There’s a 60% likelihood that the global economy will continue to grow at a steady pace with modest inflation, according to a BMO Global Asset Management report.
The report highlights three scenarios that could play out over the next five years.
The first scenario has the highest chance of happening, at 60%, notes the report. The gradual withdrawal of monetary accommodation, in the form of higher interest rates and reduced quantitative easing, is likely to be tempered by muted inflation pressures and flexible markets, reducing these headwinds to a gentle breeze rather than a disruptive gale.
The report cautions that, as a pre-condition, Europe must surpass the U.S. and lead the world in growth. With the world economy in good shape and healthy profit margins maintained, risk assets should generally do well in this scenario. Gradual tightening by central banks is a headwind, albeit a mild one, which will limit overall returns. Government bonds are likely to underperform and, with spreads likely to widen, corporate bonds could fare even worse.
In 2018, the risk of a downside scenario will increase given concerns over policy errors. The second scenario, which is given a 30% chance of happening, suggests that a global recession is a threat for two reasons: past monetary policy may have over-stimulated the markets; and, subsequently, this could fuel further inflation, which might then coincide with the quantitative tapering and exaggerate the impact. This could lead the U.S. into a recession, followed by the rest of the world.
On the flip side, central banks may take an aggressive approach to unwinding. The pace of tightening could be too fast, resulting in an economic downturn, a squeeze in corporate profits and a global recession.
This recession-based scenario would ultimately see a significant correction in equity markets and a rally in bonds. Government bonds could sell off in the early stages of this scenario as inflation and interest rates rise, before rallying hard as equities underperform—kick-starting a recession.
The third scenario, to which BMO Global Asset Management has assigned a 10% likelihood, says that central banks are successful at bringing economies back to full employment, without pushing up inflation. It also suggests that central bank balance sheets and interest rates are normalized in a smooth manner, which ensures consistent market and investor behaviour. In this perfect world, risk assets perform strongly, bonds come under only limited pressure and volatility remains low.