Stagflation, reflation, soft landing, or slump?

We analyze each of these potential scenarios, how we might get there, their likelihood, and the market implications.

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Equity and bond markets are driven by stories, hopes, and fears about the future path of growth and inflation. The story of the first half of 2022 has been one of “stagflation,” with fears that the Federal Reserve will need to hike rates faster and further to contain inflation driving bond yields higher and equities lower.

The question now is what story will drive the market over the second half of the year: “Stagflation,” “reflation,” “soft landing,” or “slump”? And how will markets react? Now that Fed officials have indicated how closely they are watching and reacting to monthly CPI prints, each inflation data point will likely cause volatility. Yet it will take several months of data, at a minimum, for the market to gain some clarity on what narrative will dominate the second half of 2022. We want to be prepared for that volatility as it presents both risk and opportunity.

In this letter, we analyze each of these potential scenarios, how we might get there, their likelihood, and the market implications. We also map our investment ideas against each scenario.

Four scenarios that could drive the market

 

 

Current

Current

Soft landing

Soft landing

Slump

Slump

Stagflation

Stagflation

Reflation

Reflation

 

S&P 500

S&P 500

Current

3,760

Soft landing

3,900

Slump

3,300

Stagflation

3,300

Reflation

4,500

 

10-year yield
   Breakeven
   Real

10-year yield
   Breakeven
   Real

Current

3.16%
2.54%
0.61%

Soft landing

3.25%
2.75%
0.5%

Slump

1.5%
1.75%
-0.25%

Stagflation

4%
3%
1%

Reflation

3%
3%
0%

 

Equity risk premium

Equity risk premium

Current

306bps

Soft landing

278bps

Slump

426bps

Stagflation

312bps

Reflation

260bps

 

Implied forward P/E

Implied forward P/E

Current

15.9x

Soft landing

16.6x

Slump

17.4x

Stagflation

14x

Reflation

17.9x

 

Forward earnings per share

Forward earnings per share

Current

USD 231*

Soft landing

USD 235

Slump

USD 190

Stagflation

USD 235

Reflation

USD 252

 

Earnings growth (y/y)

Earnings growth (y/y)

Current

 

Soft landing

3.5%

Slump

-16.3%

Stagflation

3.5%

Reflation

11%

 

Probability

Probability

Current

 

Soft landing

40%

Slump

30%

Stagflation

20%

Reflation

10%

This is not a market to position for any one scenario with high conviction. As always, our goal is to build a robust portfolio that can help protect and grow wealth under a wide range of scenarios.

In our own portfolios, we use these scenarios to uncover a broader set of investment opportunities across asset classes or structures. This helps us respond with portfolio actions when volatility creates opportunities.

We think investors looking to build a robust portfolio should take the following progressive steps:


First, to manage portfolio risks in the event of the “stagflation” narrative continuing to drive markets, investors should build and manage a Liquidity1 strategy portfolio, sized to meet 3–5 years of cash flow needs. This will likely consist of a mix of cash, cash alternatives, and short-duration bonds. Investors should also consider an adequate allocation to hedge funds, which have the potential to deliver performance even if both bonds and equities are falling.

Second, to build up defenses against a potential “slump,” in which lower corporate profit expectations drive weakness in stocks, we believe investors should add exposure to quality-income stocks, the healthcare sector, resilient credit, and the Swiss franc. Capital-protected strategies may also allow investors to use volatility to work in their favor and mitigate potential downside risks.

Third, invest in value, including energy stocks and UK equities. We think value would perform particularly well in our “soft landing” scenario as increased confidence that corporate earnings can stay resilient benefits some of value’s cyclical sectors, such as financials and energy. Inflation above 3% also supports the style. We also like stocks linked to the “era of security.” As governments and businesses aim to bolster energy, data, and food security, we think this will spur demand for carbon-zero, cybersecurity, and agricultural yield solutions.

Fourth, and finally, consider using the sell-off to build longer-term positions. A quicker-than-expected alleviation of market concerns about inflation could trigger a rally in certain growth stocks, even if this remains a low-probability scenario at this stage. Meanwhile, investing in private equity following public market declines has historically been associated with strong returns: The average annual return on global growth buyout funds launched a year after a peak in global equities has been 18.6%, according to Cambridge Associates’ data since 1995.

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