February 1, 2012

Future Growth ‘Uneven’: Vanguard Outlook

GDP expansion will remain between 2% and 3% through 2021

Headwinds from the housing industry, consumer balance-sheet repair and Europe’s–and the United States’, eventually–move toward austerity will keep GDP growth between 2% and 3%, Vanguard reported in its January 2012 economic and investment outlook.

Future growth is expected to be “uneven,” according to the firm, due to “downside risks of a full-blown European sovereign debt/banking crisis, a housing-related Chinese slowdown, and the (unresolved) process for addressing U.S. fiscal imbalances.”

Globally, emerging markets and Australia are expected to expand the fastest, while Europe, the United Kingdom and Japan will post sluggish growth.

There’s a less than 10% chance that we’ll endure the high inflation scenario Americans suffered in the 1970s and early 1980s, according to Vanguard. The firm projects that over the next 10 years, the median inflation rate will average between 2% and 2.5% per year for the Consumer Price Index. Over the next one to two years, the inflation rate should remain within its current 1.5%-3% range.

The federal funds rate will likely remain near 0% through the middle of 2013, Vanguard predicts, adding that short-term interest rates are expected to remain negative “for some time.” The report noted that further quantitative easing is possible in 2012, but Vanguard predicts such a move would require long-term inflation expectations to fall below 2%.

Bonds resemble their historical returns from the 1950s and 1960s, according to Vanguard. “Despite the modest secular bias toward rising U.S. interest rates, we caution investors against maintaining a secular short-duration bias in their fixed income portfolios,” according to the report. Simulations performed by the firm found that short-maturity yields tend to rise more than long-maturity yields, creating a “bear-flattening bias” that results in similar median returns for all Treasury bond portfolios, regardless of maturity.

Regarding the stock market, Vanguard is slightly optimistic that global equities over the next 10 years will be able to meet their post-1926 real return average. “Our long-held view is that market valuations generally correlate with future stock returns, and that consensus economic growth expectations and initial dividend yields do not,” Vanguard wrote in the report. “As a result, the expected long-run return on emerging-market equities is statistically identical to that on developed-market equities, and in fact tends to be lower when adjusted for emerging markets’ higher expected volatility.”

Vanguard is confident that the principles of portfolio construction need no changes over the next decade. In fact, the firm’s simulated mean-variance frontier of expected portfolio returns show higher expected returns for aggressive portfolios.

Investors, however, should resist the temptation to pursue better returns through higher dividend yields, inflation protection or alternative investments. “We believe that a balanced and diversified low-cost portfolio can remain an extremely high-value proposition in the decade ahead,” according to Vanguard.

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