first quarter of this year, with the MSCI USA Investable Market Index (IMI) and MSCI ACWI IMI (our flagship global equity index) up by 9.6% and 7.4%. U.S. credit spreads remain tight when compared to historical standards.[2] This raises the question whether markets are “priced for perfection,” and how potential negative news could impact portfolio values. Compared to the previous quarter, the expected return on equities has decreased, while our downside scenarios of a “hard landing” and “inflation resurgence” now indicate more-severe impacts on the value of a diversified portfolio of global stocks and U.S. bonds, with projected losses of 7% and 11%, according to our model.
Equity investors optimistic
According to a recent survey,[3] economists’ confidence in a U.S. soft landing rose compared to the same poll in December. With U.S. stocks at an all-time high and U.S. credit spreads at some of their tightest levels since the 2008 global financial crisis (GFC), it appears that equity investors share the belief in the Federal Reserve’s ability to avert recession. Furthermore, as we recently discussed, equity-volatility metrics such as implied volatility, implied-volatility skew and put-option premia are at five-year lows, implying less investor concern about drawdowns and surging volatility in the near term. The prospect of higher rates for longer — also suggested by the economist survey — does not seem to scare equity investors as much as it did last year.[4] The big question is whether equity investors might be too optimistic in the face of high valuations and concentration, and whether markets are priced for perfection.
We revised our four scenarios for 2024, accounting for updated economic forecasts and recent market shifts. We used the MSCI Macro-Finance Model to assess one-year expected returns under the soft-landing scenario, in which the Federal Reserve successfully gets inflation under control while avoiding recession. We then compared the returns to the historical model-implied baseline expected returns. The exhibit below shows that U.S. government and investment-grade bonds remain attractive compared to the past 25 years. Equities’ expected returns decreased compared to the previous quarter and are now at the lower end of the one-sigma bounds, while high-yield bonds’ expected returns are at their 25-year average.
One-year expected returns for major US asset classes under the baseline soft-landing scenario
Stress testing the soft landing
Despite the optimism about a soft landing, cautious investors may want to assess alternative downside scenarios — particularly because potential implications of downside risks have magnified due to the recent rally. We revisited the risk-factor shocks for three alternative scenarios, two reflecting downside risk and one upside opportunity:
- Hard landing: Overaggressive monetary policy effectively curbs inflation but at the cost of a U.S. recession in 2024. The Federal Reserve slashes rates to try to correct course. Equities fall steeply. Slowing demand puts downward pressure on oil prices.
- Inflation resurgence: Inflationary pressures resurface and oil prices surge, eroding central banks’ credibility. High prices and interest rates weigh on growth for an extended period.
- Increased productivity: Productivity growth — potentially fueled by AI — leads to robust growth without strong inflationary pressures. This scenario assumes AI’s downside risks are avoided.
The complete definitions of the scenarios, along with assumptions for other regions and asset classes, are shown in the following exhibit. Compared to the previous quarter, the potential losses in the equity market and corporate-bond spreads’ widening in the downside scenarios have intensified. The recent rally in riskier assets and high valuations in U.S. equity and corporate-bond markets have amplified the potential downside in case of negative events — be it a recession or a resurgence of inflation.
Our scenario assumptions
Potential implications for financial portfolios
To assess the scenarios’ impact on multi-asset-class portfolios, we used MSCI’s predictive stress-testing framework and applied it to a hypothetical global diversified portfolio, consisting of global equities, U.S. bonds and real estate.[5] The portfolio’s value gained 3% under the soft landing. Under the more bearish hard landing, the portfolio’s value dropped by 7% as rallying bonds offset the sell-off in equities. The inflation-resurgence scenario still hurts the portfolio most, with an 11% loss, as bonds and equities traded down simultaneously. Compared to the previous quarter, equities suffer more in the hard landing than in the inflation-resurgence scenario. In our most optimistic scenario, assuming AI’s positive impact, the portfolio gains 11%. The exhibit below shows more-detailed results.
Impact to portfolio values under our scenarios
After market rally, deeper downside risk?
The scenario of a U.S. soft landing still aligns most closely with current economic expectations, but given the recent equity rally and spread tightening, the downside risk of a hard landing or inflation resurgence has deepened.