Monday, 25 August 2025
In response to heightened trade tensions triggered by the U.S. tariff announcement on April 2, a group of analysts from MSCI has developed three macroeconomic scenarios to assess potential impacts on financial markets and diversified investment portfolios. The scenarios include stagflation, recession, and a worst-case combination of both.
The main concern lies with stagflation — a situation marked by stagnant economic growth and rising inflation — where central banks have limited scope to provide monetary stimulus. In this scenario, both equity and bond markets may decline simultaneously.
In the most adverse projection, a recession paired with persistent inflation could lead to a nearly 35% drop in U.S. equity markets from pre-announcement levels. A diversified portfolio of global equities, U.S. bonds, and real estate could fall by up to 19%.
Overview of the Scenarios
• Stagflation: Economic growth slows to 0% while inflation increases by two percentage points, driven by supply shocks and trade barriers. Central banks raise interest rates to curb inflation, which further suppresses growth.
• Recession: GDP contracts by 3%, but falling demand helps ease inflation. The Federal Reserve has room to lower rates, leading to a quicker recovery.
• Recession with High Inflation: A combination of economic decline and elevated inflation due to ongoing supply chain disruptions, resembling the oil shocks of the 1970s.
The potential impact on portfolios was assessed using MSCI’s stress-testing model. Under the worst-case scenario, the sample portfolio saw a 19% loss, compared to a 13% drop under stagflation and 9% in a recession scenario. Losses were more severe for equities, while bonds provided a buffer only in the absence of inflation.
Implications for Asset Classes
Under stagflation or inflationary recession, bond yields rise, reducing their value, and equity markets face pressure from both declining growth and higher rates. In contrast, during a standard recession, falling rates can support bond prices and partially offset equity losses.
The study also compared these scenarios with a possible market reversal to pre-tariff conditions. If macroeconomic pressures ease, portfolios could regain some ground, though the likelihood of a quick reversal remains uncertain given ongoing policy shifts and geopolitical risks.
Broader Context
These scenarios are modeled against a baseline set at the beginning of 2025, when expectations pointed to strong growth and declining inflation. Since then, the economic environment has shifted due to new tariffs and increased uncertainty.
The analysis underscores the importance for investors to consider a wide range of outcomes in light of current macroeconomic volatility. In particular, stagflation presents a unique challenge, as the typical tools to support markets — such as interest rate cuts — may not be available.
Authors: Monika Szikszai, Lokesh Gupta, Thomas Verbraken and Rick Bookstaber – MSCI
