Managers’ Long-Term Outlook Gives Context for Current Volatility

Despite slowing global growth, disparate inflation rates, and continued normalization of U.S. monetary policy, economists with Vanguard and J.P. Morgan Asset Management believe that a near-term recession will be avoided.

Vanguard this week published its 10th annual economic and market forecast, “Vanguard Economic and Market Outlook for 2019: Down but not out,” which a representative of the firm described as its most comprehensive recurring analysis on the state of the global economy and financial markets.

Despite slowing global growth, disparate inflation rates, and continued normalization of U.S. monetary policy, Vanguard economists believe that a near-term recession remains less than likely.

“In short, economic growth should shift down but not out,” the white paper says. “From an asset return standpoint, Vanguard foresees a 10-year outlook for a balanced portfolio in the 4% to 6% range, representing a modest improvement over 2018.”

Joseph Davis, Vanguard’s chief economist, says that while market volatility over the past two to three months has some investors overly cautious going into 2019, his firm’s outlook, while still guarded for the near term, shows optimism for long-term investors.

Higher short-term interest rates, coupled with improved international equity market valuations, slightly raises our expectations for long-term global investment returns for U.S. investors,” he says.

Giving some context to the bout of selling seen this week on Wall Street, Davis says there are some factors that point to a higher risk of a recession next year. Like other experts, he cautions investors about reading too much into catchy news headlines about the yield curve—which has not actually inverted—or other supposed indicators of an impending market crash.

“Vanguard’s analysis on the fundamentals and historical drivers causing recessions concludes that the more likely scenario is a slowdown in growth, led by the U.S. and China. However, the expected easing of global growth over the next two years is charged with economic and market risks,” Davis explains. “Potential scenarios include the possibility of a severe deceleration of China’s economy, a policy mistake by the Fed as it raises rates further into restrictive territory, trade tensions, and other geopolitical and policy uncertainties.”

He says his firm has, in recent years, been correct in its anticipation that globalization and technological disruption would make it difficult for economies—especially those of the U.S., Europe and Japan, among others—to reach and sustain 2% inflation.

“In 2018, Vanguard rightly anticipated a rise in core inflation across various economies,” Davis says. “For 2019, our economists do not see a material risk of further strong rises in core inflation despite lower unemployment rates and higher wages. Higher wages are not likely to funnel through to higher consumer prices, as inflation expectations remain well-anchored.”

For the U.S., Davis says Vanguard has confidence that the Fed will “continue on its gradual rate-hike path, reaching the terminal rate of 2.75% to 3% in mid-2019, followed by a pause or stop to reassess economic conditions.”

According to Vanguard’s analysis, the expected equity market returns in the U.S. are slightly lower than those for global or international markets, “which emphasizes the importance of global diversification going forward.”

“Vanguard’s outlook for U.S. equities over the next decade is in the 3% to 5% range, and we can expect to see equity valuations continue to contract as interest rates rise over time,” Davis says. “For non-U.S. equities, investors will likely see returns in the 6% to 8% range.”

Vanguard’s analysis concludes that, versus the firm’s previous reports, continued interest rate increases have positively benefited the investment outlook for fixed-income markets. Over the next 10 years, investors can expect to see global fixed-income returns in the 2.5% to 4.5% range. Non-U.S. bond investors could expect returns from 2% to 4%—slightly lower than the anticipated return of U.S. bonds, but also providing diversification benefits in a balanced portfolio.

“Given the somewhat challenging outlook ahead, it is important that investors focus on key factors such as saving more, spending less, and controlling investment costs, rather than concentrating on the less reliable benefits of ad hoc portfolio tilting,” Davis says. “Additionally, Vanguard believes investors should continue to adhere to time-tested investment principles such as maintaining a long-term focus, employing a disciplined asset allocation and conducting periodic portfolio rebalances.”

Similar take from J.P. Morgan Asset Management

On the same day Vanguard published its annual update, J.P. Morgan Asset Management Chief Economist David Kelly also briefed reporters about the current volatility, comparing this with his firm’s economic outlook for next year. He spoke on a panel that included four other top J.P. Morgan forecasters—all of them telling investors to remember that volatility is normal. They stressed that the lack of volatility in recent years has caused investors, many of them with portfolios tilted strongly toward risky assets, to be surprised by moves that would previously have been considered unremarkable.

Echoing Vanguard’s take, the J.P. Morgan leader said the most pressing question for 2019 is, can the U.S. economy slow down without stalling out? He said he remains more optimistic than not about avoiding a near-term recession, but, like Davis, he has some pressing concerns as well.

“Our 2019 assumptions still suggest increased global financial stability,” Kelly said. “This is a good thing insofar as it means recessions and downturns are likely to be weaker and shorter lived relative to, say, the Great Recession of 2008 and 2009. But, on the flip side, this also means that growth is likely to be slower—and that there will be fewer opportunities to exploit market rebounds.”

Kelly pointed to the firm’s recent 2019 to 2029 capital market assumptions report, “J.P. Morgan Asset Management 2019 Long-Term Capital Market Assumptions.” The full market report is quite dense, considering 50 different asset classes and sectors and featuring dozens of illustrative charts.

In U.S. equities, J.P. Morgan anticipates 5.25% potential growth on average each year for the next 10 to 15 years. According to Kelly, U.S. equities “look pretty good,” but the macroeconomic business cycle presents challenges to investors. The emerging challenges are reflected in recent stock market volatility.

One place where Kelly’s outlook seems to diverge at least a bit from Davis’ is on the global fixed-income picture. On the fixed-income side, there is “almost a new equilibrium forming,” Kelly said.

“We’ve had such great debt loads and such low interest rates for so long now that it has reshaped the behavior of central banks in a significant way,” he said. “We may even see central banks keep interest rates much lower than they have in the past, simply in order to help their governments finance these major debt loads. This in turn means we may be facing lower interest rates globally than we traditionally would expect, and for potentially quite a long time.”

For those investors who are having trouble stomaching the current bout of equity market volatility, Kelly and Davis agree that the best way to keep one’s footing is to think about what risks a portfolio is carrying and using this information to better define how the risk-taking is being compensated—or not. As Kelly said, the last decade has brought remarkably low volatility, and investors should expect a bumpier ride going forward, whether the markets go up or down in the near future.

“I think investors in particular should rethink liquidity risk and consider being compensated for accepting lower liquidity, for example in private equity,” Kelly said. “This type of investing will become more important as the cycle progresses.”