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Vanguard’s economic
and investment outlook
Vanguard research
• This paper presents Vanguard’s global perspectives on the future of
growth, inflation, interest rates, and stock and bond returns over the
next ten years. As in past outlooks, we anticipate that the modest
global recovery will likely endure at a below-average pace through a
period of low interest rates, continuing high unemployment and debt
levels, and elevated policy uncertainty.
• We detail how, after years of slightly disappointing 2% real growth,
the U.S. in 2014–2015 faces cyclical risks tilted toward better-than-trend
growth for the first time since the onset of the global financial crisis.
Our economic outlook, in short, is one of resiliency.
• We also explain why last year’s unease about the “reach for yield” is
now joined by concern about “froth” in certain equity markets. Market
volatility is likely as the Federal Reserve undertakes the multistep,
multiyear process of unwinding its extraordinarily easy monetary
policy. Rather than frame this process as a negative, we view it
as an indication of increasing economic strength.
Note: The authors would like to thank the members of Vanguard’s Investment Strategy Group for their valuable feedback
and contributions, in particular Harshdeep Ahluwalia, Vytautas Maciulis, Christos Tasopoulos, and Ravi Tolani.
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vanguard.com
January 2014
Authors
Joseph Davis, Ph.D.
Roger Aliaga-Díaz, Ph.D.
Charles J. Thomas, CFA
Andrew J. Patterson, CFA
Vanguard’s distinct approach to forecasting
To treat the future with the deference it deserves, Vanguard believes that market forecasts are
best viewed in a probabilistic framework. This publication’s primary objectives are to describe the
projected long-term return distributions that contribute to strategic asset allocation decisions and to
present the rationale for the ranges and probabilities of potential outcomes. This analysis discusses
our global outlook from the perspective of a U.S. investor with a dollar-denominated portfolio.
Global market outlook summary
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 deleveraging, 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.
2
Global equity market. After several years of suggesting that strong equity returns were possible despite
a prolonged period of subpar 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.
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 VCMM, derived from
10,000 simulations for U.S. equity returns and fixed income returns. Simulations as of November 30,
2013. Results from the model may vary with each use and over time. For more information, please
see the appendix on page 30.
All investing is subject to risk, including the possible loss of the money you invest. 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.
3
Global growth outlook
• Firming global trade and manufacturing.
Similar to our stance last year, we view the global
recovery as likely to proceed at a modest pace
(Figure 1a). Over the next decade, expansion should
occur at varying speeds, with trend growth likely
lower than during the past 20 years based on
economic, demographic, and other factors that we
will discuss later. Figure 1b presents estimates of
potential growth rates for the major world
economies.
• An aging capital stock and pent-up investment
demand.
Nevertheless, for the first time since the financial
crisis, our leading indicators point to the possibility
of a slight cyclical pickup in near-term growth for
the United States and other selected economies.
Positive factors contributing to this outlook include:
• Continued progress in U.S. consumer
deleveraging.
• Rising consumer wealth levels in many markets.
• Less fiscal drag in 2014–2015 (see Figure 2b
on page 6).1
This cyclical growth assessment should, however, be
placed within the context of a stubbornly lower-growth
world marked by high levels of both government and
private-sector debt (see Figure 2a on page 6), less
favorable demographic trends, and extremely
aggressive monetary policy with untested exit
strategies.
Downside economic tail risks appear somewhat
lower than they were two years ago, although
lingering doubts remain regarding the prospects
for a hard landing in China and for euro stability.
Various other geopolitical risks are inherently
difficult to forecast.
Indexes used in our calculations
The long-term returns for our hypothetical portfolios are based on data for the appropriate market indexes
through November 2013. We chose these benchmarks to provide the best history possible and 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: Prior to 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 3, 1957; S&P 500 Index from March 4, 1957,
through 1974; Dow Jones Wilshire 5000 Index from 1975 through April 22, 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
Index ex USA thereafter.
Global equities: Prior to 1970, 100% U.S. equities, as defined above. After 1970, 70% U.S. equities and 30%
ex-U.S. equities, rebalanced monthly.
1 Fiscal drag occurs when government spending cuts, tax increases, or both reduce the pace of overall spending and GDP growth.
4
Figure 1.
Global trend growth has been heading down
a. A cyclical upturn in a world of lower trend growth
b. Trend growth is lower across most large markets
Annualized growth of the global economy
Historical and future trend growth in the world’s ten largest
economies
Percentage Pre-recession Long-run
of world trend growth
potential
economy
(1995–2007)
growth
6%
5.5%
Average annualized growth
5
3.9%
4
3.4%
3.1%
3
2.7%
3.0%
2.5%
2
1
0
1960s
1970s
1980s
1990s
2000s
2010–
2013
2014–
2016
(projected)
Notes: World GDP is shown at market exchange rates, in constant U.S. dollars.
Data are from World Bank for 1960 through 1969 and International Monetary
Fund’s World Economic Outlook (WEO), October 2013, for subsequent years.
Projected growth is from the IMF.
Sources: Vanguard calculations, based on IMF and World Bank data.
United States
22.8%
3.2%
2.5%
Eurozone
17.3%
2.3%
1.6%
China
12.2%
10.0%
7.0%
Japan
6.8%
1.2%
1.1%
United Kingdom
3.4%
3.3%
2.3%
Brazil
3.0%
3.0%
3.5%
Russia
2.9%
3.9%
3.5%
Canada
2.5%
3.1%
2.2%
India
2.4%
6.9%
6.7%
Australia
2.0%
3.7%
3.0%
Notes: Percentage of world economy is based on IMF estimates of nominal GDP.
Pre-recession trend is based on average annualized real GDP growth from the
IMF. Long-run potential for the United States is defined as the average growth in
2018 of the Congressional Budget Office’s real potential GDP estimate; for other
regions, it is defined as the 2018 growth rate from the IMF’s October 2013 WEO.
Sources: Vanguard calculations, based on IMF and CBO data.
Europe
In Europe, the broad economy is likely to grow at
a positive albeit anemic pace after several years of
deep, deleveraging-related recession (see Figure 3a
on page 7). We believe that the euro is likely to survive
intact, although a more vibrant and balanced European
economy seems several years away.
Structurally, labor costs within Europe are continuing
their painful internal adjustment as the peripheral
economies aim to become more competitive relative
to the core nations (see Figure 3b on page 7). We
believe it is unlikely that the European economy as
a whole will grow sustainably above 1% in the near
future because significant deflationary competitive
adjustment is still occurring on the periphery. Growth
is likely to be held back by fiscal restructuring and
banking-sector deleveraging, although this should
ease in the next few years. Unemployment rates
in some peripheral economies of more than 20%,
particularly for younger workers, present a moderate
risk of social unrest leading to political instability.
Although we expect Europe to continue meandering
through its quandaries with a modest acceleration
in growth over the next few years, investors should
still prepare for periodic market volatility driven
by flare-ups in political risk, concerns regarding
the capitalization of the European banking system,
and the potential for further debt write-downs,
particularly in Greece.
5
Figure 2.
Debt and fiscal drag are significant factors affecting global growth
a. Debt levels remain high but vary by country and type
Debt dashboard for selected economies as a percentage of GDP
Central government
Households
Nonfinancial corporations
Financial institutions
United States
Eurozone
Germany
France
Italy
Spain
Netherlands
Greece
Ireland
Portugal
China
Japan
United Kingdom
Canada
Australia
Less than 50%
Between 50% and 100%
More than 100%
Notes: We caution readers against making concrete assessments based on this general analysis, as the level of debt that a given country or sector may be able to
sustain involves many factors. China’s government debt is shown on a gross basis; all others are net. Data show the latest available quarterly value in 2013 as a
percentage of the trailing four-quarter average nominal GDP.
Sources: Vanguard calculations, based on data from IMF, European Central Bank, Thomson Reuters Datastream, Moody’s Analytics, Australian Bureau of Statistics,
Reserve Bank of Australia, Federal Reserve, Bank for International Settlements, and Bank of Japan.
b. Fiscal drag is expected to ease over the next two years
Change in the pace of fiscal consolidation, 2012–2013 versus expected 2014–2015
Change in fiscal drag as
annualized percentage of GDP
3%
Policy becoming
less restrictive
Policy becoming
more restrictive
2
1
0
–1
–2
Japan
China
Australia
United Kingdom
Canada
Ireland
Eurozone
Germany
France
Portugal
United States
Spain
Italy
Greece
Netherlands
–3
Notes: Figure displays the change in the pace of government deficit adjustment, measured as the difference in the change in the primary (excluding interest) structural
government balance over the two years through 2013 relative to the expected change in the two years through 2015. Estimates for the next two years are from the IMF’s
October 2013 WEO.
Sources: Vanguard calculations, based on IMF data.
6
Figure 3.
In Europe, growth is expected to remain lackluster and divergent as imbalances slowly correct
a. Real GDP in the Eurozone
b. Unit labor costs in the Eurozone
Cumulative change relative to Eurozone average
since Q4 2000
102
Real GDP, Q1 2008=100
100
98
96
94
92
90
2005
2006
2007
2008
2009
2010
2011
2012
2013
15%
10
5
0
–5
–10
2001
2003
2005
2007
2009
2011
2013
CEPR recession
Eurozone
Eurozone core
Eurozone periphery
Notes: “Core” is defined as the GDP-weighted average of changes in unit labor costs in Germany, France, and the Netherlands. “Periphery” is defined as the
GDP-weighted average of changes in unit labor costs in Italy, Spain, Greece, Portugal, and Ireland. CEPR refers to the Centre for Economic Policy Research.
Sources: Vanguard calculations, based on data from Moody’s DataBuffet.com, Thomson Reuters Datastream, France’s National Institute of Statistics and Economic
Studies (INSEE), Deutsche Bundesbank, Statistics Netherlands, Ireland’s Central Statistics Office (CSO), Italian National Institute of Statistics (ISTAT), Hellenic
Statistical Authority (ELSTAT), Instituto Nacional de Estatística–Portugal (Statistics Portugal), and European Commission: Eurostat.
Asia
China is likely to grow at a 7% pace over the
next two to three years, in line with market
expectations but notably slower than its previous
trend. Policymakers are attempting through
structural supply-side reforms to strategically alter
the country’s growth model, which heretofore has
relied on investment and exports as its sole drivers.
As illustrated in Figure 4a on page 8, investment
currently represents a notably high share of Chinese
GDP. However, capital-to-labor ratios are fairly low,
meaning that although investment is running at a
high rate, the country is starting from a low base
in its capital stock. With capital per person at less
than one-fifth that of the United States, much
more investment is still needed.
The challenge for China is to ensure that such fastpaced investment spending flows toward the most
productive uses of capital, avoiding misallocation
and overinvestment in certain sectors. Some of
the recently announced pro-market reforms are
promising, because credit and investment will
respond more to market signals (as would emerge
with interest-rate liberalization) than to short-term
policy targets or strict controls. However, the
transition is not free of risks. Normal swings in
market-driven investment and credit flows coupled
with the current high weight of investment spending
in GDP growth could easily cause a sharp economic
slowdown. Gradual and flexible implementation
of the reforms will be critical. Under a multiyear
schedule, a growth guideline of about 7% to
7.5% for 2014 should be within reach.
7
Figure 4.
In Asia, China needs rebalancing as Japan attempts reflation
a. China’s investment spending: An unsustainable rate, but unlikely to soon collapse
$300,000
Investment as percentage of GDP
50%
250,000
40
200,000
30
150,000
20
100,000
10
50,000
0
0
China today
China average
past decade
Asia Tigers at
China’s current
income levels
15 largest
economies
average today
Capital-to-labor ratio, constant 2005 dollars
Investment as percentage of GDP and capital-to-labor ratios for selected countries and time periods
United States today
Investment as percentage of GDP
Capital-to-labor ratio
Notes: Investment as a percentage of GDP is from the IMF’s October 2013 WEO and April 2002 WEO for the stated time periods. “Today” is defined as the average
for 2013. Asia Tigers comprise South Korea, Hong Kong, Taiwan, and Singapore when each was at China’s 2013 real per capita GDP level ($6,500 in 2013 U.S. dollars).
The 15 largest economies are defined using 2013 GDP. Capital-to-labor ratio is from the Penn World Tables, in 2005 U.S. dollars, with “today” defined as the average
for 2011.
Sources: Vanguard calculations, using data from the IMF and Penn World Tables.
b. “Abenomics” in Japan: More reflation than real growth
Japan’s historical and Abenomics real GDP growth and inflation
5%
Average annual rate
4
4.8%
3.6%
3
1.9%
2
1
0.8%
1.0%
0.0%
0
1975–1991
1992–2012
Successful Abenomics 2013–2018
Inflation
Real GDP growth
Notes: Figure assumes that Abenomics achieves its goals of 2% inflation and 3% nominal GDP per capita growth by 2015. Transition assumes IMF’s WEO
October 2013 baseline is realized in 2013–2014.
Sources: Vanguard calculations, based on data from Thomson Reuters Datastream and IMF.
8
Japan’s aggressive Abenomics initiative aimed at
jump-starting its economy is promising, although real
growth will be challenged to exceed 1% for some
time. The main goal of Abenomics seems to be
reflation of prices rather than real economic growth.
Even assuming full success of its policies,2 by 2015
Japan would be growing at a pace not much higher
than its average for the last 20 years. However,
if successful, Abenomics would bring inflation to
a significantly higher level than it has been in the
recent past (see Figure 4b). This would be an
encouraging development, although as displayed in
Figure 4b, it will be a difficult task after two decades
of deflation.
United States
As in past outlooks, we maintain that U.S. trend
growth (in terms of real GDP) is near 2%, versus
its historical average of 3.0% to 3.5% since 1947.
This projection is based on several structural
headwinds, including slower labor force and
population growth, the potential for continued
consumer deleveraging, and higher levels of
structural unemployment and debt than was the
case over the past three decades.3 Indeed, actual
real GDP growth has averaged 2.3% since the
recovery began in 2009, well below the experience
in previous recoveries (see Figure 5a on page 10).
Nevertheless, we believe that our U.S. economic
outlook can best be described as one of resiliency
rather than of secular stagnation, for the reasons
outlined below.4
Significant progress has been made to date in
reducing consumer debt (see Figure 5b on page 10).
Although this debt may not reach more sustainable
levels of 60%–70% of GDP until 2016 or so, lower
interest rates to service it combined with rising
stock and home values have substantially aided
the transition to a “passive deleveraging” phase
of the cycle (see Figure 5b).
For growth, it is the pace of consumer deleveraging
that matters most, not the absolute level of debt
outstanding, and that pace is slowing. As a result,
the consumer need not “lever up” and save less
in order for the country to achieve stronger growth
in 2014–2015. Rather, this can emerge from fewer
drags and shocks hitting the economy. In fact,
the U.S. private sector (real GDP excluding the
government sector) grew at a 2.9% pace in the
four quarters through September 2013.
Over the next two to three years, further
acceleration of business investment (potentially
driven by an unleashing of so-called animal spirits)
is critical if U.S. economic growth is to exceed its
recent threshold. The health of corporate balance
sheets and profit margins (see Figure 5c on page 11)
indicate that this is feasible, albeit not assured. The
biggest risk is that policy uncertainty spikes and
again exerts an “uncertainty tax” on the economy
(similar to that surrounding, say, the debt-ceiling
debate in mid-2011). Figure 5d, on page 11, shows
that lower levels of uncertainty may be associated
with a further pickup in capital spending over the
next 12 to 18 months.
2 Japanese Prime Minister Shinzo Abe has announced targets of 3% growth of nominal income per capita and 2% inflation by 2015.
3 For more on the prospects for U.S. growth over the next decade, see Davis (2012) on a potential ”third industrial revolution.” In that presentation, we
discuss how the factors that could contribute to better-than-expected growth may be driven by marked increases in capital investment. This could be
sparked by the widespread adoption of cost-saving technologies, increased housing and infrastructure spending after a prolonged period of depressed
activity, substantial U.S. energy independence from rising domestic production, and a lower trade deficit.
4 See Summers (2013) and Gordon (2012) for in-depth discussions supporting the view of secular stagnation.
9
Figure 5.
In the United States, a modest recovery may be set to accelerate
a. Deleveraging and fiscal belt-tightening have led to a modest recovery
Contribution to annualized real GDP growth
Contribution to growth in real U.S. GDP
4.5%
4.0%
4.0
3.5
3.0
2.5
2.5%
2.3%
2.0
1.5%
1.5
1.0
0.7%
0.5%
0.5
0.6%
0.4%
0.2%
0.0
Real GDP
Consumer
spending
–0.1%
–0.2%
–0.3%
–0.5
Government
spending
Business
investment
Residential
investment
Net trade
Average of recoveries since 1950s
Current recovery, Q2 2009 to Q3 2013
Sources: Vanguard calculations, based on data from U.S. Bureau of Economic Analysis.
b. Consumer deleveraging is past the worst, but not over
Household debt as a percentage of GDP and of assets
Household debt as percentage of GDP
18
16
75
Potential equilibrium
14
12
50
10
8
25
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Percentage of GDP
Percentage of household assets
Sources: Vanguard calculations, based on data from Moody’s DataBuffet.com, Federal Reserve, and U.S. Bureau of Economic Analysis.
10 2010
Household debt as percentage
of household assets
20%
100%
Figure 5.
In the United States, a modest recovery may be set to accelerate continued
c. Businesses are positioned to expand and hire . . .
11%
5.5%
10
5
9
4.5
8
4
7
3.5
6
3
5
2.5
4
Corporate cash holdings
as percentage of total corporate assets
Corporate after-tax profits as percentage of GDP
Corporate profits and cash balances
2
1970
1975
1980
1985
1990
1995
2000
2005
2010
Corporate after-tax profits as percentage of GDP
Corporate cash holdings as percentage of total assets
Sources: Vanguard calculations, based on data from Moody’s DataBuffet.com, Federal Reserve, U.S. Bureau of Economic Analysis, and National Bureau
of Economic Research.
d. . . . as long as uncertainty doesn’t crimp confidence
200
15%
175
14
150
13
125
12
100
11
75
50
1985
10
1988
1991
1994
1997
2000
2003
2006
2009
Fixed business investment as percentage of GDP
Policy Uncertainty Index, 12-month moving average
Policy Uncertainty Index and business investment as a percentage of GDP
2012
Policy Uncertainty Index
Fixed business investment
Note: For additional information on the Policy Uncertainty Index, including the methodology behind its construction, see Baker, Bloom, and Davis (2012).
Sources: Vanguard calculations, based on data from Moody's DataBuffet.com, U.S. Bureau of Economic Analysis, National Bureau of Economic Research, and Baker,
Bloom, and Davis (2012).
11
2014 U.S. economic outlook: improving odds of above 2% growth
After years of disappointing 2% real growth, the U.S.
in 2014–2015 faces cyclical risks tilted toward betterthan-trend growth for the first time since the onset
of the global financial crisis. As evident in Figure 6a,
our proprietary U.S. leading indicators dashboard
points toward a slight acceleration. The most positive
leading indicators are those associated with the
housing market, manufacturing activity, and financial
conditions (especially those tied to the stock market).
The “red signals,” associated with credit growth,
confidence, and excess capacity, exemplify the
lingering effects of the global financial crisis.
Figure 6.
Using simple regression analysis, we can map our
proprietary set of indicators to a distribution of
potential scenarios for U.S. economic growth as
shown in Figure 6b. We estimate a 25% probability
that U.S. real GDP growth preserves the status quo
and averages 1.5%–2.5% in 2014. The odds of
growth exceeding 2.5% in 2014 (48%) are roughly
double that of the potential for it to stagnate and
fall below 1.5% (27%). Our base case is a cyclical
rebound in 2014, with growth in real GDP of close
to 3% on average over the course of the year.
Odds favor an acceleration in U.S. growth in 2014
a. Vanguard’s dashboard of leading economic indicators
b. Vanguard’s 2014 U.S. economic growth outlook
Estimated distribution of growth outcomes
35%
30
75
Odds of a
slowdown
27%
50
Trailing
three-year
growth
Odds of an
acceleration
2.2%
25%
25
Probability
Share of indicators above/below trend
100%
48%
25%
20
16%
16%
15
11%
25
10
7%
5
0
2000
2003
2006
2009
2012
Above-trend growth
Housing
Financial conditions
Stock market
Real rates
Manufacturing
Below trend but positive momentum
Global trade
Business loans
Below trend and negative momentum
Confidence
Lending demand
Excess capacity
Government
Sources: Vanguard calculations, based on data from Moody’s DataBuffet.com.
0
Recession: Less than 0.5%
Stagnation: 0.5% to 1.5%
Status quo: 1.5% to 2.5%
Cyclical rebound: 2.5% to 3.5%
Robust above-trend growth: 3.5% to 4.5%
Overheating: Above 4.5%
Historical real GDP growth
1926–2013
3.3%
2000–2013
1.8%
Past three years
2.2%
2014 consensus
2.8%
Notes: Distribution of growth outcomes generated by bootstrapping the residuals
from a regression based on a proprietary set of leading economic indicators and
historical data, estimated from 1960 to 2013 and adjusting for the time-varying
trend growth rate. The 2014 consensus is from the Federal Reserve Bank of
Philadelphia’s Q4 2013 Survey of Professional Forecasters.
Sources: Vanguard calculations, based on data from U.S. Bureau of Economic
Analysis and Federal Reserve.
12 Figure 7.
Monetary policy of unprecedented size and scope to avert the prospect of global deflation
a. Global central bank assets as a percentage
of a region’s 2008 GDP
b. Core inflation across key central bank markets,
2001–2013
10%
Onset of global financial crisis
Year-on-year percentage change
Total assets (percentage of 2008 GDP)
50%
40
30
20
10
0
2007
2008
2009
2010
2011
2012
2013
Federal Reserve
European Central Bank
Bank of Japan
Bank of England
Onset of global financial crisis
8
6
4
2
0
–2
2001
2003
2005
2007
United States
Japan
United Kingdom
Eurozone
2009
2011
2013
Typical range of
developed market
central bank inflation
targets (1%–3%)
Note: Total assets for each central bank are shown as a percentage
of that country’s or region’s 2008 GDP.
Note: Figure displays the year-on-year percentage change in each country’s
or region’s core (excluding food and energy) consumer price index.
Sources: Vanguard calculations, based on data from Federal Reserve,
Bank of England, European Central Bank, Bank of Japan, and IMF.
Sources: Vanguard calculations, based on data from U.S. Bureau of Labor
Statistics, Statistics Bureau of Japan, U.K. Office for National Statistics,
and Eurostat.
Outlook for inflation
regime 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.
In the near term, reflationary monetary policies will
continue to counteract the deflationary bias of a highdebt world still recovering from a deep recession.
Although central bank balance sheets have risen to
a combined total of more than $8 trillion since the
onset of the financial crisis (see Figure 7a), core
inflation trends are low (see Figure 7b). Indeed,
recent consumer price inflation remains near
generational lows and, in several major economies,
below the targeted rate. In the United States, the
year-over-year CPI inflation rate lingered at about
1% as of late 2013.
As stated in previous Vanguard outlooks, trend
inflationary pressures in the United States and most
other developed markets are modest. The recent
patterns in key drivers such as labor costs, economic
slack, commodity and import prices, and the velocity
of money suggest that core U.S. inflation is likely to
stay within its recent range of 1%–3% for the next
one to two years (see Figure 8 on page 14). For
now, the risk of returning to a high inflationary
For the next ten years, our VCMM simulations
project a median inflation rate averaging close to
2.0%–2.5% per year for the U.S. Consumer Price
Index (see Figure 9 on page 15). This is roughly
consistent with the Federal Reserve’s long-term
goal of inflation stability and is also near longer-term
break-even rates in the Treasury Inflation-Protected
Securities (TIPS) market.
Of note, Vanguard’s median secular inflation
expectation is approximately 1% lower than the
average U.S. CPI inflation rate observed since 1950.
All else being equal, this implies that nominal assetclass returns may be 1% lower than historical longrun averages, even if their expected average real
(inflation-adjusted) returns are identical. We discuss
this point further in the section on stocks, bonds,
and asset allocation strategies.
13
Figure 8.
U.S. drivers point to modest inflation
Inflation indicators, long-term average versus recent value
10
8
6
4
2
0
–2
–4
–6
Money
multiplier
Credit growth
Disposable
income growth
Nominal GDP
growth
U.S. import
prices
Commodity
prices
Output gap/slack (%)
Long-run average
Latest value
Notes: Money multiplier is the ratio of M2 money supply to M0, or base money; latest value is October 2013, and average is from January 1959. Credit growth is
year-on-year percentage change of the 36-month trailing average level; latest value is October 2013, and average is from January 1960. Disposable income growth
is year-on-year percentage change in the three-month trailing average level; latest value is October 2013, and average is from January 1960. Nominal GDP growth is
year-on-year percentage change; latest value is Q3 2013, and average is from Q1 1950. Import prices are year-on-year percentage change from the National Accounts;
latest value is Q3 2013, and average is from January 1960. Commodity prices are year-on-year percentage change in the Commodity Research Bureau (CRB) spot
commodity index; latest value is November 2013, and average is from January 1960. Output gap is percentage deviation from potential GDP based on an average
of CBO estimates and a statistical filter of real GDP; latest value is Q3 2013, and average is set at 0%.
Sources: Vanguard calculations, based on data from U.S. Bureau of Economic Analysis, Federal Reserve, CRB, and CBO.
Looking ahead, we continue to believe that the
countervailing forces of fiscal deleveraging and
monetary-policy reflation in the United States and
Europe will reinforce an “inflation paradox.” On the
one hand, we expect that some investors will continue
to have significant concerns about future inflation. We
estimate a nearly one-third probability that the trend
inflation rate runs above 3% over the next ten years.
As a result, conversations about portfolio construction
will include much discussion about inflation protection
and the performance of various asset classes under
expected and unexpected scenarios (Davis, AliagaDíaz, Thomas, and Zahm, 2012).
14 On the other hand, monetary policymakers in
developed markets are likely to continue to guard
against the pernicious deflationary forces of debt
deleveraging for an extended period. Indeed, our
VCMM simulations reveal that the prospects of
secular Japan-style deflation (in which the average
CPI inflation rate over the next decade is –1% or
less) are approximately 10%. It is worth emphasizing
that despite aggressive monetary policy, some
developed markets would be a recession away
from realizing deflation.
Global monetary policy has been extremely aggressive
over the past several years. Central banks have
lowered short-term interest rates close to zero and,
with their traditional policy tool thus constrained,
expanded the size and composition of their balance
sheets.5 At the same time, they have provided a
new level of communication about the length of
time markets can expect short-term rates to remain
unchanged. The Bank of Japan, the Bank of England,
and the European Central Bank have all, to some
extent and in various forms, adopted policies similar
to those pursued by the U.S. Federal Reserve. Based
on our economic outlook, it seems reasonable that
the Fed was the first of those four banks to begin
to exit these very accommodative policies.
Figure 9.
Projected U.S. CPI inflation rate,
current and 2012 ten-year outlooks
VCMM-simulated distribution of annualized expected average
40%
38%38%
30
Probability
Outlook for U.S. monetary policy
and interest rates
20
15%
17%
14% 14%
15%
17%
14%
16%
10
0
Less
than 0%
0% to 1% 1% to 3% 3% to 4%
Greater
than 4%
Ten-year annualized CPI inflation rate
Tapering of the QE program has begun, although
actual monetary tightening is likely some time off.
The unwinding of the Fed’s extraordinarily easy
monetary policy will be a multistep, multiyear
process, with the initial taper only the first in a
series of actions on the road to normalization.
Stronger forward guidance will likely be used,
for example by pairing the 6.5% unemployment
threshold with, perhaps, a “floor rate” for core
inflation or by lowering the unemployment threshold
itself. New policy tools such as the interest paid on
excess reserves and reverse repo operations are
also likely to make an appearance. We believe such
actions may be effective at the margin in anchoring
long-term interest rates, but ultimately the future
pattern of job growth and the unemployment rate
will dictate when the Fed raises short-term rates,
probably sometime in 2015.
Current ten-year outlook
Ten-year outlook as of year-end 2012
Median inflation 1950–2013
3.0%
Median inflation 2000–2013
2.5%
10-year TIPS break-even
inflation as of November 29, 2013
2.1%
Sources: Vanguard calculations, based on data from U.S. Bureau
of Labor Statistics.
5 Balance sheet expansion in most large central banks has occurred through quantitative easing—the purchase of longer-term securities, typically
government bonds, financed by creating bank reserves. This policy is intended to influence longer-term interest rates when the traditional short-term
policy rate is near 0%. The European Central Bank is an exception—its balance sheet expansion occurred through policies designed to promote liquidity
in the banking system, referred to as long-term refinancing operations, or LTROs.
15
Figure 10.
Questions about structural unemployment are a wild card for the Fed’s exit
a. Demographics and structural change cast doubt
on the headline unemployment rate
b. Labor force participation has fallen, but will it improve
as the recovery continues?
Unemployment rate under hypothetical scenarios
for labor force participation
Change in labor force participation rates across demographic
groups, 2007–2013
13%
2%
1.1%
Change in labor force participation rate
since December 2007
12
Unemployment rate
11
10
9
8
7
6
5
1
0
–1
–2
–2.2%
–3
–3.0%
–4
4
2007
2008
2009
2010
2011
2012
2013
Actual unemployment
Assuming labor force participation rate
constant at December 2007 levels
Constant labor force participation, adjusted
for aging population
Notes: Figure displays actual unemployment rate along with two adjusted
measures. The first assumes the labor force participation rate stays constant
at the December 2007 level of 66%, with any labor force dropouts being added
to the unemployment rate calculation. The second assumes labor force
participation is held at December 2007 levels but controls for the impact of
demographics, with workers shifting to and from age groups with different
participation rates.
–5
Overall
–4.6%
16–24
25–54
55+
Ages
Note: Figure displays change in the labor force participation rate
from December 2007 to November 2013 for the stated age groups.
Sources: Vanguard calculations, based on data from U.S. Bureau
of Labor Statistics.
Sources: Vanguard calculations, based on data from U.S. Bureau of Labor
Statistics and Census Bureau.
When will the Fed raise rates?
The timing depends on two critical labor-market
issues: (1) how quickly the actual unemployment
rate falls, and (2) why it falls.
As illustrated in Figure 10a, the unemployment rate
may be understated because of the severe drop in
the labor force participation rate, as illustrated in
Figure 10b. We find it unlikely that this figure is
driven solely by an aging population (i.e., the aging
and retirement of the baby boomers). In our
estimates, approximately one-half of the reduction
in the working-age-adjusted labor force is due to
cyclical factors (e.g., weak demand, return
16 to schooling) rather than more permanent, structural
changes (e.g., skill mismatches, demographics).
Put another way, the “real” unemployment rate,
corrected for the cyclical drop in participation, is
likely somewhere between the blue and purple
lines in Figure 10a, closer to 8.0%–8.5% than to
the official 7.0% rate (as of November 2013).
By extension, this implies that the federal funds
rate will remain near 0% through mid-2015. However,
as noted in Figure 11, the risk that this lift-off date
is further delayed to, say, 2016 is lower than it
has been in previous years. Correct calibration of
monetary policy based on current labor market
Figure 11.
Handicapping Fed tightening and the end of financial repression
VCMM-simulated probabilities of the level of nominal and real 3-month Treasury bill yields
100%
90
75.8%
80
65.4%
Probability
70
57.5%
60
51.8%
50
50.2%
44.4%
40.1%
40
31.7%
25.3%
30
21.2%
20
10
0
One year out
Two years out
Three years out
Four years out
Five years out
Probability of T-bill rate near 0%
Probability of T-bill rate below inflation
Note: Figure displays VCMM-projected probability that the 3-month Treasury bill yield will be less than 0.5%, or less than the 12-month trailing inflation rate at the end
of the stated year.
Source: Vanguard.
conditions hinges on an accurate portrayal of
labor market slack. Wage growth and inflation
expectations are critical indicators in light of the
marked (and partly cyclical) drop in labor force
participation.6
Whether or not the Fed raises short-term rates in
2015, real (inflation-adjusted) short-term interest rates
are likely to remain negative through perhaps 2017.
Globally, the burdens on monetary policymakers are
high as they contemplate moving away from QE
policies to prevent asset bubbles on one hand and
remain mindful of raising short-term rates too
aggressively on the other. The unwinding process
may induce market volatility at times, but long-term
investors should prefer that to no exit at all.
U.S. Treasury yield curve
The bond market continues to expect Treasury yields
to rise, with a bias toward a steeper 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,
with the current macroeconomic environment
justifying a 10-year yield in the range of 2.75% to
3.75% (see Figure 12a on page 18). Based on our
estimates of the fundamental drivers of Treasury
bond yields, we are hard pressed to find a bubble
in Treasury securities. With the recent rise in longterm interest rates since summer 2013, we find
that bond yields are toward the middle of the range
of our fair-value estimates.
6 Broad measures of wage growth currently are near 2%; growth above 3% would imply that the amount of slack in the economy is overestimated (i.e., the
nonaccelerating inflation rate of unemployment [NAIRU] is higher).
17
Think twice before adjusting duration to avoid a bubble in Treasuries
a. Fair value factors suggest that long-term Treasury
yields are reasonable, with the market already pricing
an increase
Vanguard’s fair value model of the 10-year Treasury yield,
with forward-inferred and VCMM-simulated projections
12%
10-year Treasury bill yield
10
8
6
4
2
0
1990
1995
2000
2005
2010
2015
Fair value range
Actual
Forward curve (November 2013)
VCMM 50th percentile
VCMM 25th/75th percentile
b. Short-duration tilts involve giving up significant income
Difference in yield between a broad-market and a
short-duration U.S. bond investment
Difference in yield,
broad bond market versus short-duration bonds
Figure 12.
2.5%
2.0
1.5
1.0
0.5
0
1995
1998
2001
2004
2007
2010
2013
Note: Figure displays the difference in yield to worst between the Barclays U.S.
Aggregate Bond Index and the Barclays U.S. Aggregate 1–3 Year Index.
Sources: Vanguard calculations, based on data from Barclays.
Notes: Historical fair value is based on a model derived from Warnock and
Warnock (2009) and includes expected inflation, expected real GDP growth,
expectations regarding monetary and fiscal policy, and domestic and foreign
capital flows. Range reflects standard error margin of plus or minus 0.5
percentage points. Forward curve is derived from the Federal Reserve data
set provided by Gürkaynak, Sack, and Wright (2006). VCMM projections
reflect data through November 2013.
Sources: Vanguard calculations, based on data from the Federal Reserve.
The future path for interest rates, including our
fair value estimates, will likely change over time
in response to growth, inflation, and monetary
conditions. In our simulations, the bias is toward
a rise over the next several years, a view that is
consistent with the forward market and therefore
reflected in today’s bond prices.7 We continue to
believe that a bond bear market in which rates move
toward 5% based on stronger growth, inflation, and
monetary tightening may be several years away. We
estimate the odds of a U.S. fiscal crisis and sharp
spike in yields at less than 10% at the moment;
these odds rise later in the decade based on the
expected trajectory of federal debt.
In the long run, short-term rates tend to rise more
than long-term rates in substantially more than onehalf of our VCMM scenarios. This so-called “bear
flattening” of the yield curve is typical in a Fed
tightening cycle with stable inflation expectations.
This has important implications for those inclined to
strategically tilt the duration exposure of their bond
portfolios away from that of the broad fixed income
market. In a Fed tightening cycle, the prospects for
near-term losses in short-term bond portfolios are
elevated as well. A short-duration strategy entails
forgone income (see Figure 12b). Focusing solely on
avoiding capital losses ignores the fact that a steep
yield curve produces significant income differences
7 For further detail on the forward curve and the implications of the bond market pricing forward interest rate expectations, see Davis et al. (2010).
18 Figure 13.
Projected global fixed income ten-year return outlook
VCMM-simulated distribution of expected average annualized return of the global fixed income market,
estimated as of year-end 2013 and 2012
30%
Global bond returns
1926–2013
5.4%
1926–1969
3.1%
7.7%
1970–2013
2001–2013
4.6%
25
Probability
20
15
10
5
0
Less
than 0.5%
0.5% to 1%
1% to 1.5%
1.5% to 2%
2% to 2.5%
2.5% to 3%
3% to 3.5%
More
than 3.5%
Ten-year annualized return
Current ten-year outlook
Outlook as of year-end 2012
Notes: Figure displays projected range of returns for a portfolio of 80% U.S. bonds and 20% ex-U.S. bonds, rebalanced monthly. Benchmarks used for historical
returns are defined on page 4.
Source: Vanguard.
among duration strategies. In other words, “going
short duration” may not necessarily outperform a
broadly diversified fixed income portfolio in the
years ahead.
Asset-class outlook: Bonds
Expected range of returns
for the broad taxable 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. As displayed in Figure 13,
the expected ten-year median return of the broad
taxable U.S. fixed income market is centered in the
1.5%–3.0% range, as opposed to last year’s expected
0.5%–2.0% range. This return is near current
benchmark yields and thus most closely resembles
the historical bond returns of the 1950s and 1960s.
Expected diversification effects
We expect the diversification benefits of fixed income
in a balanced portfolio to persist under most scenarios.
Although yields in most developed markets are at
historically low levels, diversification through exposure
to hedged non-U.S. dollar-denominated bonds should
help offset some of the risks specific to the U.S.
fixed income market. Less-than-perfect correlation
between two of the main drivers of bond returns—
interest rates and inflation—is one potential benefit.8
8 For additional details, see Philips et al. (2012) and Philips and Thomas (2013).
19
Figure 14.
Bonds can provide ballast in an equity bear market
Median return of various asset classes during the worst decile of monthly equity returns, 1988–2012
2%
0
Median return
–2
–4
–6
–8
–10
U.S.
stocks
Emergingmarket
stocks
REITs
Dividend Commod- High-yield Emergingstocks
ities
bonds
market
bonds
Hedge
funds
Corporate
bonds
Treasury
bonds
InterInternational
national
bonds
bonds
(unhedged) (hedged)
Notes: U.S. stocks, U.S. bonds, and international bonds represented by indexes listed on page 4. Emerging-market stocks represented by FTSE Emerging Index and
emerging-market bonds by Barclays Emerging Markets Tradable USD Sovereign Bond Index. REITs represented by FTSE NAREIT Equity REIT Index, dividend stocks
by Dow Jones U.S. Select Dividend Total Return Index, commodities by S&P GSCI Commodity Index, high-yield bonds by Barclays U.S. Corporate High Yield Index,
hedge funds by median hedge fund-of-funds return as identified by Morningstar, Inc., corporate bonds by Barclays U.S. Corporate Investment Grade Index, and
Treasury bonds by Barclays U.S. Treasury Index.
Sources: Vanguard calculations, based on data from S&P, Citigroup, Barclays, Dow Jones, MSCI, CRSP, and FTSE.
We encourage investors to evaluate the role of
fixed income from a perspective of balance and
diversification rather than outright return. High-grade
or investment-grade bonds act as ballast in a portfolio,
buffering losses in riskier assets.9 Figure 14 shows
how these bonds have performed during the most
significant equity downturns of the past 25 years. They
may very well not provide the same magnitude of
benefit during periods of flight-to-quality when interest
rates are low.10 However, as shown in Figure 15, the
prospects of significant near-term annual losses of
–5% or more are higher for equities than they are for
investment-grade bonds. Therefore, investors should
approach with caution any decision to replace bonds
with riskier assets.11 Although history is not necessarily
indicative of future results, 200 instances of rolling
12-month losses of 5% or more occurred in a portfolio
of global equities since 1926, compared with 38 in
bonds (see Figure 15).
9 We define high-grade or investment-grade bonds as those fixed income securities rated Baa3 and above by Moody’s.
10 For additional details, see Kinniry and Scott (2013).
11 For additional details, see Davis (2013b).
20 Figure 15.
Focus on the potential magnitude of losses
Relative risk of loss in equities and bonds over a rolling 12-month period
200%
Rolling 12-month return
150
100
50
0
–50
–100
1926
1932
1938
1944
1950
1956
1962
1968
1974
1980
1986
1992
1998
2004
2010
Equities
Bonds
Note: Benchmarks used for historical returns are defined on page 4.
Sources: Vanguard calculations, based on data from S&P, Citigroup, Barclays, Dow Jones, MSCI, CRSP, and FTSE.
Corporate bonds and TIPS
The median expected total return of an investmentgrade corporate bond index in our VCMM scenarios
modestly exceeds that of a similar-duration U.S.
government bond portfolio. This expected positive
risk premium, a function of the current level of
corporate bond spreads, is not realized in all
scenarios because of corporate bonds’ sensitivity
to credit risk.
The probability of realizing a positive “spread return”
in investment-grade or high-yield corporate bonds
has decreased in the past few years as yield spreads
over less risky U.S. Treasury bonds have narrowed
(see Figure 16 on page 22). At the same time, real
Treasury yields have increased, particularly during
the past summer. This indicates that the payoff
for tilting bond portfolios to riskier segments of
the market is lower than was the case, say, two
or three years ago.
21
Figure 16.
Treasury yields are up, and corporate spreads have compressed
Treasury and corporate bond yields for selected time periods
16%
High risk premiums
14
12
Yield
10
8
6
6.6%
Falling risk premiums
Low risk premiums
2.5%
1.0%
4.2%
4
2.4%
2
1.3%
1.7%
1.7%
2.0%
1.7%
Prerecession
2004–2007 average
Recession
2008–2009 average
0
2.8%
3.4%
2.2%
2.2%
0.6%
0.4%
Recovery
2010–2012 average
Current
Real yield
Break-even inflation
Investment-grade corporate spread
High-yield corporate spread
Notes: Real yield is defined as the yield of the active 10-year TIPS bond. Break-even inflation is the difference between the active 10-year nominal Treasury and the
10-year TIPS bond. Investment-grade corporate spread is the option-adjusted spread (OAS) of the Barclays U.S. Investment-Grade Corporate Index. High-yield corporate
spread is the difference between the OAS of the Barclays U.S. High Yield Corporate Index and the Barclays U.S. Investment-Grade Corporate Index. “Current” is as
of November 2013.
Sources: Vanguard calculations, based on data from Federal Reserve and Barclays.
In the inflation-linked segment of the bond market,
the distribution in our VCMM scenarios of TIPS
returns is wider than that of nominal Treasury
bonds. The expected median long-term return on
a U.S. TIPS portfolio is lower than that of a similarduration nominal Treasury portfolio by a modest
amount that represents the estimated inflation risk
premium. As would be expected, TIPS generally
outperform nominal Treasuries in scenarios
22 featuring higher-than-average inflation rates over
a ten-year outlook. On a more cautionary note,
TIPS have displayed a higher probability of negative
returns over shorter investment horizons because
of their sensitivity to a rise in real rates. Balancing
these considerations, investors should continue to
evaluate the role of TIPS in providing protection
against inflation risk—that is, the possibility of
higher-than-expected inflation.
Figure 17.
Projected global equity ten-year return outlook
VCMM-simulated distribution of expected average annualized return of the global equity market, estimated as of
year-end 2013 and 2012
25%
Shift in distribution of outcomes
relative to last year
Probability
20
15
10
5
0
Less than 0%
0% to 3%
3% to 6%
6% to 9%
9% to 12%
12% to 15%
15% to 18%
More than 18%
Ten-year annualized return
Current ten-year outlook
Outlook as of year-end 2012
Historical global equity returns
1926–2013
10.2%
1926–1969
9.7%
1970–2013
10.6%
2001–2013
5.6%
Notes: Figure displays the projected range of returns for a 70% U.S., 30% ex-U.S. equity portfolio, rebalanced monthly. Benchmarks used for historical returns
are defined on page 4.
Source: Vanguard.
Asset class outlook: Global equities
Centered in the 6%–9% range, the long-term
median expected return for global equity markets is
moderately below the historical average and revised
downward from this time last year, mainly because
of current market valuations and their implications
for the equity risk premium (see Figure 18 on page
24). Similar to the situation in riskier segments of the
bond market, the premium compensating risk in the
equity market appears to have fallen recently. When
returns are adjusted for future inflation, we estimate
a roughly 40% likelihood that a global equity portfolio
will fail to produce a 5% average real return over the
decade 2013–2023.
Our return outlook is informed by valuation metrics
(such as price/earnings ratios) that relate accounting
measures of value to the market’s aggregate price.
Valuations today are elevated in relation to both
their lows in 2009 and their historical averages (see
Figure 18a on page 24). Although Figure 18b (on
page 24) shows some divergence across regions,
we caution investors against implementing tactical
tilts based on this. Historically, emerging-market
stocks have tended to possess lower relative market
valuations in recognition of their higher perceived
investment risk, and divergences today are less
pronounced than those in the mid-2000s that led to
large return differentials. To account for this, we
aggregate our global return outlook in Figure 17.
The expected central ranges of long-run returns on
various regional equity investments are statistically
similar to one another, especially after accounting for
differences in expected volatility.
23
Figure 18.
Some differences exist across metrics and regions, but valuations are generally elevated
a. Most developed-market valuation metrics are above
long-term averages
b. Regional valuations are more similar today than in the
middle of the previous decade
Valuation metrics for the U.S. equity market
relative to historical average value
Price over 36-month trailing earnings for selected global
equity indexes
60
8
50
7
6
Price/earnings ratio
Standard deviations from long-term mean
9
5
4
3
2
1
40
30
20
0
10
–1
–2
–3
1927
1942
1956
1970
Broad market price/earnings
Broad market price/book
Broad market price/sales
1985
1999
2013
Shiller CAPE (3-year)
Shiller CAPE (10-year)
Notes: Figure displays valuation metrics standardized to have a long-term
average of 0.0 and a standard deviation of 1.0. Broad market price/earnings
displays the market value of domestic corporations from the Federal Reserve
Flow of Funds database relative to the trailing four-quarter average of after-tax
corporate profits from the BEA’s national accounts. Broad market price/sales
displays the market value of domestic corporations from the Flow of Funds
database relative to the Gross Value Added of Corporate Business from the
BEA’s national accounts. Broad market price/book displays the market value
of domestic corporations relative to the net worth at historical cost of
Nonfinancial Corporate Business, both from the Flow of Funds database.
Shiller CAPE (10-year) is the ten-year cyclically adjusted price/earnings ratio
as defined in Shiller (2000). Shiller CAPE (3-year) is Shiller’s measure, adjusted
to smooth earnings over a trailing 36-month period.
0
2003
2005
2007
2009
2011
2013
Emerging markets
United States
Developed markets ex-U.S.
Notes: Figure displays the price/earnings ratio with 36-month trailing average
earnings. United States is defined as the FTSE United States Index, developed
markets ex-U.S. are defined as the FTSE All-World Developed ex US Index, and
emerging markets are defined as the FTSE All-World Emerging Markets Index.
Sources: Vanguard calculations, based on data from FTSE.
Sources: Vanguard calculations, based on data from Federal Reserve,
U.S. Bureau of Economic Analysis, and Robert Shiller’s website,
aida.wss.yale.edu/~shiller/data.htm.
Of note, the projected distribution of annualized
ten-year global equity returns shown in Figure 17 on
page 23 displays wide and fat tails. As discussed in
Davis, Aliaga-Díaz, and Thomas (2012), valuations are
the most useful metric in estimating forward-looking
expected returns of equity markets. However, they
still leave more than half the volatility of long-run
returns unexplained. Although we emphasize a focus
on the wide distribution, we note that the central
tendency of our projected returns has come down
24 since last year, reflecting the valuation levels shown
in Figures 18a and 18b. Figure 19 displays the
historical relationship between U.S. valuations and
subsequent real ten-year returns. The results
underscore the fact that today’s valuation levels
have been associated with lower average returns
but with a significant range around this average.
Indeed, every valuation bucket has been associated
with subsequent real returns near the historical
average in at least some time periods.
Figure 19.
Today’s valuation levels have been associated with modest average returns but a wide range
of possible outcomes
Distribution of future ten-year real equity returns
Initial cyclically adjusted price/earnings ratio and subsequent range of ten-year real U.S. equity returns, 1926–2013
20%
19%
16%
15
10
14%
Current
valuation
levels
5
12%
10%
10%
5%
3%
1%
0%
9%
8%
8%
8%
4%
0
Percentiles:
14%
12%
8%
5%
95th
75th
Median
3%
0%
–2%
Key
16%
25th
–2%
–5
5th
–4%
Top
2nd
Middle
4th
Bottom
Quintile ranking of initial Shiller CAPE (10-year)
U.S. average real return = 7%
Notes: Figure displays the initial valuation quintile of the S&P 500 Index, defined as the ten-year cyclically adjusted price/earnings ratio (CAPE) as defined by Shiller (2000),
with the 5th/25th/50th/75th/95th percentile range of subsequent realized ten-year real returns on the U.S. equity market. Data represent January 1926–September 2013.
U.S. equities are defined as on page 4, deflated by U.S. consumer price inflation.
Sources: Vanguard calculations, based on data from Robert Shiller’s website, aida.wss.yale.edu/~shiller/data.htm; S&P; Dow Jones; MSCI; and U.S. Bureau of Labor Statistics.
The results in Figure 19 are driven by the tendency
of valuations to revert to a long-term average
level, at least over this sample. In a simple return
decomposition, this reversion has been the largest
driver of the movement of long-term equity returns
over time (see Figure 20 on page 26). This supports
our long-held view that valuations, not growth, are
the most significant drivers of returns (Davis et al.,
2013). But to what level will valuations revert? As
shown in Figure 18a, most valuation metrics have
been above their long-term averages for more than
two decades, raising questions about the potential
for structural shifts. Without certainty as to where
exactly valuations will move in the future, it is very
difficult to pin down a precise estimate of the
equity risk premium. This is a key reason for our
distributional approach to forecasting.
In short, although we are hard-pressed to identify
market bubbles, there is some evidence of froth in
global equity markets. The uncertainty associated
with forward-looking return estimates underscores
the fact that today’s valuation levels present a
range of potential outcomes. However, because
the premium compensating increased equity risk
appears to have fallen recently, we would encourage
investors to exercise caution in making strategic or
tactical portfolio changes that increase this risk.
25
Figure 20.
For reference, the figure also shows how the
hypothetical portfolios would have performed over
two past periods: 1926–2013 and 2000–2013. The
results have several important implications for
strategic asset allocation, as discussed next.12
Valuation movement is the largest
component of returns, but predicting
this is extremely difficult
Components of ten-year real U.S. equity returns
Components of ten-year real U.S.
equity returns
15%
Modest outlook for long-run real returns
Amid widespread concern over the current low
level of dividend and long-term U.S. Treasury yields,
Figure 21’s real long-run return profile for balanced
portfolios may seem better than expected. However,
Vanguard believes it’s important for investors to
consider real-return expectations when constructing
portfolios because today’s low dividend and Treasury
yields are, in part, associated with lower expected
inflation than those of 20 or 30 years ago.
10
5
0
–5
–10
–15
1935
1948
1961
1974
1987
2000
2013
Average dividend yield
Earnings growth
Valuation adjustment return
Notes: Figure displays the backward-looking return components of the S&P 500
Index. Dividend yield is the average trailing dividend yield of the S&P 500 Index,
taking an average of each monthly observation of 12-month trailing yield in each
ten-year time period. Earnings growth is the average annualized growth of the
ten-year smoothed real earnings for the S&P 500 Index constituents. Valuation
adjustment return is the annualized percentage change of the cyclically adjusted
price/earnings ratio, as defined in Shiller (2000).
Sources: Vanguard calculations, based on data from Robert Shiller’s website,
aida.wss.yale.edu/~shiller/data.htm.
Implications for asset allocation strategies
To examine the potential portfolio construction
implications of Vanguard’s range of expected longrun returns, Figure 21 presents simulated real
(inflation-adjusted) return distributions for 2013−2023
for three hypothetical portfolios ranging from more
conservative to more aggressive:
The figure does show that the inflation-adjusted
returns of a balanced portfolio for the decade ending
2023 are likely to be moderately below long-run
historical averages (indicated by the small boxes for
1926−November 2013 and 2000–November 2013).
But the likelihood of achieving real returns in excess
of those since 2000 for all but the most conservative
portfolios is considerably higher.
Specifically, our VCMM simulations indicate that the
average annualized returns of a 60% equity/40%
bond portfolio for the decade ending 2023 are
expected to center in the 3.1%–5.2% real-return
range, below the actual average real return of 5.5%
for the same portfolio since 1926. Viewed from
another angle, the likelihood that our portfolio
would achieve the 1926–2013 average real return
is estimated at approximately 40%, and the odds
of attaining a higher real return than that achieved
since 2000 (2.1%) are near 70%.
• 20% equities/80% bonds.
• 60% equities/40% bonds.
• 80% equities/20% bonds.
12 See the Appendix for the range of returns in nominal terms before adjusting for inflation.
26 Figure 21.
Projected ten-year real return outlook for balanced portfolios
VCMM-simulated distribution of expected average annualized inflation-adjusted return of balanced global equity and global fixed
income portfolios, estimated as of year-end 2013
16%
Key
14
History, 1926−2013
History, 2000−2013
Average annualized return
12
10
95th percentile
8
6
4
25th−75th
percentile
2
0
–2
–4
–6
5th percentile
20%/80%
60%/40%
80%/20%
Portfolio stock/bond allocation
Underlying data for this figure
25th percentile
0.0%
1.3%
1.7%
Notes: Figure displays the 5th/25th/75th/95th percentile range of VCMMprojected returns for balanced portfolios. Historical returns are computed
using the indexes defined on page 4.
75th percentile
3.4%
7.1%
9.0%
Source: Vanguard.
Top 95th percentile
5.8%
11.4%
14.3%
Portfolio stock/bond allocation
Bottom 5th percentile
Annualized portfolio volatility
20%/80%
60%/40%
80%/20%
−2.5%
−2.9%
−3.6%
6.2%
11.2%
14.4%
History, 1926−2013
3.5%
5.5%
6.3%
History, 2000−2013
2.4%
2.1%
1.8%
Principles of portfolio construction are intact
Contrary to suggestions that this decade warrants
some radically new investment strategy, Figure 21
reveals that the simulated ranges of expected
returns are upward sloping. Simply put, higher risk
accompanies higher (expected) return. More
aggressive allocations have a higher—and wider—
range of expected returns, with greater downside
risk if the equity risk premium is not realized over the
next decade.13 To put this in context, the risk
premium over bonds may be lower than it has been
in the past few years, but it is still positive. Indeed,
the expected risk-return trade-offs among stocks and
bonds show why the principles of portfolio
construction remain unchanged, in our
view, even if expected returns are lower.
The upward-sloping and wider-tailed pattern in
Figure 21 reaffirms the beneficial role that bonds
should be expected to play in a broadly diversified
portfolio, despite their currently low yields and
regardless of the future direction of interest rates.
Although our scenarios generate slim, below-average
nominal returns for a broad taxable bond index for
the next ten years—a central tendency of 1.5%–
3.0% annually, on average—bonds should be
expected to moderate the volatility in equity
portfolios in the years ahead.
Still, we are concerned that the low nominal rate
environment may encourage savers and bond
investors to very aggressively pursue higher nominal
total returns by making investment decisions that
13 Although the downside tails may appear somewhat similar across the portfolios, we note that these are ten-year distributions. The downside risk for a
more equity-oriented portfolio increases substantially over a shorter horizon, as demonstrated in Figure 15 on page 21.
27
increase risk, often based solely on asset-class yields
rather than on a more holistic total return approach.
Popular considerations at the moment include
moving away from conservative bond portfolios
and into either higher-yielding junk bonds or incomeoriented equity funds such as dividend-focused
equity funds or REIT funds. Recent cash flows
suggest that, in addition to focusing on income,
investors have begun to move strongly into equities,
indicating that risk-taking behavior is increasing.
As discussed throughout, investors reaching for yield
and moving out of bonds into equities should realize
that risk premia—the compensation for taking on this
extra risk—are likely lower now than at any point in
the past five years. As the recent performance of
stocks and bonds over the 14 years through 2013
reminds us (see Figure 21 on page 27), investors
who increase their allocation to riskier segments of
the capital markets should realize that portfolio
volatility will likely increase as a result.
We encourage investors to evaluate the trade-offs
involved in a move toward risky asset classes,
whether that means tilting a bond portfolio toward
corporate and high-yield investments or a wholesale
move from bonds into equities. Having a realistic
expectation of the extra return to be gained from
such a strategy and an understanding of the
implications for holistic portfolio risk is crucial to
maintaining the discipline needed for long-term
success.
Key terms
Beta. A measure of the volatility of a security or
portfolio relative to a benchmark.
Price/earnings ratio. The ratio of a stock’s
current price to its per-share earnings over a
designated period.
Risk premium. The amount by which an
asset’s expected return exceeds the risk-free
interest rate.
28 References
Baker, Scott R., Nicholas Bloom, and Steven J. Davis,
2012. Measuring Economic Policy Uncertainty;
available at policyuncertainty.com.
Davis, Joseph H., Roger Aliaga-Díaz, Charles J.
Thomas, and Ravi G. Tolani, 2013. The Outlook for
Emerging Market Stocks in a Lower-Growth World.
Valley Forge, Pa.: The Vanguard Group.
Davis, Joseph H., 2013a. Look Back Before
Looking Ahead. Vanguard blog posting; available
at vanguardblog.com.
Davis, Joseph H., 2013b. Bond Risk—A Theory
of Relativity. Vanguard blog posting; available at
vanguardblog.com.
Davis, Joseph H., 2012. Our Economic Future,
Vanguard video; available at institutional.vanguard.com.
Davis, Joseph H., and Roger Aliaga-Díaz, 2012.
Vanguard’s Economic and Investment Outlook.
Valley Forge, Pa.: The Vanguard Group.
Davis, Joseph H., Roger Aliaga-Díaz, and Charles J.
Thomas, 2012. Forecasting Stock Returns: What
Signals Matter, and What Do They Say Now? Valley
Forge, Pa.: The Vanguard Group.
Davis, Joseph H., Roger Aliaga-Díaz, Charles J.
Thomas, and Nathan Zahm, 2012. The Long and
Short of TIPS. Valley Forge, Pa.: The Vanguard
Group.
Davis, Joseph H., Roger Aliaga-Díaz, and Andrew J.
Patterson, 2011. Asset Allocation in a Low-Yield
and Volatile Environment. Valley Forge, Pa.: The
Vanguard Group.
Davis, Joseph H., Roger Aliaga-Díaz, Donald G.
Bennyhoff, Andrew J. Patterson, and Yan Zilbering,
2010. Deficits, the Fed, and Rising Interest Rates:
Implications and Considerations for Bond Investors.
Valley Forge, Pa.: The Vanguard Group.
Davis, Joseph H., Roger Aliaga-Díaz, Julieann
Shanahan, and Charles J. Thomas, 2009. Which Path
Will the U.S. Economy Follow? Lessons From the
1990s Financial Crises of Japan and Sweden.
Valley Forge, Pa.: The Vanguard Group.
Philips, Christopher B., Francis M. Kinniry Jr., Brian
J. Scott, Michael A. DiJoseph, and David J. Walker,
2013. Risk of Loss: Should the Prospect of Rising
Rates Push Investors From High-Quality Bonds?
Valley Forge, Pa.: The Vanguard Group.
Gordon, Robert J., 2012. Is U.S. Economic Growth
Over? Faltering Innovation Confronts the Six
Headwinds. Working Paper. Cambridge, Mass.:
National Bureau of Economic Research; available
at nber.org/papers/w18315.
Philips, Christopher B., Joseph Davis, Andrew J.
Patterson, and Charles J. Thomas, 2012. Global
Fixed Income: Considerations for U.S. Investors,
Valley Forge, Pa.: The Vanguard Group.
Gürkaynak, Refet S., Brian Sack, and Jonathan H.
Wright, 2006. The U.S. Treasury Yield Curve: 1961
to the Present. Washington, D.C.: Federal Reserve
Board, Divisions of Research & Statistics and
Monetary Affairs, Finance and Economics Discussion
Series; available at federalreserve.gov.
Kinniry Jr., Francis M., 2013. Same As It Ever
Was. Vanguard blog posting; available at
vanguardblog.com.
Shiller, Robert J., 2000. Irrational Exuberance,
second edition. New York: Broadway Books.
Summers, Lawrence H., 2013. Economic Forum:
Policy Responses to Crises, International Monetary
Fund video; available at imf.org.
Warnock, Francis E. and Veronica Cacdac Warnock,
2009. International Capital Flows and U.S. Interest
Rates. Journal of International Money and Finance
28: 903–919.
Kinniry Jr., Francis M., and Brian J. Scott, 2013.
Reducing Bonds? Proceed With Caution, Valley
Forge, Pa.: The Vanguard Group.
Philips, Christopher B., and Charles J. Thomas, 2013.
Fearful of Rising Interest Rates? Consider a More
Global Bond Portfolio. Valley Forge, Pa.: The
Vanguard Group.
29
Appendix: Vanguard Capital Markets Model
IMPORTANT: 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 Vanguard Capital Markets Model® is a
proprietary financial simulation tool developed
and maintained by Vanguard’s primary investment
research and advice teams. 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
Figure A-1. Projected ten-year nominal return outlook for balanced portfolios
VCMM-simulated distribution of expected average annualized return on balanced global equity and global fixed income portfolios,
estimated as of year-end 2013
18%
Key
Average annualized return
16
14
History, 1926−2013
History, 2000−2013
12
95th percentile
10
8
25th−75th
percentile
6
4
2
0
–2
5th percentile
20%/80%
60%/40%
80%/20%
Portfolio stock/bond allocation
Underlying data for this figure
Portfolio stock/bond allocation
20%/80%
60%/40%
80%/20%
Bottom 5th percentile
1.5%
0.4%
−0.4%
25th percentile
2.8%
3.9%
4.2%
75th percentile
4.6%
8.6%
10.5%
Top 95th percentile
6.0%
12.2%
15.3%
14.4%
Annualized portfolio volatility
30 6.2%
11.2%
History, 1926−2013
6.6%
8.6%
9.5%
History, 2000−2013
4.9%
4.6%
4.3%
Notes: Figure displays the 5th/25th/75th/95th percentile range of VCMMprojected returns for balanced portfolios. Historical returns are computed
using the indexes defined on page 4.
Source: Vanguard.
Figure A-2. VCMM simulation output for broad U.S. stock market (10,000 simulations)
Annualized ten-year returns
40%
1950s
30%
20%
1980s
1990s
10%
1940s
1960s
0%
1930s
1970s
2000s
−10%
−20%
0
5
10
15
20
25
30
35
40
45%
Annual volatility
10,000 simulations
Median simulation
History
Source: Vanguard.
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 assetclass forecasts—comprising distributions of expected
returns, volatilities, and correlations—are key to the
evaluation of potential downside risks, various risk–
return trade-offs, and 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, such as the
data presented in this paper, 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. Indeed, this is a key reason why we
approach asset return outlooks in a distributional
framework, as shown in Figure A-1, which highlights
balanced portfolio returns before adjusting for inflation.
Figure A-2 further illustrates this point by showing
the full range of scenarios created by the model.
The scatter plot displays 10,000 geometric average
ten-year returns and standard deviations for U.S.
equities. The dispersion in returns and volatilities
is wide enough to encompass historical market
performance for various decades.
31
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