Economic growth: Vanguard’s prospective- must read!

Vanguard, one of the world’s largest and most respected mutual fund companies, has published an extensive paper on their global growth and assessment, covering topics such as economic growth, inflation, interest rates, stock, and bond return over the next 10 years. I urge to read full report here:

Here are the snippets of their economic growth report:

Global economy. For the first time since the financial crisis, our leading indicators point to a slight pickup in near-term growth for the United States, parts of Europe, and other select developed markets. Continued progress in U.S. consumer de-leveraging, strong corporate balance sheets, firmer global trade, and less fiscal drag indicate U.S. growth approaching 3%. That said, this cyclical assessment should be placed against a backdrop of high unemployment and government debt; ongoing structural reforms in Europe, China, and Japan; and extremely aggressive monetary policy with exit strategies that have yet to be tested.

Inflation. In the near term, reflationary monetary policies will continue to counteract the deflationary bias of a high-debt world still recovering from a deep financial crisis. As was suggested in previous outlooks,
consumer price inflation remains near generational lows and, in several major economies, below the targeted rate. Key U.S. drivers generally point to higher but modest core inflation trends in the 1%–3% range for the next several years. For now, the risk of returning to the high inflationary regime of the 1970s is low despite the size of central bank balance sheets; in parts of Europe and in Japan, the specter of deflation remains a greater risk.

Monetary policy. Tapering of the Federal Reserve’s quantitative easing (QE) program has begun, although an actual tightening is likely some time off. The Fed’s forward guidance implies that the federal funds rate will remain near 0% through mid-2015; the risk that this “lift-off” date will be further delayed is notably lower than it was in prior periods. However, real (inflation-adjusted) short-term interest rates will probably remain negative through perhaps 2017. Globally, the burdens on monetary policymakers are high as they contemplate exiting from QE policies to prevent asset bubbles on one hand and remain mindful of raising short-term rates too aggressively on the other. The exit may induce market volatility at times, but long-term investors should prefer that to no exit at all.

Interest rates. The bond market continues to expect Treasury yields to rise, with a bias toward a steeper yield curve until the Federal Reserve raises short-term rates. Compared with last year’s outlook, our estimates of the “fair value” range for the 10-year Treasury bond have risen; the macroeconomic environment justifies a ten-year yield in the range of 2.75%–3.75% at present. However, we continue to hold the view that a more normalized environment in which rates move toward 5% based on stronger growth, inflation, and monetary tightening may be several years away. We maintain that the odds of a U.S. fiscal crisis and a sharp spike in yields are less than 10% at the moment, although they rise later in the decade based on the expected trajectory of U.S. federal debt.

Global bond market. As in past editions, the return outlook for fixed income is muted, although it has improved somewhat with the recent rise in real rates. The expected ten-year median nominal return of a broad, globally diversified fixed income investment is centered in the 1.5%–3.0% range, versus last year’s expected range of 0.5%–2.0%. It is important to note that we expect the diversification benefits of fixed income in a balanced portfolio to persist under most scenarios. We believe that the prospects of losses in bond portfolios should be weighed against the magnitude of potential losses in equity portfolios, because the latter have tended to exhibit much larger swings in returns.

Economic Growth Outlook-Vanguard

Global equity market. After several years of suggesting that strong equity returns were possible despite a prolonged period of sub-par economic growth, our outlook for global equities has become more guarded. The expected ten-year median nominal return is below historical averages and has shifted toward the bottom of the 6%–9% range compared with this time last year, a reflection of less constructive market valuations (i.e., price/earnings ratios) in the United States and some other developed markets. A notably wide range of outcomes is possible, even over long horizons, making us hard-pressed to identify market “bubbles.” However, we are uneasy about signs of froth in certain segments of the global equity market. Because the premium compensating increased equity risk appears to have come down recently, we would encourage investors to exercise caution in making strategic or tactical portfolio changes that increase this risk.

Asset allocation strategies. Broadly speaking, the outlook for risk premiums is lower across a range of investments than was the case just two or three years ago. Our simulations indicate that balanced portfolio returns over the next decade are likely to be below long-run historical averages, with those for a 60% stock/40% bond portfolio tending to center in the 3%–5% range, adjusted for inflation. Even so, Vanguard still firmly believes that the expected risk-return trade-off among stocks and bonds leaves the principles of portfolio construction unchanged. Specifically, our simulated mean-variance frontier of
expected returns is upward sloping—it anticipates higher strategic returns for more aggressive portfolios, accompanied by greater downside risk. We believe that a long-term, strategic approach with a balanced, diversified, low-cost portfolio can remain a high-value proposition in the decade ahead.

This was an excellent report; well written, supported with plethora of details. Great Job to the authors (Joseph Davis, Ph.D., Roger Aliaga-Díaz, Ph.D., Charles J. Thomas, CFA, Andrew J. Patterson, CFA)

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