We often hear from clients: “What is the difference between scenario planning and forecasting?” Why do we prefer scenario planning at SFG? Scenario planning sits at the heart of our risk management process and philosophy. The official definition of scenario planning is: “The process of visualizing what future conditions or events are probable, what their consequences or effects would be like, and how to respond to, or benefit from them.” As you can see, scenario planning takes into consideration past events, as well as events that we are currently monitoring as probable disruptions.
The Stagflation Scenario
A scenario example that we are working on is a version of stagflation. With a lot of the global supply chain being shut off during the early months of COVID-19, we have seen a dramatic mismatch in supply and demand. If this problem persists, we could have a market environment similar to the early 1970’s where we witnessed globally the effects of stagflation. Stagflation is where inflation skyrockets upwards (in the 1970’s case this was caused by an oil price shock) and high unemployment is present. We are currently scenario planning for what this would look like in 2021 and beyond. We believe that supply chains will begin to stabilize, unemployment will remain low, and we will remain in an inflationary, slow-growth economy. Currently, our base case scenario is that inflation begins to taper down from 5% to around 2% for a period and then increases to a persistent level of 4-5%.
A historical scenario that we reference quite often is the 2008 Financial Crisis. Using this scenario, we can reference what the economic environment was like, as well as the draw-downs that the markets experienced, and build out a scenario where our portfolios would be if exposed to similar draw-downs but in today’s environment. History never repeats itself but it does rhyme which is why it is just as important to look back at history as it is to look toward the future.
Scenario Planning Versus Forecasting
The strength of using scenario planning is that it is a mix of qualitative (fiscal policy, geopolitical tensions, etc.) and quantitative (GDP, unemployment, etc.) views when approaching risk management. This allows for a top-down/bottom-up approach, as well as looking forward to the future and seeing how a portfolio might react to certain market situations. We believe this makes scenario planning much less rigid than traditional forecasting methods.
Forecasting deploys historical quantitative methods. These methods predict what will happen in the future by relying mainly on data from the past and present. This leads to a very rigid risk management assessment. These models often fail to predict quick and significant changes in market conditions. A weak spot when using forecasting to assess risk is that in dynamic market conditions, these models often break down because they are experiencing new events that are not modeled in their test statistics.
We believe scenario planning to be far superior and more strategic than traditional forecasting methods. Scenario planning offers a greater level of flexibility and preparedness than purely quantitative forecasting models. Because we manage money for the long-term, building around scenarios allows us to react and not predict regarding these black swan events, and gives us the ability to help assess risk measures at the individual client level.