Three sobering predictions for a world of 'lower for longer' energy prices, inflation and interest rates

BMO Global Asset Management has outlined its three most likely scenarios for investors in the next five years, saying their base case is the global environment will continue to see low energy prices, inflation and interest rates in the near future.

It is a sobering prediction for a world where weak economic growth has been the defining market trend in the seven years since the Great Recession. BMO said another five years of weak growth means that returns for many asset classes will be muted and that income generation from bonds will continue to be difficult as rates remain near historic lows.

“Over the timeframe of this scenario we expect that the phrase ‘lower for longer' will be frequently employed to refer to energy prices, inflation and interest rates,” the asset manager said in its outlook.

The main scenario does envision opportunity for investors, however. While growth remains relatively low around the world, the U.S. leads an expansion among developed countries, which includes a rebound in growth in the eurozone and Japan.

Under this scenario, investors are advised to remain overweight in stocks relative to fixed income, because near-rock bottom yields will persist in the latter.

 “The emphasis on U.S. equities focuses on non-resource cyclicals, which include Information Technology, Financials, Consumer Discretionary and Industrials,” the asset manager said in its outlook. “A further emphasis is placed on companies that have domestically generated revenue. Commodity and other cyclical sectors are underweighted.”

But investors will also have to guard against risks. BMO notes that the U.S. recovery is showing signs of maturing and there is a material risk of recession over the next three-to-five years. Diversifying outside is recommended as a result, particularly in Japan and the eurozone, where loose monetary policies should begin having positive effects in the coming years.

BMO assigns about a 60 per cent probability that the above scenario will take hold. But the asset manager also outlined two other scenarios for investors in its outlook.

The second scenario, the most bullish of the three, envisions a world where all the decisions made by global central banks in recent years turn out to be the correct ones — resulting in stronger-than-expected growth. BMO assigns this scenario a 20 per cent probability and says investors in this environment would need to go “full risk on” to reap the benefits.

That would mean buying highly cyclical U.S. stocks, such as energy, materials, information technology and consumer discretionary. Canadian growth stocks and emerging market countries that produce commodities, particularly oil, would also benefit portfolios in this environment.

For fixed income investors, inflation-lined bonds would be preferred over sovereign bonds, and short-dated securities would be best over longer-dated securities. Alternative investments, such as commodities and global macro strategies, would also do well in this scenario.

The final scenario is the opposite of the rosy scenario. It envisions a world where, rather than getting everything right, the major central banks make policy errors that derail global growth. This could come in the form of the U.S. Federal Reserve waiting too long to hike interest rates, or where it hikes them too soon.

This is where investors who are defensive, as well as those who stick to U.S dollar assets, would benefit most.

BMO recommends large cap U.S. stocks in such an environment, particularly companies that have low debt. Long-dated U.S. Treasuries would be the main choice for fixed-income investors. Outside of the U.S., stocks from the so-called eurozone core countries, such as Germany, are recommended.

Finally, BMO notes that alternative investments, such as gold or volatility futures, would make a smart addition to portfolios.

Whichever scenario plays out, BMO notes that investors should be well diversified, with some strategies from each group being held to protect investors from whatever environment takes hold in the next five years.