We use medium-term scenario analysis as a complement to the long-term valuation driven process (encapsulated in the Valuation Dashboard). We have often said that the ‘long-term often happens in the short-term’, or put another way ‘valuation can not matter for extended periods, until it suddenly does’. Looking at different scenarios helps us envisage the market mechanisms through which that might happen. 

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As we discuss in this week’s video, three years ago, in mid-2021, we considered three main scenarios:

1) ‘Fighting the Fed’ and positioning for rising inflation, 

2) Going with the flow and maintaining risk asset exposure and allocations to government bonds. 

3) A neutral ‘it’s all in the efficient market price’ stance. 

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At the time, the audience was split fairly evenly across these possibilities and in fact all three scenarios have held sway during that time and the ‘probability weighted’ estimated return actually turned out to be pretty much bang on! That meant that asset allocators had to be quite nimble. And as it turned out, active asset allocators who positioned themselves more defensively for the inflationary surge, significantly outperformed passive strategies over the subsequent three years, limiting drawdowns and generating superior risk-adjusted returns. This underscores the value of scenario planning - while the future is always uncertain, evaluating the possibilities and positioning accordingly can add meaningful value.

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Last week, we outlined four potential scenarios we are looking at in the most recent PCF Strategies Summit:

1) A bullish case driven by AI-fueled productivity gains and falling clean energy costs

2) A "muddle through" where the Fed engineers a soft landing

3) A hard recession caused by excessive monetary tightening

4) A stagflationary environment of weak growth and resurgent inflation

When polled, the audience leaned somewhat optimistic but ascribed non-trivial probabilities to the bearish cases. Preliminary probability-weighted return calculations point to a subdued 3-4% annual return for a balanced 60/40 portfolio, with significant dispersion between the bullish and bearish scenarios. 

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We believe scenario analysis is especially pertinent again today with some assets fairly fully valued after a strong run and seemingly quite sensitive to a change in outlook. Pockets of exuberance (like CBA in the local market as much as many US tech stocks?!) - may hint at overly optimistic sentiment and strong investment flows. The wide valuation disparities between global equity markets also spotlight the potential for active management to add value by leaning into cheaper assets. Maybe.

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Over the next few weeks, we plan to further develop these scenarios and evaluate the implications across asset classes and even down to a fund level. This will help identify the portfolio positioning and active tilts that can navigate the range of potential outcomes. To deepen your understanding now, download this explainer of how the next 3 years could play out in each of the scenarios. 

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While the future remains as uncertain as ever, a scenario-based approach can provide a structured framework to assess the possibilities and invest accordingly. As Mike Tyson famously said ‘everyone has a plan until they get punched in the face’ so you might as well make a few different plans.