Rothschild has identified four different scenarios that, in their view, are the most likely to occur. The series of scenarios for GDP growth and inflation in the main western economies, Japan and China may guide investor thinking but their somewhat ominous conclusion is worth bearing in mind: “Further monetary ‘experiments’ are becoming less probable. However, significant imbalances and risks persist. This is the reason why we have left the size (probability) of our depression scenario unchanged.”

Notably, equities are not well supported by current valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero...exposing equities to a potentially sharp correction.”

Setting the scene

The scenarios presented here are intended to illustrate our economic outlook over the next few years.

What this is

A series of scenarios for GDP growth and inflation in the main western economies, Japan and China.

A simplification. The global economy is complex and multi-dimensional, and can be represented in many different ways. While narrowing in on just growth and inflation involves some simplification, we believe it is still worthwhile – most other economic variables and policy actions can be covered in relation to their impact on growth and inflation.

A guide to our thinking. The scenarios flow from our investment analysis. They are intended to illustrate the thinking that shapes the way we have built our clients’ portfolios. They can also help identify some of the main investment risks and opportunities.

What this isn’t

A series of detailed forecasts. In any exercise like this, there is always a danger of giving a false sense of certainty. We have kept our comments at a fairly high level, providing a sketch of what we see as the most likely outcomes.

Something set in stone. Our analysis evolves over time: the scenarios provide a snapshot of our outlook in 2014.

Something prescriptive. The scenarios are mainly a tool for communication. While they are valuable in our investment decisionmaking, they are not something we use rigidly.

What has changed?

Since we last published this report, the global economy has continued to recover, driven by the US. Although growth remains weak, conditions in the eurozone have also improved. Meanwhile, Japan appears to be making progress with efforts to stimulate its economy and China seems to have avoided a sharp slowdown.

Improving global economic data suggests to us that the world could begin to move away from the current situation of sluggish growth and loose monetary policies. Further monetary “experiments” are becoming less probable. However, significant imbalances and risks persist. This is the reason why we have left the size (probability) of our depression scenario unchanged.

Four main scenarios

We have identified four different scenarios that, in our view, are the most likely to occur.

For each scenario, the position of the bubble shows the combination of growth and inflation that we expect to see in the next one to three years.

The size of the bubble illustrates our view on the likelihood of this scenario occurring – this is subjective, and is intended just to illustrate our thinking.

Growth is expressed in relation to the potential for each country. For example, a growth rate of 4% would be low for China but very high for Europe. Similarly, inflation relates to a country’s individual inflation target.

We have adjusted the size of the bubbles to reflect our view that conditions in the global economy should continue to improve in 2014. We believe the world could begin to move away from our core “muddling through” scenario towards “economic renaissance” and that the “new monetary world” situation has become less likely.

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Implications for returns from asset classes

The table summarises the expected returns of the major asset classes under each of our four main scenarios.

The circles in the boxes show the expected return over the next three years, relative to the long-term expected returns*. Light green means higher than long-term expected returns*, while light red means lower.

These figures are an illustration of our thinking. They are based on an informed interpretation of our fundamental valuation models.

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Our conclusions

In most scenarios equities are the most attractive asset class. But valuation support is limited, exposing equities to a potentially sharp correction.

1. Continue to favour equities

We continue to favour equities despite their demanding valuations:

• Abundant liquidity and repressed interest rates in our “muddling through” and “new monetary world” scenarios continue to support equities.
• Improved earnings prospects in our economic renaissance” scenario should also boost equity prices despite the prospect of higher interest rates.
• This pattern applies particularly to the US market. It is the most overvalued region but prices could continue to rise if the “economic renaissance” scenario becomes increasingly likely.

2. Remain cautious on bonds

• We are avoiding long-maturity nominal bonds because they would be negatively affected by a normalisation of monetary policy in our “economic renaissance” scenario.
• Within fixed income we continue to like shorter-maturity corporate bonds. This part of the market has two attractive features. First, there is still a decent yield advantage relative to government bonds. Second, the short maturity would offer some protection against rising interest rates, especially in our “economic renaissance” scenario.

3. Maintain exposure to real assets

• The still sizeable probability of our “new monetary world” scenario lies behind our ongoing exposure to real assets such as gold, real estate and possibly inflation-linked bonds.
• We are also confident that over an economic cycle equities continue to offer protection against inflation.
• Additionally, we are focusing on hedge funds that have the flexibility to adjust to an unexpected increase in inflation.

4. Maintain our portfolio hedges

Although we believe the “depression” scenario is the least likely, its impact would be so disruptive that it must be considered within our investment strategy. Notably, equities are not well supported by current valuations, while monetary policy is limited by high debt levels and interest rates that are already close to zero.

Therefore, we include hedging strategies that can limit the potential losses from our portfolios:

• We have a sizeable allocation to hedge funds that can provide significant protection in a bear market or which are not affected by movements in equity markets and therefore provide true diversification.
• Additionally, we have direct equity hedges usually in the form of out-of-the-money put options on broad equity indices.