A gradual uptick in the global economy, a series of winning moves by the world’s central banks or an error by policymakers are the three scenarios that would significantly influence investor portfolios during the coming five years, according to BMO Global Asset Management. 
In its 2016-2021 Global Investment Forum Five-Year Outlook, the group’s investment leaders and strategists highlight three scenarios that could come about in the near future as well as the assets to hold and avoid if each one takes place.
“Our longer-term view remains solidly constructive on further global economic growth. This is reflected in the 80 per cent cumulative probability we’ve assigned to our first two scenarios, especially our base case,” the report says.
“To be sure, the expansion, for some economies, is starting to show signs of maturity, and the intermediate window becomes problematic as it may likely encompass a recession. Overall, it’s a challenging environment, but one that can be navigated.”
In the following article, we take a close look at the three scenarios and explain how investors might consider reacting to them.
Firing on more than one cylinder – 60 per cent probability
This is BMO’s base case and revolves around the argument that decent economic growth will start to broaden out from the US to other parts of the globe, leading to a more balanced recovery from the great recession. This growth is in part down to continued lows in the prices in energy and commodities.
“In North America, our view is predicated on a belief that the US economy is a resilient engine and will continue to chug along with its modest growth trajectory,” BMO’s strategists said.
“In Asia, Japan, though at an early stage in the cycle, realises expansion potential, having put favourable policy change and structural reform in place to address – and contain – challenges. Europe, which has been much slower to recover from the global financial crisis of 2008, is on more solid footing. Given slow global growth, even a slight contribution from Europe could prove meaningful.”
The US job gains, which have been consistently robust over recent years and surprised analysts earlier this month after being much stronger than expected, is one encouraging sign that the world’s largest economy is on a good footing, as is continued firming in the housing market.
In Europe, BMO expects to see rigid austerity balanced with prudent fiscal stimulus, which could allow it to overcome issues such as Greek solvency, massive unemployment and a double-dip recession to get into a “more fulsome” recovery.
Rebound in eurozone PMI and GDP
Source: Capital Economics, BMO
This scenario also sees the structural changes made under Abenomics start to have a positive effect on Japan’s competitiveness, while the weaker yen continues to support the country’s manufacturing and export growth. Ideally, further stimulus allows Japan to cope with its high government debt-to-GDP ratio and adverse demographics are partly offset by higher female participation in the workforce.
When it comes to investments under this scenario, BMO’s positioning would be an overweight to equities relative to fixed income. Areas of focus would include non-resource cyclicals including information technology, financials, consumer discretionary and industrials in the US. Exposure to European and Japanese equities would also make sense, as would Indian stocks (owing to demographics and the country’s reform agenda) and commodity importers.
Overweights are also tipped for inflation-linked, investment grade and high yield debt, and bonds from peripheral Europe but underweights to emerging market debt, government bonds and short-dated bonds would be appropriate. In the alternatives space, infrastructure, property and private equity are highlighted.
Policy panacea – 20 per cent probability
This scenario involves a surprise to the upside with policymakers across the globe “getting it right” in both the short and intermediate terms. BMO highlights a number of potential catalysts that would cause this to happen, although not every one of them needs to occur for the ‘policy panacea’ to be seen.
“The US Federal Reserve begins to tighten interest rates in a well-communicated manner – and at a measured pace,” the firm said. “Markets acknowledge the initiative as a positive economic sign and respond accordingly: GDP growth is stimulated as businesses and manufacturers make capital investments; consumers ramp up spending, achieving previous on-trend GDP growth; and housing also firms to trend.”
In Europe, the European Central Bank stands by its commitment to do “whatever it takes” by keeping interest rates low and expanding quantitative easing. Aided by a cheaper euro and low energy costs, economic growth takes off and unemployment falls, while European government use this ‘growth dividend’ to lower debt and stick to sustainable budgets.
BMO adds that this scenario would see China remain the world’s best growth leader, with only minor errors being made in its attempt to restructure its economy, while India’s investment rate grows thanks to policy reforms and supportive demographics. Japan’s Abenomics policy is also successful in pushing inflation up to its 2 per cent target, which prompts a boost to consumer and corporate spending.
Japanese consumer sentiment
Source: Bloomberg, BMO
When it comes to investment implications, the group’s strategists say this scenario would be best captured through a “full ‘risk on’ asset class exposure”.
This would suggest US, European and Japanese equities in highly cyclical sectors such as energy, basic materials, information technology, consumer discretionary, industrials and financials; small-caps would also be preferred over large. Emerging market equities would also be in the spotlight, especially oil exporters like Russia, Brazil and Venezuela.
In bonds, inflation-linked debt would be preferred over sovereign bond and short-dated securities over longer- dated ones; emerging market and corporate debt wold also be attractive. Meanwhile, commodities and global macro strategies would be alternative investments expected to do well in these conditions.
Debt is a four-letter word – 20 per cent probability
While the previous scenario relies on policymakers getting things right, BMO’s final one is based around the “equally likely” event of a policy error causing a downside surprise.
“In this scenario, with a maturing expansion, tightening labour market and aggressively stimulative monetary policy, the US Federal Reserve walks a tightrope in that either acting too quickly, or failing to act in time, can have a potentially disastrous outcome,” the strategists said.
“The assumption by the Fed has been that it has the tools to deal with a re-emergence of inflation, but once that inflation genie is out of the bottle, it’s difficult to contain. If the central bank stays at the party too long, the downside surprise includes aggressive rate hikes – required to choke off reaccelerating inflation – and, ultimately, the overall impact on global GDP growth, which would have a tough time withstanding a retrenchment.”
Other events that could occur in this scenario include Chinese policymakers failing to repurpose the economy away from investment-led growth towards consumption-led. A hard landing occurs, which then spreads to other emerging market countries and, at its worst, causes a global recession led by Asia.
China GDP growth over 7yrs
Source: Bloomberg, BMO
Furthermore, it could be the case that Japan’s reforms fail and the country plunges further into deflation and recession because of adverse demographics, weak inflation and an inability to grow fast enough. In addition, if BMO’s belief that global debt is ultimately sustainable proves wrong, global growth could be squashed by debt.
Under this scenario, non-cyclical sectors like consumer staples, healthcare and telecoms would be the most attractive, along with US large-cap exposure and core eurozone nations such as Germany and the Netherlands. Sectors like energy, materials, consumer discretionary and information technology would likely be out of favour.
In the bond space, longer maturities would be more appealing than shorter while corporate bonds and emerging market debt would be avoided in favour of US treasuries and core European government bonds. Alternatives like gold, infrastructure and long/short strategies would also be in demand.
