Testing Investment Impacts from Rising U.S. Inflation and a Potential Recession

Given U.S. concerns of slowing economic growth and price hikes due to tariffs, in this article we perform a March 26 scenario analysis for investment portfolios.

U.S. inflation had been steadily rising since September 2024, until in February the pace mildly slowed. Still, consumers’ fear of higher prices for household staples and rising inflation from tariffs in the next one year continue to grow, according to the Federal Reserve Bank of New York’s Center for Microeconomic Data and the Survey of Consumer Expectations.

From another market-oriented perspective we also review inflation expectations with an analysis of the U.S. zero-coupon inflation rate, which represents expected inflation derived from inflation swaps and the U.S. breakeven inflation rate, which represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities. Both of these rates have steadily risen in the last six months.

Amid downward revisions for GDP growth and pessimistic economic outlooks, a negative forecast of GDP growth for Q1 2025 from the Federal Reserve Bank of Atlanta, despite the U.S. is not in a recession, concerns of a U.S. recession are growing.

Recession, as a rule of thumb, is defined as a significant decline in economic activity measured by negative GDP growth in two consecutive quarters. The National Bureau of Economic Research defines recession as a period of widespread decline in economic activity across the economy lasting more than a few months. Additional indicators include GDP, employment rates, industrial production, and consumer spending.

Keeping in mind that reported statistics have a time lag, official statistics do not yet show negative GDP growth; only a slowing down from 3.1% in Q3 2024 to 2.5% in Q4 2024 and an unemployment rate that is gravitating 0.1% up and down around 4.1% in the last six months. Still, we decided to include a recession scenario in our analysis as a hypothetical test of the change in the value of investments, based on concern for the Q1 2025 forecast to worsen.

Scenario Definitions

Inflation

We include a couple of scenarios on rising inflation by defining a rise of 0.5% and 1% as the range of change, which equates to the current 2.8% inflation rate potentially increasing to 3.3% and 3.8%, respectively. 

The factor we shock is the 5-year zero coupon inflation. The stressed return of all risk model factors will be calculated based on their correlation to that inflation and the stressed values of 0.5% or 1%. Then the return of each asset is computed based on the sensitivity of the asset to those factors and is aggregated at the index/portfolio level using the weights of each asset.

Recession

The timing and drivers of recessions may vary, as these examples illustrate:

• Commodity-driven: Oil price increased from 1990 and combined with other factors that led to galloping inflation.

• COVID outbreak from 2020: The pandemic impacted the economy, public health, and employment rates.

• Financial market crises: Households were significantly impacted by the dot-com bubble that burst in early 2000, the U.S. housing bubble that peaked 2005-2006, and the subprime mortgage crisis from 2007-2008.

Therefore, it is difficult to unite all historical recessionary periods by a few drivers or factors we could use to shock one recession scenario analysis. To define recession scenarios, we looked back into historical impacts on the main investable markets and selected them as representative factors for a recessionary environment.

Based on the historically observed returns, we defined two scenarios:

• Shallow recession: equities drop 15%, High yield bonds drop 10%, Corporates and Treasuries rise 2%

• Severe recession: equities drop 30%, High yield bonds drop 20%, Corporates drop 7%, and Treasuries rise 3%

Stagflation

Stagflation is defined as a period of rising inflation in a recession environment of slow economic growth and high unemployment. Following that definition, we set up a stagflation scenario by combining a rising inflation scenario with a recession scenario. We set slightly higher inflation increase of 1.5%, as during stagflation there it is more difficult to tame inflation:

• Mild stagflation scenario: inflation rises 1.5%, equities drop 15%, High yield bonds drop 9%, Corporates and Treasuries rise 2%

• Pronounced stagflation scenario: inflation rises 1.5% and equities drop 30%, High yield bonds drop 11%, Corporates drop 2.5%, and Treasuries rise 4.5%

Analysis

We will explore the impact of scenarios on a few standard investment strategies:

• US Aggressive Growth: 100% equity

• US Growth: 80% equity, 20% bonds

• US Moderate: 60% equity, 40% bonds

• US Balanced: 50% equity, 50% bonds

• US Conservative: 40% equity, 20% government, 40% bonds

• US Income: 20% equity, 40% government, 40% Bonds

• US Core Bond: 100% bonds allocation

We can see that under U.S. inflation increase scenarios equities have positive returns, while bonds are negatively impacted. Thus, strategies with more allocation to equities perform better than fixed-income tilted strategies.

Recession scenarios combine a few shocks, however both shallow and severe recessions draw equities down. Thus, in recession scenarios the equity component of the investment strategy brings the overall return down, so strategies with a higher weight in equity perform worse under these scenarios.

During shallow recession core bonds perform well, serving as a safer asset, which reduces the negative impact from equities drop—the more allocation to bonds, the more visible this effect. During the COVID outbreak and 2008 financial crisis, however, even bonds’ returns plunged. Therefore under severe recession scenarios, all strategies show negative returns with effects from equities intensifying the overall drop.

Stagflation scenarios provide a very similar order of performance. We can see that during a shallow recession bonds returns are still predominantly positive, and the increasing inflation dampens the negative returns for stocks that resulted from the recession environment. However, in the state of severe stagflation, the negative impact from recession dominates all strategies; only core bond strategies may provide neutral to small positive return.

Conclusion

We presented an example of how investment strategies could be tested for changes in a macro-economic environment with increasing inflation, recession, or stagflation. The factor shocks and indices selected serve as a base, which could be enhanced with specific views or assumptions for other expected effects. FactSet’s stress testing in Portfolio Analysis enables a flexible and user-friendly way to implement these or enhanced scenarios to test the resilience of investment strategies or portfolios.

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.