The purpose of SKBA's multi-scenario forecasting process is to enable the firm to assess the
return opportunities and risk of loss inherent in today's financial market and economic environment and from today's
valuation levels for stocks and bonds. Furthermore, the process also frames the discussion for setting industry and
sector allocations, and SKBA believes an investment manager cannot be agnostic about the impact of the economic and
financial market outlook on such decisions. At the same time, the monthly updates to these perspectives and outlook
are made independent of any actions SKBA undertakes in its client portfolios.
In addition, we provided our intellectual thought process behind such forecasts as an example of how SKBA approaches
such analysis. For sake of simplicity of analysis, the risks of loss and estimated returns that result from our
multi-scenario framework and analysis are calculated and displayed for only two asset classes, the S&P 500 and
the 30-year Treasury bond. The historical observations represent the conditions and forecasts that existed on
an as was basis in each time period displayed. Such forecasts can be changed at any time and are not
intended to represent a recommendation for purchase or sale of any asset or security, nor to support any course
of action as being suitable for the reader.
Economic cycles are like seasons. Deciduous trees are photogenic in the fall only to turn barren in the winter. Likewise, fundamental characteristics (valuation, expected return, and risk) of asset classes in economic upcycles look nothing like they do in economic downturns. But the simple upcycle/downturn classification loses nuance for investing in stocks and bonds, so SKBA specifies five of these economic cycles (or scenarios) according to the two variables of real GDP growth and inflation.
Characterizing economic history into these five scenarios is the first step. Each scenario is examined for central tendencies of fundamentals, like the stock price to earnings ratio (P/E). The P/E on the S&P 500 index might trade in an 18-22x range in a normal scenario but fall into an 8-14x range in a stagflation scenario. P/E, along with other fundamental factors like risk, influences SKBA's preference for each asset class, and these preferences vary with what SKBA thinks the future economic scenarios will be. If SKBA thinks that stagflation is imminent and the current environment is normal, then the firm would lower expectations of stock performance based on the lower P/E tendency, all else equal.
Unlike seasons, economic scenarios do not have a fixed length or fixed cycle. Normal economic growth can continue, worsen, or boom year-to-year. A quick overview of the scenarios is described below:
Recession/Deflation - Low growth with low inflation . The financial crisis in 2008 and 2009 wreaked havoc on equities while investors chased bond yields downwards. This episode also produced run-ups in commodities like oil, gold, and agriculture though the equity representation was still hit from the volatility.
Stagflation - Low growth with high inflation. The term stagflation was first coined in the early 1970's. The 1970 to 1973 era of low growth was bad for most equities but not all, high inflation favored the consumer staples and energy sectors.
Normal - Normal growth with normal inflation . The vanilla flavor of scenarios can be a complex and isn't always the same. Normal is only slightly more prominent than the other scenarios.
Boom/Inflation - Normal growth with high inflation . Following the stagflation of the early 70's, growth returned in the late 70's but inflation couldn't be stopped. Fed Chair Paul Volker became a household name (among economists) with interest rate increases designed to combat inflation. This was not a good time to be a bond holder.
Perfection - High growth with low inflation. From 1997 to 1999, the US entered into a tech boom and equities climbed faster than fixed income. High GDP growth for this period was driven by massive productivity growth enabled by information technology. Equities linked to that sector ended up did the best.
Every month, SKBA distills its qualitative outlook of what the years ahead hold into numbers with a probability distribution of the five scenarios.
as of 12/31/18
For longer time horizons like SKBA's 2 and 5 year outlook, SKBA calculates the possible paths
and weighs the paths according to a conditional function. Conditional functions are if/then statements.
An example: if the current scenario is normal, then the probability of staying normal the next year is 45%.
So the chance that of a [normal, normal] scenario (based on the table above) in the two year outlook is 27%
(60% normal * 45% normal if normal). Based on the aforementioned study of history and the current price levels,
SKBA has an expected equity return in the 2 years of normal scenario of ~13% annually. Putting the two statements
together: SKBA thinks there is a 27% chance that stocks return 13% in each of the next two years.
These statements (y% chance of x% return) are the individual bars in the histogram below.
The second chart shows the expected 2-year risk of loss, a function of the first chart. The third chart
shows what actually happened in the 2-year time horizon. The trends in the second and third chart are compared
against each other to see if the predictions are correct. Trends in the same direction indicate a reasonable
forecast, high expected risk should equal low actual return.
This quantitative, feedback loop helps qualitative prediction accuracy and can also be used to allocate assets. Periodic changes are made in the functions so that future predictions are more accurate.
This multi-scenario outlook is presented to portray a forecasting process to enable SKBA to assess the
return opportunities and risk of loss inherent in today's financial market and economic environment and
from today's valuation levels for stocks and bonds. Such forecasts may be changed at any time and are
not intended to represent a recommendation for purchase or sales of any asset or security, nor to support
any course of action as being suitable for the reader. This does not represent actual performance of SKBA
or its clients nor does it predict performance a client could achieve.
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