Like all imperial capitals throughout history, Washington DC has a cynical streak. Last week, the buzz at the International Monetary Fund/World Bank gatherings I attended noted (with irony) that Iran’s strike on Israeli soil was clearly audible even 10,000km away, in the US Congress. After months of legislative stalemate, a rare bipartisan coalition enabled Congress to enact a sweeping set of measures that include aid to Israel, Ukraine, Taiwan, and Indo-Pacific allies, as well as additional sanctions on China, Russia, and Iran.
It’s too soon to say if recent events mark a turning point in world history, or indeed whether the upward surprise in US inflation marks a turn in the macroeconomic trend. But as investors, we have no choice but to navigate portfolios through a volatile and complex geopolitical and macroeconomic environment full of “butterfly effects” that don’t care about earnings forecasts or valuation metrics.
Still, we find that a grounding in scenario analysis, built on understanding the most probable drivers of future market outcomes, is the best tool to help set our asset allocations. In the rest of this letter, I present our latest scenario analysis and what we think it means for investors.
In our base case, we expect US inflation to gradually resume its downward trend, falling to 3% by the end of the third quarter. Although Federal Reserve officials have indicated there is no urgency to cut interest rates, we think they will be able to make a first reduction in September. Meanwhile, we think the conflict in the Middle East will stay geographically contained. We think this scenario is consistent with the S&P 500 rising to 5,200 by year-end, and the 10-year Treasury yield falling to 3.85%.
Our bear case scenario would see a combination of “too good” US growth, worries about US fiscal policy, and/or a sustained commodity price shock driving the 10-year Treasury yield to 6%. We would expect the S&P 500 to fall to around 4,400 in such a scenario. A bull case scenario would depend on optimism about artificial intelligence building further, at the same time as US growth stays robust and inflation resumes a downward trajectory. This could support a rise in the S&P 500 toward 5,500, in our view, despite the 10-year Treasury yield climbing to 5%.
What do these scenarios mean for investors? We see the overall risk-return outlook for equities as balanced, and therefore think investors should hold equity allocations close to strategic benchmarks. Within equities, we see better opportunities below the index level in quality stocks, including technology. We also expect small-caps to outperform.
High-quality bonds are our preferred asset class. Quality bonds have value in a portfolio context given the likelihood that they would rally sharply in case of a recession, even if we see this outcome as unlikely over our tactical investment horizon. Interest rate expectations would have to rise significantly from here for investors to earn a negative return, and in our base case we expect total returns of around 10% for quality bonds by year-end (10-year Treasuries, based on yields as of the 24 April close).
Meanwhile, an allocation to alternatives can help investors diversify and manage risks across scenarios. Our bear case would likely be negative for both bonds and equities, and hedge fund strategies like macro and equity-market neutral could help stabilize portfolios in such a scenario.
A likely undersupplied market underpins our positive view on oil, and we also see scope for gold prices to rise further by the end of the year. Both also have value in a portfolio context, particularly to help hedge geopolitical risks.
