Highlights from Vanguard's 2016 global economic and investment outlook
December 04, 2015
Vanguard's economic team, led by Global Chief Economist Joe Davis, Ph.D., projects what various market and economic events the coming year may bring, along with the challenges and opportunities for investors. Their study spans the general global economic environment, inflation, monetary policies, interest rates, bond and stock markets, and asset allocation considerations.
Read their global market outlook summary below, and find their in-depth analysis in the comprehensive research paper, Vanguard's economic and investment outlook.
Global economy: Structural convergence
World economic growth will remain frustratingly fragile. As in Vanguard's past Economic and Investment Outlooks, we view a world not in secular stagnation but, rather, in the midst of structural deceleration. Vanguard's non-consensus view is that the global economy will ultimately converge over time toward a more balanced, unlevered, and healthier equilibrium, once the debt-deleveraging cycle in the global private sector is complete.
Most significantly, the high-growth "goldilocks" era enjoyed by many emerging markets over the past 15 years is over. Indeed, we anticipate "sustained fragility" for global trade and manufacturing, given China's ongoing rebalancing and until structural, business-model adjustment occurs across emerging markets. We do not anticipate a Chinese recession in the near term, but China's investment slowdown represents the greatest downside risk.
The growth outlook for developed markets, on the other hand, remains modest, but steady. As a result, the developed economies of the United States and Europe should contribute their highest relative percentage to global growth in nearly two decades.
Now at full employment, the U.S. economy is unlikely to accelerate in 2016, yet is on course to experience its longest expansion in nearly a century, underscoring our continuing view of its resiliency. Indeed, our long-held estimate of 2% U.S. trend growth is neither "new" nor "subpar" when one both accounts for structurally lower population growth and removes the consumer-debt-fueled boost to growth between 1980 and the global financial crisis that began in 2007. Our interpretation fully explains the persistent drop in U.S. unemployment despite below-average economic growth.
Inflation: Secular deflationary bias waning
As we have discussed in past outlooks, policymakers are likely to continue struggling to achieve 2% inflation over the medium term. As of December 2015, however, some of the most pernicious deflationary forces (commodity prices, labor "slack") are beginning to moderate cyclically. Inflation trends in the developed markets should firm up, and even begin to turn, in 2016. That said, achieving more than 2% core inflation across developed markets could take several years and will ultimately require a more vibrant global rebound.
A deflationary threat will likely continue to hover over the world. In aggregate, reflationary monetary policies will continue to counteract the disinflationary drag of post-financial crisis global deleveraging. As suggested in Vanguard's past outlooks, recent consumer price inflation remains near generational lows and, in several major economies, is below the targeted inflation rate.
Key drivers of U.S. consumer inflation generally point to price stability, with core inflation in the 1%–3% range over the next several years. Nascent wage pressures should build in the United States in 2015 and beyond, but low commodity prices and the prospects of a strong U.S. dollar should keep inflation expectations anchored. In Europe, deflation remains a significant risk that will not soon disappear.
Monetary policy and interest rates: A 'dovish tightening' by a lonely Fed
Convergence in global growth dynamics will continue to necessitate and generate divergence in policy responses.
The U.S. Federal Reserve is likely to pursue a "dovish tightening" cycle that removes some of the unprecedented accommodation exercised due to the "exigent circumstances" of the global financial crisis. In our view, there is a high likelihood of an extended pause in interest rates at, say, 1%, that opens the door for balance-sheet normalization and leaves the inflation-adjusted federal funds rate negative through 2017.
Elsewhere, further monetary stimulus is highly likely. The European Central Bank and Bank of Japan are both likely to pursue additional quantitative easing and, as we noted in our 2015 outlook, are unlikely to raise rates this decade. This view is another potential factor that could result in a pause for the federal funds rate this business cycle.
Chinese policymakers have arguably the most difficult task of engineering a "soft landing" by lowering real borrowing costs and the real exchange rate without accelerating capital outflows. The margin of error is fairly slim, and policymakers should aggressively stimulate the economy this year in an attempt to stabilize below-target growth.
Investment outlook: Still conservative
Vanguard's outlook for global stocks and bonds remains the most guarded since 2006, given fairly high equity valuations and the low-interest-rate environment. We continue to view the global low-rate environment as secular, not cyclical.
The return outlook for fixed income remains positive, yet muted. In line with our past outlooks, our long-term estimate of the equilibrium federal funds rate remains anchored near 2.5% and below that of the Fed's "dot plots."1 As a result, our "fair value" estimate for the benchmark 10-year U.S. Treasury yield still resides at about 2.5%, even with a Fed liftoff. As we stated in our 2015 outlook, even in a rising rate environment, duration tilts are not without risks, given global inflation dynamics and our expectations for monetary policy.
After several years of suggesting that low economic growth need not equate with poor equity returns, our medium-run outlook for global equities remains guarded in the 6%–8% range. That said, our long-term outlook is not bearish and can even be viewed as constructive when adjusted for the low-rate environment.
Our long-standing concern over "froth" in certain past high-performing segments of the capital markets has been marginally tempered by the general relative underperformance of those market segments in 2015. Despite our more muted outlook for stocks, the ongoing U.S. equity bull market is likely to persist for some time.
Going forward, the global crosscurrents of not-cheap valuations, structural deceleration, and (the exiting from or insufficiency of) near-0% short-term rates imply that the investment environment is likely to be more challenging and volatile. Even so, Vanguard firmly believes that the principles of portfolio construction remain unchanged, given the expected risk–return trade-off among asset classes. Investors with an appropriate level of discipline, diversification, and patience are likely to be rewarded over the next decade with fair inflation-adjusted returns.
1 "Dot plots" refer to charts published by the Federal Open Market Committee (FOMC) in the Summary of Economic Projections that show where the FOMC participants, who are kept anonymous, think the federal funds rate should be over the next few years.
**Indexes used in our historical calculations
The long-term returns for our hypothetical portfolios are based on data for the appropriate market indexes through September 2015. We chose these benchmarks to provide the best history possible, and we split the global allocations to align with Vanguard's guidance in constructing diversified portfolios.
U.S. bonds: Standard & Poor's High Grade Corporate Index from 1926 through 1968; Citigroup High Grade Index from 1969 through 1972; Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; and Barclays U.S. Aggregate Bond Index thereafter.
Ex-U.S. bonds: Citigroup World Government Bond Ex-U.S. Index from 1985 to January 1989 and Barclays Global Aggregate ex-USD Index thereafter.
Global bonds: Before 1985, 100% U.S. bonds, as defined above. After 1985, 80% U.S. bonds and 20% ex-U.S. bonds, rebalanced monthly.
U.S. equities: S&P 90 Index from January 1926 through March 1957; S&P 500 Index from March 1957 through 1974; Dow Jones Wilshire 5000 Index from 1975 through April 2005; and MSCI US Broad Market Index thereafter.
Ex-U.S. equities: MSCI World ex USA Index from January 1970 through 1987 and MSCI All Country World ex USA Index thereafter.
Global equities: Before 1970, 100% U.S. equities, as defined above. After 1970, 70% U.S. equities and 30% ex-U.S. equities, rebalanced monthly.
The asset-return distributions shown here represent Vanguard's view on the potential range of risk premiums that may occur over the next ten years; such long-term projections are not intended to be extrapolated into a short-term view. These potential outcomes for long-term investment returns are generated by the Vanguard Capital Markets Model® (VCMM—see the description in the appendix) and reflect the collective perspective of our Investment Strategy Group. The expected risk premiums—and the uncertainty surrounding those expectations—are among a number of qualitative and quantitative inputs used in Vanguard's investment methodology and portfolio construction process.
IMPORTANT: The projections or 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 the VCMM, derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2015. Results from the model may vary with each use and over time.
- All investing is subject to risk, including the possible loss of the money you invest.
- The projections or 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 VCMM is a proprietary financial simulation tool developed and maintained by Vanguard Investment Strategy Group. 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. The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk-return tradeoffs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered is the most effective way to use VCMM output. The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognize that the VCMM does not impose "normality" on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths.
- Past performance is no guarantee of future returns.
- Investments in bond funds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty.
- Diversification does not ensure a profit or protect against a loss in a declining market. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
- Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent price fluctuations. Investments that concentrate on a relatively narrow market sector face the risk of higher price volatility.