ROBUST, RESILIENT, RECESSION – these are the Three Scenarios Citi analysts have devised to forecast possible outcomes as the world faces an exceedingly complex set of challenges. The war has created a new supply shock. The Fed is looking to attack inflation even as growth is slowing. And the distortions of the pandemic have extended longer than expected.

Currently, Citi’s base case is RESILIENT at a 40% probability, with each of ROBUST and RECESSION at 25% probabilities. Markets are leaning toward the ROBUST outcome at present. This is why, in Citi’s view, proactively building strong and resilient portfolios is prudent.

Allocations to the right equity sectors, adding equity positions that may hedge tail risks in natural resources, and leaning heavily toward quality, dividend-paying companies are all strategies in which diversified portfolios are able to “power through” this unusual period in world history.

• The RESILIENT scenario expects Fed tightening policy will constrain growth in the US and world economy this year. This will be neutralized to some degree by growth generated from lean inventories and recovering production. In this scenario, strong corporate profits will shift to sectors with “durable demand” – companies selling goods and services that are “must-haves” for consumers, rather than just “nice to have.”
• The ROBUST scenario assumes there is greater risk in Europe’s markets than in the US, and that the conflict in Ukraine and Russian economic sanctions do not expand further. A compromise between Ukraine, Russia, and NATO would bring commodity prices down and might diminish the Fed’s urgency to tighten policy.
• In the RECESSION scenario, the Fed would tighten too fast for growth in supply to meet decelerating demand, resulting in recession in 2023 with a sharp drop in US share prices. The forecasted path for US Treasury 2-year notes – coupled with expectations of reduced Fed lending – suggests a growing recession risk in 2023.

Portfolio Considerations

• For most investors, our CIO believes a well-balanced, diversified portfolio has the potential to provide sustained, positive risk-adjusted returns even under adverse circumstances.
• Given today’s unique conditions, the Global Investment Committee (GIC) has added tactical exposures to natural resources, oil services firms and gold. Our global equities allocation is 2% overweight, but this can be seen as 2% underweight if one considers the thematic allocation to natural resources as a hedge. Citi views this 4% commodity-focused allocation as an inflation and growth-risk mitigator.
• Conservative means high quality – the GIC’s thematic overweight to consistent dividend growers has translated into stable returns this year. These shares may produce smaller losses in stressed markets.
• Other non-cyclical thematic overweights, such as pharmaceuticals and cybersecurity, are also areas of the market that have and may potentially continue to outperform with stable earnings profiles.
• With both intermediate- and long-term rates having posted 170- and 50-basis point increases, respectively, over the last 12 months, Citi analysts could begin to look favorably on adding a longer-duration position to balanced stock/bond portfolios as a risk hedge if 10-year yields rise above 2.5%.
• The recent drawdown in the Treasury market has made high-quality US municipal bonds more attractive relative to Treasuries. This year, the 5y M/T ratio has risen from about 45% to around 77% now, while the 10y ratio has risen from about 70% to 89%.