Vanguard: Volatility And Inflation May Disrupt Status Quo In 2018

VALLEY FORGE, PA (December 4, 2017)—Vanguard today released its market and economic report for 2018 that reflects the $4.8 trillion global investment management firm’s most guarded outlook in a decade, as global return expectations have settled into a lower orbit amidst extended valuations and secularly low interest rates. 

In its 2018 Economic and Market Outlook, Vanguard states that in an environment in which consensus expectations have finally centered on a long-term outlook characterized by tepid growth and inflation, there is risk that a cyclical rebound in economic fundamentals could cause a market repricing—ultimately mistaking the “the trend for the cycle.” In the U.S. specifically, a wage or inflation hike could lead markets to reprice a more aggressive path of policy rate normalization by the Federal Reserve, ending a long period of low volatility.

“The secular forces of globalization, demographics, and technology have for years served as the foundation for Vanguard’s long-term outlook of modest growth and tepid inflation. As we head into 2018, investors should not mistake these secular trends for short-term cycles,” said Joseph Davis, Ph.D, Vanguard Global Chief Economist and head of Vanguard Investment Strategy Group. “Instead, we anticipate a bit more volatility and an uptick in inflation in the year ahead, accompanied by more muted equity returns.”

The path to normalization: Tightening labor markets and inflation risk

As the global economies embark on a historic path towards normalization, beginning first in the U.S., and enter into unchartered territory, the chances of unexpected shocks to markets are high. However, Vanguard research emphasizes that this past decade of low volatility should not be directly attributed to quantitative easing practices. Rather, an environment of low volatility and muted sensitivity to economic surprises is not specific to this current rate cycle. Therefore, while the forthcoming removal of extraordinary easy monetary policies will not be without uncertainty, Vanguard believes it is overly pessimistic to assume that the level and persistence of volatility will be equally extraordinary.

Despite the short-term risk of an “inflation surprise” due to tightening labor markets, Vanguard’s long-term inflation outlook remains unchanged from 2017, driven by long-term structural forces of technology and globalization. Vanguard research shows that falling prices for technology in the U.S. have restrained overall core inflation metrics by 50 basis points on average over the past 20 years and could be accountable for the drag on inflation even during recent periods of strong growth and full employment.

A lower orbit for investment returns and a caution to investors

In determining equity valuations, Vanguard’s proprietary “fair-value” CAPE (cyclically adjusted price-earnings) formula looks beyond historical averages to account for current interest rates and inflation levels to provide a more useful, comprehensive benchmark. While the market is approaching overvalued territory according to traditional CAPE measures, Vanguard believes it is not grossly overvalued as it would be in a bubble and is hard-pressed to find such a scenario.

Vanguard’s outlook for global stock and bonds is the most subdued it has been in a decade. Elevated equity valuations, low interest rates, and compressed spreads have pulled the market’s efficient frontier into a lower orbit. In the U.S., equity returns are expected to hover in the 3-5% range, in stark contrast to the 10% annualized return generated over the last 30 years. Non-U.S. equity markets could see returns closer to the 5.5-7.5% range, emphasizing the benefits of a globally diversified portfolio in the years ahead. Additionally, the return forecast for fixed income is positive but muted in the 2-3% range for the next decade.

In low-return environments, investors might be tempted to reach for a “shiny” new investment strategy in search for alpha, such as overweighting emerging market equities and high yield corporate debt. However, Vanguard finds that these strategies would not raise the expected portfolio returns to levels investors may have realized in previous decades. Additionally, Vanguard’s analysis of three portfolio scenarios (diversified; overweight equity and short duration; overweight long-duration and underweight equity) found that the diversified portfolio works best for investors who lack a strong conviction on the future state of the economy.

“While our global market outlook suggests a somewhat more challenging and volatile environment ahead, investors can continue to find potential for long-term success by lowering their return expectations and maintaining a balanced and globally diversified portfolio. Saving more and keeping an eye toward costs are even more crucial elements of a successful investment strategy,” Davis said.

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About Vanguard
Vanguard is one of the world’s largest investment management companies. As of October 31, 2017, Vanguard managed $4.8 trillion in global assets. The firm, headquartered in Valley Forge, Pennsylvania, offers more than 376 funds to its more than 20 million investors worldwide. For more information, visit vanguard.com.

All data as of October 31, 2017, unless otherwise noted.

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IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2017. Results from the model may vary with each use and over time.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.