Volatility and inflation may disrupt status quo in 2018

Vanguard | 19 December 2017


Vanguard Australia has released its economic and market outlook for 2018 that reflects the $5.9 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 characterised by tepid growth and inflation, there is risk that a cyclical rebound in economic fundamentals could cause a market repricing–ultimately mistaking “the trend for the cycle.”

“The secular forces of globalisation, 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,” Joseph Davis, Ph.D, Vanguard Global Chief Economist and head of Vanguard Investment Strategy Group said.

“Instead, we anticipate a bit more volatility and an uptick in inflation in the year ahead, accompanied by more muted equity returns.”

Australia: All eyes on households

Equity market valuations look reasonable for Australia with a Price Earnings multiple close to the historical average. However, unlike expectations for continued improvement for much of the developed world, the potential downside risks are elevated for the Australian economy.

Vanguard's cautionary view is also informed by the country's run of uninterrupted expansion, now into its 105th quarter, the longest in modern history, which may have resulted in a positivity bias among investment analysts and investors.

The risks of a slowdown are elevated given the fading tailwinds of a housing construction boom, and higher household debt. Modelling suggests a base case where the Australian economy centres on growth below trend at 2-2.5%.

While the unemployment picture is one of a relatively tight labour market, the demographic shift, including the aging population, means the supply of labour is leaning toward part-time workers, many of whom fit the definition of under-employed.

This is likely to keep inflation anchored at the lower end of the Reserve Bank of Australia's target range, and creates somewhat of a dilemma for the central bank- tighten to help reduce the household debt burden; or keep rates accommodative to stimulate growth and inflation. In the face of the RBA's dilemma, interest rates are likely on hold until at least the second half of 2018.

Our expected return outlook for Australian equities over the next decade is centred in the 5%–7% range, in stark contrast to the 9.4% annualised return generated over the last 30 years.

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.

The ten-year outlook for global equities has deteriorated since last year and is now centred in the 4.5%–6.5% range, based on our Vanguard Capital Markets Model projections.

Additionally the return forecast for fixed income is positive but muted, given our long-term outlook of modest growth and inflation it is in the 2%–4% range for the next decade, slightly higher than projected at this time last year.

In low-return environments, investors might be tempted to reach for a 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 realised in previous decades.

Vanguard's analysis of three portfolio scenarios against a diversified portfolio (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.

The comprehensive Vanguard 2018 economic and market outlook is available online.