As the Covid crisis continues, the economic outlook is more uncertain than at any point in the last decade. To help our clients with their long-term asset allocation, we have identified six possible macroeconomic scenarios. Assigning a probability to each of these helps us to forecast returns for different asset classes. So what are these scenarios, and what is the likelihood of each?
1. Back to the new normal.
This is our base case. We think it has a 35% chance of occurring. In this scenario, the global economy broadly returns to its pre-Covid state. Trend growth rates and the equilibrium interest rate (the rate at which supply and demand for money are equal) resemble the ‘new normal’ of secular stagnation that followed the global financial crisis. Average inflation is lower. By 2025, real growth settles at a trend level of 1.8% and consumer-price inflation at 2%.
But while this is our starting point, we see an even chance of scenarios in which inflation is either higher or lower.
2. Central-bank rethink
In this more inflationary scenario, the Covid crisis prompts central bankers to reassess the monetary framework. The authorities attempt controlled reflation through coordinated fiscal and monetary stimulus – sometimes called ‘helicopter money’. This allows the economy to recover and eventually creates excess demand, which drives up inflation. However, central banks are still committed to keeping prices stable in the long run, so inflation and inflation expectations remain anchored. Growth reaches 2.4% in 2025, with consumer-price inflation at 3.3%. Stimulus continues, keeping nominal rates at 1% – well below the equilibrium rate of 3.5%.
This scenario is broadly in keeping with the policy moves we have seen from some central banks, including the US Federal Reserve (Fed). However, we view the Fed’s policy review as too timid to drive inflation expectations much higher. That’s why we put the probability of this scenario at no more than 20%.
3. Lowflation acquiescence
The institutional conservatism of central banks explains the most likely disinflationary scenario. Here, inflation continues to fall below the base case, but central banks accept it rather than fight it. They think that the adverse effects of further stimulus outweigh the benefits and don’t pursue reflation. So we settle into a lower-inflation regime. Growth is 1.3% in 2025 and inflation 1.3%. With the Fed no longer trying to stimulate the economy, its interest rates are at 1%, above the equilibrium rate of 0.8%.
We give this scenario a 20% probability. Given persistently weak demand and the constraints of existing policy frameworks, central banks and governments may accept that much lower inflation is here to stay. Indeed, policymakers in the Eurozone and Japan already seem to be heading in this direction.
4. Deflationary slump
In the most extreme disinflationary scenario, the crisis lowers trend growth, equilibrium interest rates and inflation even further. This leads to ‘secular stagnation on steroids’. Either because the virus becomes endemic and social distancing permanently constrain economic activity, or because behavioural changes outlive the virus, the global economy is held back well into the future. Central banks do little to fight this. Growth is a meagre 0.5% in 2025 with inflation at 0%, reflecting both deep disinflationary trends and the difficulty of generating sustained deflation. We give this outcome a 12.5% probability.
5. Productivity rebound
In this scenario, inflation is slightly higher, thanks to positive news from the supply side. The crisis spurs a new wave of innovations, increasing productivity growth and the trend growth rate. Equilibrium interest rates rise. Because this is a supply-side driven improvement, inflation does not take off, although central banks would have more room to achieve their inflation targets. The equilibrium policy rate would increase to 3% with the US policy rate at just 2.5%. This would push growth up to 3% and inflation to 2.3%. Given our somewhat pessimistic assessment of the future of globalisation and the ways crises tend to both spur and harm innovation in subtle ways, we give this a relatively low probability of 7.5%.
6. Full fiscal dominance
Our final scenario entails much higher inflation, with the Covid crisis fundamentally altering the balance between monetary and fiscal policy. Fiscal policy becomes the main tool of macroeconomic management, and governments, rather than central banks, set the price level. Monetary policy is kept highly accommodative and the central-bank balance sheet is used to fund government spending. Nominal interest rates rise only to match increases in inflation, which rises sharply, dragging inflation expectations up with it. After an initial spurt, growth declines, as high and volatile prices weigh on economic activity. So real growth in 2025 is only 1%, with inflation at 6%. Real interest rates are at -5.5% – far too low to choke off the inflationary spiral. But we put the chances of this happening at just 5%.
All in all, the key change since Covid is that the most probable outcome is now much less likely than in the past. So we must acknowledge that there is a higher likelihood of a more inflationary or disinflationary scenario than there is of a continuation of the post-2008 ‘new normal’. And we must prepare our clients’ portfolios accordingly. In the post-Covid world, astute asset allocation and smart security selection will be more important than ever.
In our next article, The outlook for assets in the post-Covid world, we look at what these scenarios mean for the main asset classes.