You probably know that the U.S. Federal Reserve’s main job is to set policy for overnight interest rates. You may not realize that the Fed also produces an annual forecast of not only interest rates, inflation and unemployment, but also the potential impact of those forecasts on the stock market, commodity prices, and more.
Just recently, the Fed released its 2016 forecast, and my team and I decided to “stress test” them. So with many thanks to our friends at Hidden Levers, we created a table below that projects out one year based on the Fed’s three types of scenarios. Two of them are not pretty.
The “Baseline Scenario” assumes that inflation and interest rates are moderate, GDP growth is steady and unemployment dips a bit further. This is the so-called “Goldilocks” scenario, not too hot or cold, but just right. Under this scenario, the stock market (using the S&P 500 Index as a proxy) rises to 2,158, which is about 1% above its all-time closing high of 2,133 reached last July. That is also about 11% above where the S&P 500 closed in February. Oil prices would recover to about $42 a barrel and the 10-year U.S. Treasury yield would climb to over 2.8%, a level it has not seen in over two years.
What if things get a little hot under the collar over the next year? Well, we did say this was a stress test. The Fed outlines two scenarios in which the economy weakens and a mild recession ensues. The Adverse Scenario is the lighter of the two, though oil prices project to decline to the $25-$26 area. The 10-year bond yield stays in the recent 1.7% zone, unemployment climbs to over 6.5% and home prices dip.
As for the S&P 500, the Fed’s Adverse Scenario would drop it down to 1524, a decline of more than 20% from February’s closing level. That would retrace all of that index’s gains since the first week of March 2013, a full three years ago. Perhaps this is a bad time to remind you that this is the Adverse Scenario. The third scenario is called “Severely Adverse,” so read on.
Severely Adverse Scenario
Here, we’re talking deep recession. Think 2008, but perhaps with different triggers. The 10-year Treasury drops well below 1%, home prices decline by 10% and unemployment flies back up to over 8.5%. And as for the stock market? The S&P 500 projects to a level of 1,064 which was last seen in September of 2010.
As with any forecast, particularly those billed as “stress tests,” we have to recognize that it will take a series of dominos to fall before either of the adverse scenarios could play out. But the key for you as an investor is to understand a wide range of possibilities and invest without being blindsided later.
The Fed may be in the business of interest rate policy, but that doesn’t mean they are myopic (though some wish they were). This analysis shows how fragile the economy can be if just a few components become misaligned and investor emotion kicks in. Stay sharp, stay flexible, and think more about how to pursue your objectives while thinking a bit out of the box. If you do that, it won’t matter what scenario actually occurs, you will be in better position to survive it.