Since 2000 and 2001, the US stock markets have not lost money for two consecutive years, but it is something that could potentially happen again this year. Ortec Finance’s modelling is pointing to negative equity returns over the next 12 months as the most likely market scenario. Pension funds with tactical or dynamic allocations at their disposal may want to temper their risk and consider fixed income instead.

Based on our modelling, it is expected that equity returns will disappoint again in the short term, even after the MSCI World Index’s 18% correction in 2022. Why? In a word, uncertainty. We have seen the combination of a pandemic stimulus hangover, negative supply shocks and the Russia-Ukraine war result in the highest inflation in 40 years. That, in turn, prompted the quickest monetary tightening by the world’s leading central banks since the 1980s.

Higher inflation and interest rates effectively devalue stocks’ future earnings and lower their net present value. If you discount stocks’ future cash flows by the substantial amount implied by current rates, you arrive at a valuation, in most cases, below current market prices. That does not mean markets will fall to those levels. Inflation could subside, and eventually rates, too, faster than we expect. But in terms of probability, it is looking as though markets will trend downward before global growth recovers.

Managers concerned primarily about their funds’ solvency 10, 20 or 30 years out shouldn’t be overly concerned, mind you. This is a short-term projection, run through our Economic Scenario Generator, that creates a range of possible outcomes. Whether an issue or not depends on many fund-specific variables, such as risk appetite and risk budget, current asset and liability valuations, funded ratio, contribution rates, and benefit payments.

The Economic Scenario Generator simultaneously captures long, medium, and short-term cycles. The long-term component represents slow-moving trends that take more than 15 years to materialise. The medium-term component corresponds to the business cycle, and the short-term component captures the fickle short-term market movements over a horizon of at most one year.

Put all three together, and you get a total model simulation that is not looking promising for stocks right now. At any time, we can look back on a huge range of historical returns in global stock markets, from 30%-plus losses to 30% gains. Our model might project a range of returns within 10% or 15% of a median with 99% confidence. The current projection calls for a high likelihood of a negative medium with a probability of over 50%.

At Ortec Finance, we believe that models in general, and the latest version of our scenario models in particular, enable people to manage the complexity of investment decision-making. Moreover, we believe that proper models, when properly used, are, in fact, the best tool for this because they are consistent, objective and transparent.

Regardless, some funds may be overexposed to equity market risk. Institutional investors could be overallocated to stocks simply because low yields on bonds were not meeting their needs for returns. Funds may be vulnerable to additional risk in the short term, given the uncertainty around inflation, weak economic growth (or recession) and the trajectory of interest rates. For those managing a dynamic or tactical asset allocation, we can help quantify whether this is the right time to increase or decrease risk exposures or overweight or underweight asset classes. Adding this kind of market intelligence into your risk management process could lead to better results for your stakeholders.

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