After the Federal Reserve cut the policy rate by 50 basis points (bps) last month and indicated that further reductions were likely, the equity market rallied, reflecting investor confidence in the Fed's ability to engineer a soft landing.[1] But the sell-offs in August and September — when U.S. equities declined by 6.2% and 4.3%, respectively — signaled potential investor concerns about an economic slowdown. What are the potential outcomes for investors to consider?
In our hard-landing scenario, which assumes a GDP contraction and declining inflation, U.S. equities could drop by 14%, while a diversified portfolio of global stocks and U.S. bonds might fall by 6%. In the scenario of resurgent inflation, this portfolio could lose 8%, as both bonds and equities sell off simultaneously.
Soft-landing baseline scenario, with downside risks
In the exhibit below, we present four macroeconomic scenarios, each offering potential trajectories for growth and inflation. The MSCI baseline scenario anticipates a moderate slowdown in GDP growth and gradual decline in inflation, pointing to a possible soft landing as monetary-policy measures take effect. Downside risks remain, however, with the hard-landing scenario — in which we assume GDP will contract by 0.4% a year from now, compared to 1.3% growth under the MSCI baseline. There is also the risk of inflation resurgence, where rising prices could lead to stagnant growth and increased pressure on interest rates. We also consider an upside scenario, where enhanced productivity drives robust growth without adding inflationary pressures.[2]
GDP and inflation under our scenarios
First, we assessed five-year capital-market assumptions for various U.S. asset classes under the MSCI baseline scenario. As inflation gradually declines and growth remains positive, U.S. equities are expected to generate a five-year annualized return of 7.1%, while investment-grade and high-yield credit are projected to return slightly less. Nominal and inflation-linked sovereign bonds, meanwhile, could deliver solid returns exceeding 4%.
Assumptions for US capital markets under the MSCI baseline scenario
Slowdown fears jittered markets
The sell-offs in August and September — when the MSCI USA Index declined by 6.2% and 4.3%, respectively — suggested investor concerns about a potential hard landing. Since then, the U.S. stock market has shown resilience and rallied after the Fed’s 50-bp rate cut. The one-year U.S. Treasury yield, sensitive to Fed policy, dropped by approximately 90 bps since the end of July, and market prices are now implying 75 basis points of additional rate cuts by the end of the year. Some argue that the “dis-inverting” of the yield curve may also be the harbinger of recession this time around.[3] The scenarios outlined above allow investors to assess alternative scenarios to the baseline, like a hard landing or inflation resurgence. A shift from the MSCI baseline to one of the stressed scenarios would trigger an “instantaneous” repricing. The narratives and immediate market shocks under these alternative scenarios are illustrated in the exhibit below.
Our scenario assumptions
Potential implications for financial portfolios
To evaluate the impact of these scenarios 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 and U.S. bonds and real estate.[4] Under the hard-landing scenario, the portfolio’s value dropped by 6%, with rallying bonds offsetting the equity sell-off. The inflation-resurgence scenario had the most severe impact, resulting in an 8% loss, as both bonds and equities traded down simultaneously. In our most optimistic, increased-productivity scenario, the portfolio gained 7%.[5] The exhibit below provides more detailed results.
Impact to portfolio values under our scenarios
Summing up
While MSCI’s baseline scenario implies moderate growth, receding inflation and expected returns in line with long-term averages for equity markets, recent market volatility suggests investors remain on edge. Our alternative scenarios help put potential market impacts into perspective.
The authors thank Will Baker for his contributions to this blog post.