Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 264

Three market scenarios, including a 30% fall

We are cautious about global equity markets at present and running a defensive portfolio. This is because we face an extraordinary cocktail of circumstances that skews risks to the downside, including:

  • Asset prices are at, or near, record levels

Prices for sovereign, corporate and high-yield bonds and equities are at, or near, record levels thanks to the ultra-low policy interest rates and the massive quantitative-easing programs of the G3 central banks (the US Federal Reserve, the European Central Bank and the Bank of Japan) over the past decade.

  • Central banks have commenced quantitative tightening

In response to the strengthening economic environment, the Federal Reserve is raising the cash rate and has commenced a pre-set programme to shrink its balance sheet while the European Central Bank has announced that it will cease its asset buying program by 31 December 2018. The combined impact of announced balance sheet activities of the Federal Reserve and the European Central Bank will remove liquidity from global markets, resulting in a reduction in demand for bonds and other assets by these central banks of about US$1.5 trillion on an annualised basis from October 2017 to the end of December this year. We believe that a change in demand by the central banks of this magnitude is likely to have a meaningful impact on longer-term bond yields by early 2019.

  • Late-cycle US fiscal stimulus

In our view, the Federal Reserve’s strategy to tighten monetary policy in a smooth and well-foreshadowed manner has been complicated by the large fiscal stimulus being implemented by the Trump administration at the tail end of an extended economic expansion. The tax cuts and additional spending will make a fiscal injection into the US economy of nearly 2% of GDP per annum for the next two years. The US unemployment rate at 4% is near an 18-year low and the US economy has added jobs over the past 93 months, which is the longest such consecutive stretch on record. While there appear to be powerful longer-term secular forces at work that are likely to result in low inflation over the longer term, there is a significant risk that the size and timing of the US fiscal stimulus could trigger a jump in US inflation, in particular from stronger wages growth, over the next year or two. This could be highly problematic for the Federal Reserve and complicate its efforts to engineer a gradual tightening with a soft landing. We cannot think of a similar combination of circumstances in modern history. The cocktail of circumstances could be explosive. The best hope for investors is that either the US tax cuts and extra spending have limited effects on growth and inflation in coming years or the secular forces that have kept inflation low accelerate to offset any inflationary pressures from the fiscal stimulus.

The possibilities of three scenarios

We assess that there are three possible scenarios for markets over the next 12 to 18 months:

  • The first scenario is a continued US economic expansion without triggering a material increase in US wages growth or inflation. In these circumstances, we would expect the Federal Reserve to increase short-term interest rates and to shrink its balance sheet broadly in line with current expectations. In these circumstances, it would be reasonable to expect that over the next, say, 18 months the US cash rate would rise to 3% to 3.5% and the 10-year Treasury yield would increase to about 4%. In this scenario, defensive equity assets, longer-term bonds and emerging-market equities are likely to underperform growth assets and economically cyclical assets, and some commodities are likely to outperform driven by the economic expansion. We would place slightly less than a 50% probability on this scenario.

  • The second scenario is where the Federal Reserve is forced to act more swiftly and forcefully than expected to counter inflationary forces. It would be reasonable to assume that US longer-term bond yields could jump suddenly and meaningfully (above 4% compared with 2.86% for the US 10-year Treasury bond at the end of June), which could trigger the biggest slump on world share markets since the global financial crisis. In our view, a 20% to 30% global stock market correction in the next 12 to 18 months is conceivable. In these circumstances all equities are likely to be affected. We would put a similar probability on this scenario to the first or, in other words, we don’t know which of these two scenarios is more likely.

  • The third scenario is where an external event occurs that causes the Federal Reserve and the European Central Bank to reverse course and put on hold any further tightening of monetary policy. We believe that this is most likely to occur in circumstances of a significant event and, therefore, this scenario is likely to be negative for share markets. There is a remote possibility of a ‘Goldilocks moment’ where the central banks stop their plans to tighten money policy, longer-term bond yields fall and equity markets don’t fall or even rise.

 

While global stocks have set record highs over the past 12 months, we are cautious on the outlook for equity markets and consider that risks are asymmetrical to the downside. Our caution is reflected in the defensive positioning of the Magellan Global Trust with cash at 30 June 2018 representing 21% of the portfolio.

Conservative investors sleep well

Some people might consider that having such a large cash holding exposes investors to underperformance if equity markets rise. We have no fear of missing the tail end of an extended bull market. Renowned investor Sir John Templeton was perhaps best known for saying:

“Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

In our view, only conservative investors sleep well. Implicit in conservative investing is the focus on the conservation of capital. As Warren Buffett has said, there are two rules in investing: 1. Don’t lose money. 2. Don’t forget the first rule.

 

Hamish Douglass is Chief Executive Officer and Chief Investment Officer at Magellan Asset Management, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.

For more articles and papers from Magellan, please click here.

 

RELATED ARTICLES

Equity investing in an inflationary environment

banner

Most viewed in recent weeks

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Welcome to Firstlinks Edition 627 with weekend update

This week, I got the news that my mother has dementia. It came shortly after my father received the same diagnosis. This is a meditation on getting old and my regrets in not getting my parents’ affairs in order sooner.

  • 4 September 2025

Latest Updates

Shares

Why the ASX may be more expensive than the US market

On every valuation metric, the US appears significantly more expensive than Australia. However, American companies are also much more profitable than ours, which means the ASX may be more overvalued than most think.

Economy

No one holds the government to account on spending

Government spending is out of control and there's little sign that Labor will curb it. We need enforceable rules on spending and an empowered budget office to ensure governments act responsibly with taxpayers money.

Retirement

Why a traditional retirement may be pushed back 25 years

The idea of stopping work during your sixties is a man-made concept from another age. In a world where many jobs are knowledge based and can be done from anywhere, it may no longer make much sense at all.

Shares

The quiet winners of AI competition

The tech giants are in a money-throwing contest to secure AI supremacy and may fall short of high investor expectations. The companies supplying this arms race could offer a more attractive way to play AI adoption.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Infrastructure

Renewable energy investment: gloom or boom?

ESG investing has fallen out of favour with many investors, and Trump's anti-green policies haven't helped. Yet, renewables investment is still surging, which could prove a boon for infrastructure companies.

Investing

The enduring wisdom of John Bogle in five quotes

From buying the whole market to controlling emotions, John Bogle’s legendary advice reminds investors that patience, discipline, and low costs are the keys to investment success in any market environment.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.