Market and economic perspectives: May 2019

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Recession watch

Key takeaway: 35% chance of a recession over the next 12 months

  • The yield curve (as traditionally defined by the 3-month and 10-year U.S. Treasury) briefly inverted in late March.
  • A key distinction about this inversion compared with others is, it’s driven almost exclusively by long-term rates dropping below short-term rates.
  • We see little evidence that the inversion, in isolation, is signaling a recession in 2019/early 2020.
  • The expected easing of global growth in the next two years—driven by a fading boost from U.S. fiscal stimulus and the continued slowing of growth in China—is fraught with economic and market risks.

 

Traditionally when yield curve inverts before recession, short-term real rates are significantly higher

Traditionally when yield curve inverts before recession, short-term real rates are significantly higher

Sources: Vanguard, using data from Bloomberg and the Federal Reserve Bank of St. Louis.

The Fed in focus

Key takeaway: No Fed hikes!

  • While we believe the U.S. economy could tolerate an additional hike, the Federal Reserve has clearly stated its intention of no hikes in 2019.
  • We do not see a valid justification for cutting interest rates as of now, and given our expectation for a modest recovery in the second half of 2019, a cut seems quite unlikely.
  • We do not see a material risk of further strong increases in core inflation despite lower unemployment rates and higher wages.
  • In the United States, we expect core inflation to remain near or below 2.0%; an escalation in tariffs would only temporarily affect U.S. core inflation.

 

Interest rates likely to rise less than previously anticipated

Traditionally when yield curve inverts before recession, short-term real rates are significantly higher

Sources: Vanguard, using data from Bloomberg and the Federal Reserve Bank of St. Louis.

Notes: The solid lines represent central bank policy rates as defined by the federal funds rate, U.K. Bank of England Official Bank Rate, and Euro Overnight Index Average. Data as of March 31, 2019.

Global asset returns

Key takeaway: Lower returns and higher risks

  • With slowing growth, disparate rates of inflation, and continued policy normalization, volatility in the financial markets is likely to accelerate.
  • Long term, our ten-year outlook for investment returns remains guarded, given the backdrop of high valuations and depressed risk-free rates across major markets.
  • Returns in global equity markets are likely to be about 4.5%–6.5% for U.S.-dollar-based investors.
  • We do, however, foresee improving return prospects in non-U.S. developed markets, building on slightly more attractive valuations.
  • U.S. fixed income returns are most likely to be in the 2.5%–4.5% range, driven by rising policy rates and higher yields across the maturity curve as policy normalizes.

Ten-year projected return ranges

  • U.S. equities: 4.0%–6.0%
  • U.S. aggregate bonds: 2.5%–4.5%
  • International equities: 7.5%–9.5%
  • International bonds (hedged): 2.0%–4.0%

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model® (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 are derived from 10,000 simulations for each modeled asset class. Simulations as of December 31, 2018. Results from the model may vary with each use and over time. For more information on VCMM, see the Important Information.

Source: Vanguard Investment Strategy Group.

Global growth and risks that keep us up at night

Key takeaway: 2.0% growth in the United States

  • We expect the global economy to continue to grow, albeit at a slightly slower pace, over the next two years.
  • Trade, policy, and financial market uncertainty may prompt growth scares.
  • U.S. economic growth should drop back toward a more sustainable 2.0% as the benefits of expansionary fiscal and monetary policy abate.
  • China’s growth will remain near 6.0%, with increasing policy stimulus applied to help maintain that trajectory.
  • We estimate that a sustained growth-scare scenario in China could have a negative impact on U.S. growth of nearly 30 basis points.

 

2019 growth expectations and key risks

2019 growth expectations and key risks

*This sector is heavily skewed by continued strong growth in Asia (5.0%–7.5% range) and low growth levels in Latin America and Central and Eastern Europe, Middle East, and Africa (CEMEA).

 

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IMPORTANT: The projections and 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 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.

All investing is subject to risk, including the possible loss of the money you invest. Past performance is not a guarantee of future results. Investments in bond funds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. 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.

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