Part I: Deterministic scenario projections

We present four sets of projections of the economy and capital markets.

Real GDP in the US peaked in the fourth quarter of 2019 at $21.7 trillion and contracted sharply thereafter. In our base case, we project real GDP will remain below $21.7 trillion until late 2022. In the Bull case, we expect that it will be early 2021, but in both our Stagnation and Stagflation cases, which have near identical levels of growth, it will take years to recover.

In all the scenarios, we expect the normal measures of inflation to decline sharply in the coming months. In the Bull case, it rebounds to a 2.0% level and the Fed starts to raise rates in 2023. In the base case, inflation is slightly below most Central Banks' target levels (2.0%, usually). In the Stagnation case, it is initially low and stays low. In the Stagflation scenarios, inflation starts low, but aggressive monetary and fiscal stimulus triggers higher inflation, which creeps up and disrupts the markets.¹

Now, let's extend these economic fundamentals to pricing in the capital markets for the four scenarios. First, below is a set of paths for the fixed income market.

In most scenarios, we expect the Federal Reserve to keep short interest rates low and on hold well into 2022, with the most likely hikes not occurring until at earliest 2023. And we don't expect the 10-year bond yield to get near its highs seen in 2018 (less than two years ago it was over 3.0%!). The Fed has several reasons to keep rates low: a historic recession with unprecedented levels of slack in the labor market and huge budget deficits that need to be financed. In recent communications, the Fed has indicated that they are willing to have inflation above their target level of 2% for a period of time in order to achieve full employment. We expect they will apply this in the coming future.

One difficulty in modeling the Stagflation scenario is the reaction of the Fed. We have the Fed being somewhat cautious here and focusing more on employment than inflation; thus, we model T-Bills rising modestly and lagging inflation. However, a more aggressive, hawkish Fed is clearly possible over time.

A key question is how the Fed will react: does it suppress the yield curve to support weak growth or does it raise rates to trim inflation expectations starting to accelerate?

In our base case, we expect 10-year government bond yields are steady through the next few months and then gradually rise as the economy shows moderate to strong growth. In our Stagnation case, we expect rates to stay low through the projection period.

After rising sharply earlier this year, credit spreads narrowed in March and April, especially in the US where the Fed established programs to buy a wide array of bonds to keep interest rates low, facilitate easier refinancing, and provide liquidity to stressed markets. In our base Case we expect the recovery to be slower than what the market currently is pricing and we expect ongoing volatility in the credit market as the economy confronts challenges with restarting.

¹ Inflation deserves a special note in the short run. In normal times, the basket of goods that are included in the definition of the consumption basket  is stable. But in times of huge disruption, the measure of inflation may be difficult to interpret, potentially even misleading. How do we incorporate goods for which demand is plummeting (airfares and restaurant dining) with goods surging in demand (personal protection equipment)?

Source: UBS Asset Management. Data as of 30 April 2020.

Source: UBS Asset Management. Data as of 30 April 2020.

One key area that we want to highlight across these scenarios is the stock-bond correlation. Over the last 22 years, the returns of stocks have been negatively correlated with the return on Treasury bonds. (In general, this is true for most developed countries, but there are exceptions such as Canada, Australia and several emerging market countries).

We believe that there is an increased likelihood that this negative correlation will break down sometime in the next five years. First, with central banks committed to low interest rates, QE, and potentially yield curve control, the correlation would go to zero because short-term rates would remain constant. Then, if inflation creeps up, investors will likely start to shun bonds, pushing yields up through the auctions (though central banks will not allow significant increases and will buy up the bonds to keep rates low). At some point central banks may relent and at least allow the yield curve to steepen in order to accommodate inflation risk premiums for holding longer dated bonds. In this case, we believe we would see a reversal and a positive stock-bond correlation.

The historic data indicate that the stock-bond relationship is regime dependent. The critical threshold is sustained 2.5% inflation; below this, we expect the relationship to be negative; above this, there has been a positive stock-bond correlation.

These scenarios provide a range of market events that investors need to prepare for. These scenarios not only affect returns, but the potential relationship of stocks and bonds as well as the relative performance of asset classes.

With adjustments, these scenarios project to other major markets and produce similar results, though the level may vary depending on local valuation, interest rates and policy reactions.

One major adjustment is for valuation outside the US. Non-US equity markets have done worse than the US, but we expect  a rebound, as not only the markets are cheaper, but their currencies are as well.

Normally, in scenario analysis, it is difficult to comment on the direction of currencies. Currency performance is about relative performance. For example, if one region is growing more strongly than the other, the currency will typically appreciate relative to the other, though underlying fundamentals will alter this drift and rate. We will address our expectations for currency in our five-year capital market assumptions in the following section.

The negative stock-bond correlation appears to be robust for the US, Japan, Europe, and the non-commodity emerging markets. Again, until we see a burst of sustained inflation, we don't expect the relationship to turn positive.