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3 Economic Scenarios for Investors to Watch in Next 5 Years

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Over the five years from 2018 to 2023, there’s a healthy likelihood that the world’s economy will continue to grow at a steady pace with modest inflation, BMO Global Asset Management said Tuesday.

The five-year outlook emerged from BMO’s annual Global Investment Forum, which captures the views of a group of its international investment leaders and strategists stimulated by the input of independent experts.

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The discussion strives both to anticipate how a realistic set of events could unfold over the next five years, and to consider some of the possible extreme outcomes of these scenarios.

The report highlights three scenarios expected to play out over the next five years:

  • “Steady as she goes”
  • “Policymakers pull the punchbowl”
  • “Perfect policy prevails”

“The findings in this report reflect the key themes presented at our Global Investment Forum,” BMO’s chief executive and chief investment officer Richard Wilson said in a statement.

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“We believe that the report helps investors make sense of the world we are operating in, allowing them to feel more confident in making informed investment decisions.”

Here’s a closer look at the three scenarios.

Scenario #1: Steady as She Goes — 60% probability

BMO’s base-case scenario predicts that the global economy will steadily grow with modest inflation. The gradual withdrawal of quantitative easing and higher interest rates will likely to be tempered by muted inflation pressures and flexible markets, “reducing these headwinds to a gentle breeze rather than a disruptive gale.”

However, this relatively optimistic base case is preconditioned on Europe’s surpassing the U.S. and becoming the leader in the global growth race, able to enjoy several years of above-trend growth without hitting the labor supply buffer, in contrast to the U.S. where modest expansion has involved a significant reduction in unemployment.

Investment implications: With the world economy remaining in good shape and healthy profit margins being maintained, risk assets should generally thrive in this scenario. Gradual tightening by central banks is a mild headwind, which will limit overall returns. Government bonds are likely to underperform and with spreads apt to widen, corporate bonds could fare even worse.

Scenario #2: Policymakers Pull the Punchbowl — 30% probability

In 2018, the risk of a downside scenario has increased given concerns over policy errors. This second scenario suggests that global recession is a threat. Here’s why:

On the one hand, past monetary policy may have over stimulated the markets, possibly fueling further inflation, which might then coincide with the quantitative tapering and exaggerate its effect. This could lead the U.S. into a recession, followed by the rest of the world.

On the other hand, central banks may take an aggressive approach to unwinding. If tightening occurs too fast, the result could be an economic downturn, a squeeze in corporate profits and a global recession.

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Global fund managers polled by Bank of America Merrill Lynch in November cited a policy error from the Federal Reserve/European Central Bank as the biggest tail risk to the markets.

Investment implications: This recession-based scenario would ultimately involve a significant equity market correction and a bond rally. Government bonds could sell off in the early stages of the scenario as inflation and interest rates rise, before rallying hard as equities underperform — kick-starting a recession.

Scenario #3: Perfect Policy Prevails — 10% probability

This scenario suggests that central banks are successful at bringing economies back to full employment smoothly, without pushing up inflation. It also suggests that central bank balance sheets and interest rates are normalized in a deft manner, which ensures consistent market and investor behavior.

Investment implications: In this “perfect world;” risk assets perform strongly, and bonds come under only limited pressure. Volatility remains low.

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