If you thought the global financial crisis was over, don’t be too hasty. Scenario analysis by MLC Investment Management – placing probabilities against 40 different scenarios – puts the possibility of further massive falls in values for some asset classes a little too likely, or not unlikely enough, for comfort. While not alarmist, with the most likely probability being continued recovery, the analysis illustrates the uncertainty embedded in asset values over the medium term, particularly for Australian and global equities and emerging markets. Susan Gosling, head of capital markets research for MLC, has produced a summary of the analysis to illustrate recent asset allocation adjustments to some MLC funds – the “horizon” series and long-term absolute returns fund. She compares these with the probability of weighted real returns for most asset classes. This shows that the MLC funds have reduced the chances of outlier downside performance in all major asset classes but have given up some potential returns in the event, which is most likely, of relatively benign conditions. Insurance comes at a cost. The chart shows the analysis for asset classes only, not the MLC funds. I’m sure MLC would be very happy to provide the full summary on request. While clearly there is most risk of big gains or losses in equities, some of the debt categories could also produce some nasty surprises. MLC assigns a probability to each of the 40 different scenarios for the economic and investment environment based on its own assessment. This generates a single expected real return for each asset class, or its own portfolios.

The expected returns are shown in the chart by the blue columns. For comparison the long-term neutral return expectations are calculated by assuming a stable “fair value” world, shown by the red boxes. Then, to indicate how uncertain the returns are, the analysis includes the bottom and top 10 per cent of the scenario returns with their probability weighted average return in the “tail” outcomes, shown by the grey and white columns. Gosling says there are a number of different scenarios that could result in the kind of returns that constitute the top and bottom 10 per cent. There is no single best case or worst-case scenario. She says: “Growing optimism in financial markets creates the appearance that we are transitioning back to normality.

However, expectations of a return to a pre-crisis normality may ultimately be disappointed. “We remain concerned about the potential for an ultimate inflationary workout but prior to that deflationary concern are likely to re-emerge as the wind-back of the monetary stimulus commences. “We also note that while banking systems have been pulled back from the precipice, the IMF estimates that so far banks have recognised only half of their expected losses. “Investors have moved from terror to complacency at an alarming pace.” The principal 40-scenario set is relatively positive about the recovery and the future performance of Australia but MLC believes that the extent of positive news already factored into prices creates a vulnerability in the event that the outcomes disappoint.

Liquidity has been the key driver of market behaviour and what happens next depends as much on monetary policy as the real economy. Gosling says: “There remains considerable risk of further short-term equity market volatility and fluctuating expectations about both the strength of economic growth and inflation versus deflation should be expected. My own view is that ultimately higher inflation will be a feature of the path back to normality but there is a wide range of views on this.” The chart shows expected listed equity returns remain below long-term normal levels with positive returns in the December quarter reducing return potential.

This is offset by changes to probabilities for Australian equities in particular but is reinforced for unhedged global shares by the assumption by MLC of a higher equilibrium level for the Australian dollar. The return potential of unhedged global equities is assumed to be more modest than previously but the sector is relatively risk controlled. Prospective returns for debt assets also generally remain below normal levels, particularly long-dated global treasuries which have limited potential and relatively high downside risk. “The ultimate solution to the crisis might involve higher inflation. That possibility, as well as the massive increases in government bond issuance that are in prospect, pose significant threats to world bond markets,” Gosling says.