Vanguard today released its 10th annual economic and market outlook – the firm’s comprehensive analysis on the current and future state of the global economy and financial markets. Despite slowing global growth, disparate inflation rates, and continued normalisation for monetary policy, Vanguard economists believe that a near-term recession will be avoided. In short, economic growth should shift down but not out. From an asset return standpoint, Vanguard foresees a ten-year outlook for a diversified portfolio in the 4%-6% range, representing a modest improvement over 2018.*
“While market volatility over the past two-to-three months has some investors overly cautious going into 2019, our outlook, while still guarded for the near-term, shows optimism for long-term investors as we move into the next year,” said Joseph Davis, Ph.D, Vanguard’s Global Chief Economist and head of Vanguard’s Investment Strategy Group. “Higher short-term interest rates, coupled with improved international equity market valuations, slightly raises our expectations for long-term global investment returns for US investors.”
Economic growth will shift down, but not out
Despite several factors pointing to a higher risk of a recession in 2019, Vanguard’s analysis on the fundamentals and historical drivers causing recessions concludes that the more likely scenario is a slowdown in growth, led by the U.S. and China. However, the expected easing of global growth over the next two years is charged with economic and market risks. Potential scenarios include the possibility of a severe deceleration of China’s economy, a policy mistake by the Fed as it raises rates further into restrictive territory, trade tensions, and other geopolitical and policy uncertainties.
Anchored inflation and normalised monetary policy
In previous outlooks, Vanguard research correctly anticipated that globalisation and technological disruption would make it difficult for economies like those of the U.S., Europe, and Japan, among others, to reach and sustain 2% inflation. In 2018, Vanguard economists rightly anticipated a rise in core inflation across various economies. For 2019, our economists do not see a material risk of further strong rises in core inflation despite lower unemployment rates and higher wages. Higher wages are not likely to funnel through to higher consumer prices, as inflation expectations remain well-anchored. In the U.S., core inflation will likely continue hovering near 2%, likely falling below the Fed’s inflation target in the second half of 2019. Higher wages are likely, but higher inflation is not.
Though as inflation continues to track to target levels, Vanguard economists warn economies could see an increased risk of volatility. As we observe the effects of monetary policy going forward, we can expect to see countries other than the U.S. just beginning to raise rates above post-crisis lows. Global central banks will be expected to continue on their gradual paths to normalisation, which will likely include a rate increase from the European Central Bank in the third quarter. For the U.S., Vanguard has confidence that the Fed will continue on their gradual rate hike path, reaching the terminal rate of 2.75-3% in mid-2019, followed by a pause or stop to reassess economic conditions.
Focus on Australia
Australia may experience growth in the region of 2.5% in 2019, as trend growth continues to fall as a result of changing demographics, improvements in technology, and expanding globalisation.
Vanguard’s Melbourne-based economist, Matthew Tufano said “Australia has not been immune to concerns that the business cycle might experience a downturn, but our observation is that the strength in the Australian economy will sustain into 2019 despite a reversion to trend growth”.
“Investors should be prepared for market volatility to persist however, with Australia’s labour market now in a similar position to that of the U.S. a year ago, so upward surprises to wages could quickly change market expectations in a similar fashion to what we saw in the U.S. in February 2018.
“The Reserve Bank of Australia continues to face a dilemma between an ever-tightening labour market and the combination of low inflation and concerns over household debt. There is a chance the RBA will move sooner than the market expects however, if the labour market tightness feeds into inflation pressure.”
An improved, though guarded, investment outlook
While our return outlook remains guarded and well below historical norms, Vanguard economists have found some optimism for long-term investment returns over the next decade. According to Vanguard’s Capital Markets Model projections—Vanguard’s proprietary investment analysis tool used to produce simulations and analyses that help to inform effective investment decisions—our global outlook for equities is in the 4%-6% range for returns. This remains starkly lower than the experience of previous decades and of the postcrisis years, when global equities have risen 11.8% a year since the trough of the market downturn. Strong performance over the past 9 ½ years has raised valuations much higher and they remain elevated relative to Vanguard’s “fair-value” CAPE benchmark in the United States, hence the more guarded outlook than what may be reflected in investors’ portfolios of late.
The expected returns in Australia are barely higher than those for global or international markets, which emphasises the importance of global diversification going forward. Vanguard’s outlook for Australian equities over the next decade is in the 4.5%-6.5% range and we can expect to see equity valuations continue to contract as interest rates rise over time. For non-Australian equities, investors will likely see returns in the 4%-6% range, though equity valuations may remain higher as we don’t expect valuation contraction to be as severe as it has in the past.
Continued interest rate increases have positively benefited Vanguard’s outlook for fixed income markets versus previous reports. Over the next 10 years, investors can expect to see global fixed income returns in the 2%-4% range. Non-Australian bond investors could expect returns in the same range, and while similar to that of Australian bonds, would still provide positive diversification benefits in a balanced portfolio.
“As the global markets continue to move into a lower orbit of returns, it’s only natural that investors start seeking out strategies to help increase their chances for investment success,” said Mr. Davis. “These strategies, like reaching for yield or reaching for return, while tempting, are still unlikely to escape the forces of expected lower portfolio returns especially when compared with the unprecedented returns investors have experienced over the past decade.”
Given the somewhat challenging outlook ahead, it’s important investors focus on key factors like saving more, spending less, and controlling investment costs, rather than concentrating on the less reliable benefits of ad-hoc portfolio tilting. Additionally, Vanguard believes investors should continue to adhere to time-tested investment principles such as maintaining a long-term focus, employing a disciplined asset allocation, and conducting periodic portfolio rebalances. * Diversified portfolio with 60/40 equity/bond asset split.