After a bumpy start to 2018 for financial markets, what lies ahead?

August 14, 2018

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Andrew Patterson

Andrew Patterson
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At the end of last year, Vanguard published its annual outlook for the global economy and financial markets in 2018 and beyond. A lot's happened in the short time since then—Congress passed tax cuts, oil and other commodity prices trended higher, the United States pulled out of the Iran nuclear accord, negotiations over North Korea's denuclearization advanced in fits and starts, political risks in Europe increased, and trade tensions heated up across much of the world. We sat down with Vanguard Senior Economist Andrew Patterson to get an update on how Vanguard's outlook has evolved against this backdrop.

Let's start with interest rates. Not so long ago, the financial markets weren't convinced that the U.S. Federal Reserve would make all the hikes it had penciled in. Now they are even more confident than the Fed itself that we will see four hikes overall in 2018. What's brought about the change and where does Vanguard stand?

We actually singled out a resetting of inflation expectations back in December as the greatest risk—among many—to the status quo, but it played out faster than we had expected. And our concern centered on inflation in the United States and action from the Federal Reserve to contain it, because of where the U.S. is in the economic cycle compared with other developed markets. We don't see inflation in Europe or Japan, for example, reaching levels that would warrant rate hikes by the European Central Bank or the Bank of Japan for years to come.

A little background on our thinking: The markets had settled on a muted outlook for growth and inflation after years of anticipating a cyclical bounce in the wake of the great financial crisis that never materialized. While we agree that structural factors such as globalization, demographics, and technology will result in moderate long-run growth and inflation, the market's universal acceptance of this view overlooked the possibility of a short-term spike in inflation expectations.

In late January, several U.S. economic statistics pointed to exactly that—an upswing in inflation. The markets responded by pricing in a more aggressive pace of monetary tightening from the Federal Reserve. At its June meeting, the Fed indicated that it expected to make two rate hikes in the second half of 2018, rather than just one. That came as a result of adjustments to some of its assumptions: the economy growing a little faster, unemployment falling a little lower, and inflation running a little higher in 2018 than it had expected.

Given current expectations for the U.S. core personal consumption expenditures price index to end 2018 at slightly higher than 2% and continued strength in the labor market, we expect that the Fed will in fact raise rates two more times this year, for a total of four increases in the 2018 calendar year. We have not changed our view that the rate will be 2.75%–3% at the end of  this cycle, and therefore we expect to see two increases in 2019.

Can you elaborate on Vanguard's outlook regarding employment?

The U.S. and much of the world are at full employment, even as we keep hearing that robotics, artificial intelligence, and digital technology are going to replace humans.

We looked into this conundrum a while ago and will soon come out with a new paper, The Future of Work, that extends our analysis on the topic.

We're not in the camp that foresees a future of mass unemployment. While jobs that are largely made up of repetitive tasks—like those in the auto manufacturing industry—may get automated away, we believe there will be more jobs ten years from now. And they will be better jobs because, with less routine tasks to perform, we'll be spending more of our time thinking creatively and resolving conflicts. We call these sorts of activities "uniquely human" tasks.

This will result in a paradox. In the next decade, as the number of jobs focused on uniquely human tasks increases, we are likely to see both rising levels of automation and labor shortages. We'll have more robots, and not enough human workers

Inflation, which was a story investors were focused on at the beginning of the year, has been overtaken by headlines about rising trade tensions. What impact will tariffs have on Vanguard's economic outlook, and what can investors do to protect their portfolios?

We researched tariffs and their effects last year in a paper in our Global Macro Matters series called Trade Status: It's Complicated. In estimating what will happen if trade tensions escalate to varying degrees, we found that a slight increase in tariffs provides a short-term marginal benefit to the U.S. economy. Any benefits quickly diminish, however, and can be offset by retaliatory tariffs and market volatility. The end result would be higher consumer prices and reduced trade activity, resulting in lower economic growth—a lose-lose scenario.

Investors can reasonably assume that trade rhetoric will remain a source of volatility for some time, especially for equities, which tend to react poorly to uncertainty. Few observers expect the renegotiation of trade agreements among the U.S., Canada, and Mexico to be complete before 2019 or 2020. When it comes to Europe and China, we see the road to renegotiating trade relations as long, winding, and bumpy.

The good news is that experience shows the markets are able to place trade disputes in the proper context, ranking them behind currency valuations and central-bank policy in overall importance to the global economy.

It's prudent to closely monitor policy decisions in the U.S. and the reactions of its trading partners, but we would caution investors against making tactical or short-term changes to their portfolios in response.

After U.S. stocks rose more than 20% in 2017 (according to the CRSP U.S. Total Market Index), some investors felt they might have become overvalued. Since then, we've seen a correction and then a rebound. Where does that leave valuations now both within and outside of the U.S.?

No valuation metric can tell you with any degree of accuracy what stock prices will do in the short term. And there are very few that can give you any predictive insight even over the longer term. One exception is economist Robert Shiller's cyclically adjusted price/earnings ratio, or CAPE as it's commonly referred to. That metric, which incorporates earnings for S&P 500 stocks for the previous ten years rather than just one, currently stands at roughly 32, which is almost double its long-term average of about 17.

The CAPE assumes the ratio will revert to its long-run average, so a high CAPE ratio indicates that stock returns over the next ten years will be below average (a low CAPE ratio would indicate the opposite).

Beginning around 1985, however, the CAPE's predictive power began to deteriorate, with the metric remaining stubbornly above its historical average even as equity returns in the following decades remained robust.

As part of a renaissance in research in the financial industry into refining the CAPE, we revisited the standard assumption that the CAPE ratio will revert to its long-run average regardless of the economic environment. Instead, we adjust the CAPE to take into account current low interest rates and inflation expectations, which has significantly increased its forecast accuracy.

So to get back to your question, despite the upturn we saw in volatility early in the year, our current "fair-value" CAPE indicates that although U.S. stock valuations are high, they are not in "bubble" territory.

Our fair-value CAPE also indicates that other developed markets remain reasonably valued—an additional argument in favor of geographical diversification.

Emerging market stocks are a different story. They were a source of concern heading into 2018. Although they were valued at a discount to U.S. stocks—as they tend to be normally, given the higher risk associated with investing in them and the higher earnings yields required by investors to buy them—they were nevertheless trading above fair value according to our estimates.

Since then, though, a number of headwinds—including protectionist trade concerns, the strength of the U.S. dollar, and rising U.S. interest rates—have sapped demand for these securities and brought their valuations closer to what we would see as fair value.

Vanguard's published outlook for the past several years hasn't been very optimistic regarding market returns. Last year we stated: "For 2018 and beyond, our investment outlook is one of higher risks and lower returns." Has Vanguard's stance on that shifted?

The short answer, unfortunately, is no.

The era of very accommodative monetary policy we've been living through is coming to an end. Since the great financial crisis, central bankers across the world have been deliberately stimulating markets by buying assets, pushing down risk premiums, and pushing up the price of risky assets to try to encourage firms and households to spend money. Now it's payback time, if you will: The depressed returns looking forward are very much a consequence of the unwinding of those stimulative policies and a reversion of the slightly elevated valuations discussed earlier.

Stock returns, particularly here in the United States, are likely to be muted. Global equities should return somewhere in the range of 4.5% to 6.5% on an annualized basis, compared with about 15% in the 8½ years since the last recession. That's not to say we won't have years when the markets do better than that, or years when returns are negative.

So global equity returns in the 4.5% to 6.5% range. Is that after accounting for inflation?

That range is in nominal terms—that is, before taking inflation into account.

But thankfully, inflation is likely to be lower than the 3% to 4% rates we saw in the 1990s and much lower than in the 1980s.

Going forward, our base case is that inflation will run a little bit below 2%. So using back-of-the-envelope math, you're looking at an annualized return for global equities in the range of 2.5% to 4.5% after adjusting for inflation.

As you just pointed out, those return projections are a far cry from what investors may have become accustomed to in recent years. What's an investor to do?

Admittedly, our return projections are low. And while that's hard to hear, we think it's important to be very forthright about them so that investors can make informed asset allocation decisions.

Investors who already have a sensible investment plan designed to carry them through good markets and bad will hopefully have the discipline and perspective to remain committed to it despite the muted return outlook.

That will probably result in better investment outcomes than if they give in to the temptation of adding higher-yielding investments in the hope of getting back to the levels of return we've seen in recent years. In some circumstances, those investments might deliver higher returns. What's more certain is that they will add risk.

There's nothing you can do about the outlook for lower expected market returns, no radical new investment strategy to turn to. As always, it's important to stay focused on the things you do have control over that can increase your chances of achieving your investment goals, like saving more and keeping your investment costs low. 

For more discussion of Vanguard's current outlook on the global economy and the financial markets, you can watch the recent webcast with Vanguard's Qian Wang, Andrew Patterson, and Peter Westaway titled Where's the global economy heading? or read the transcript.


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