During the Asset Class Outlook Roundtable 2024 at the PCF Strategy Summit in Sydney last week, the panel analysed four economic scenarios. Scenario analysis is helpful because it allows us to prepare for a range of possible future outcomes, rather than relying on a single prediction. It helps identify potential risks and opportunities, enabling more informed decision-making. Additionally, it encourages flexibility and adaptability in portfolio management, ensuring strategies remain resilient under varying economic conditions.

Economist Andrew Hunt & Dominique Dwor-Frecaut outline the key indicators and their potential outcomes. They are:

‍

1. A Bullish AI/Energy Driven Productivity Boom

Productivity enhancements from AI and other technological innovations could significantly boost real incomes and alleviate social tensions.

‍Indicators

- Disinflation dynamics from pre-pandemic era reassert as goods prices fall and worker bargaining power declines

- Inflation durably contained to target levels without need for recession

- Fiscal prudence and strong growth solve government debt burdens over time

‍Potential Outcomes 

- Equities and bonds both perform well in low inflation, high growth environment

- Australia and New Zealand benefit from strong global demand and rising commodity prices, supporting income growth and investment

‍

2. A  "Muddle Through" where central banks land the economy

Central banks opt for a cautious approach, tolerating moderate inflation levels without decisive action, which introduces policy uncertainty.

Indicators:

- Central banks tolerate 2.5-3% inflation without decisive action, causing policy uncertainty

- Periodic inflation scares and volatility spikes as markets doubt central bank resolve

- China offsets some inflation in the West through exporting deflation, but trade tensions limit impact

- Governments employ fiscal tools to stimulate growth ahead of key elections, followed by gradual fiscal consolidation.

Potential Outcomes:

- Growth slows but rebounds by late 2025, bond yields rise then fall, equities range bound

- Long-term winners in equities but index returns muted, favours active stock picking

- Australia and New Zealand navigate a middle path of moderate growth and inflation, with policy settings gradually normalising but remaining accommodative

‍

3. A Bearish Debt Deflation Spiral

A series of financial shocks and geopolitical tensions lead to a significant deflationary spiral, affecting global economies and financial markets.

Indicators

- Private credit bust and liquidity withdrawal trigger severe asset price deflation

- Geopolitical shocks also expose fragilities, exacerbating drive credit crunch

- Job losses and deleveraging cause aggregate demand to contract sharply

Potential Outcomes:

- Inflation falls below zero as economy gets stuck in deflationary trap

- Central banks expand QE to absorb government debt issuance and cap yields

- Explicit yield curve control targets implemented to ensure accommodative conditions

- Liquidity backstops extended to a wide range of credit markets to unfreeze lending

- Australia and New Zealand face deep recessions as global demand collapses and deflationary pressures intensify, forcing aggressive policy easing

‍

4. Stagflation - Short-term gain, long-term pain 

Loose financial policies temporarily prop up the economy, leading to inflationary pressures that eventually trigger a recession.

Indicators

- Pre-election spending and loose financial conditions delay downturn but boost inflation

- Corporate margins squeezed as input costs rise faster than pricing power

- Central banks hike aggressively to contain inflation, tipping economy into recession

‍Potential Outcomes:

- Inflation proves sticky as expectations de-anchor and de-globalization disrupts supply chains

- Antitrust policies perversely boost prices by weakening mega-firms' ability to squeeze suppliers

- Central banks force recession to control inflation, causing severe wealth destruction

- Private credit boom turns to bust as rising carry costs prove unsustainable, infecting public markets

- Australia and New Zealand grapple with weakening growth and persistent inflation, challenging the policy framework and eroding living standards

‍

Conclusion

The panel rated the 'Muddle Through' scenario as the most probable but didn’t dismiss the Bullish scenario. Yet, as insights from the previous year remind us, these scenarios are just tools to help us think about what could happen, not predictions of what will happen. Through this uncertainty, diversification becomes a powerful approach.  By spreading and dynamically managing investments across different types of assets and locations, portfolios can better manage risks and take advantage of opportunities. We are currently working through asset allocation, product implications and scenario implications at what this means at a fund level in our portfolios.  

Next week we will be working through the content and outcomes from the PCF Strategies Summit and specifically applying some probabilities to the scenarios and how they impact underlying investment strategies, watch this space.