January 15, 2018

Global economic outlook: An ‘inflation surprise’?

The financial markets’ low volatility underscores investors’ conviction that the long-term global economic trends of modest growth and tepid inflation will also define shorter-term cycles. But risks lie in mistaking the trend for the cycle.

The most pronounced risk in our 2018 outlook is that already tight global labour markets will grow tighter, finally leading to a cyclical uptick in inflation. A wage or inflation spike in 2018 could lead markets to anticipate a more aggressive normalisation from historically low interest rates just as central banks are either normalisation monetary policy or contemplating doing so, thereby producing a market-rattling shock.

Global investment outlook: Higher risks, lower returns

For 2018 and beyond, our investment outlook is modest, at best. Elevated valuations, low volatility, and secularly low interest rates are unlikely to be allies for robust financial market returns over the next five years. Downside risks are more elevated in the equity market than in the bond market.

In our view, the solution to this challenge is not shiny new objects or aggressive tactical shifts. Rather, our market outlook underscores the need for investors to remain disciplined and globally diversified, armed with reasonable return expectations and low-cost strategies.

What follows is a brief overview of our economic and investment outlook for 2018.

Global economy: Tight labour markets become tighter

We expect economic growth in developed markets to remain moderate in 2018, while strong emerging markets growth should soften a bit. Yet investors should pay more attention to low unemployment rates than GDP growth at this stage of the cycle for prospects of either higher spending for capital expenditures or wage pressures. We see low unemployment rates across many economies declining further. Improving fundamentals in the United States, Europe and Japan should help offset weakness in the United Kingdom. China’s ongoing efforts to rebalance from a capital-intensive exporter to a more consumer-based economy remains a risk, as does the need for structural business-model adjustments across emerging markets economies. We do not anticipate a Chinese “hard landing” in 2018, but the Chinese economy should cool.

Inflation: Secularly low, but not dead

Previous Vanguard outlooks have rightly anticipated that the secular forces of globalisation and technological disruption would make achieving 2% inflation in the United States, Europe, Japan, and elsewhere more difficult. Our trend view holds, but the cycle may differ.

In 2018, we think that the influences recently bearing down on inflation will subside, increasing the probability of higher-than-trend inflation.

Specifically, the growing impact of cyclical factors such as tightening labour markets, stable and broader global growth, and a potential nadir in commodity prices is likely to push global inflation higher from cyclical lows. The relationship between lower unemployment rates and higher wages, pronounced dead by some, should begin to re-emerge in 2018, beginning in the United States.

Monetary policy: Tighter and trickier from here

The risk in 2018 is that a higher-than-expected bounce in wages – at a point when 80% of major economies (weighted by output) are at full employment—may lead markets to price in a more aggressive path or pace of global monetary policy normalisation. The most likely candidate is in the United States, where the Federal Reserve is increasingly likely to raise rates to 2% by the end of 2018, a more rapid pace than anticipated by the bond market. Elsewhere, the European Central Bank and Bank of Japan are unlikely to raise rates in 2018, although a cyclical bounce may lead to a market surprise. Overall, the chance of unexpected shocks to the economy as global monetary policy becomes more restrictive is high, particularly when considering that it involves unprecedented balance-sheet shrinkage.

Investment outlook: A lower orbit

The sky is not falling, but our market outlook has dimmed. Since the depths of the 2008–2009 global financial crisis, Vanguard’s long-term outlook for the global stock and bond markets has gradually become more cautious – evolving from bullish in 2010 to constructive in 2012 to guarded in 2017–as market returns have risen with (and even exceeded) improving fundamentals. Although we are hard-pressed to find compelling evidence of financial bubbles, risk premiums for many asset classes appear slim. The market’s efficient frontier of expected returns for a unit of portfolio risk now hovers in a lower orbit.

Based on our “fair-value” stock valuation metrics, the ten-year outlook for global equities has deteriorated a bit and is now centred in the 4.5%–6.5% range. Expected returns for the US stock market are lower than those for non-US markets, underscoring the benefits of global equity strategies in the face of lower expected returns. The projected odds of a US market correction are higher than they have been historically.

And despite the risk for a short-term acceleration in the pace of monetary policy normalisation, the risk of a material rise in long-term interest rates remains modest. For­example, our fair-value estimate for the benchmark 10-year US Treasury yield remains centred near 2.5% in 2018, in part because we believe the chances of the federal funds rate heading back towards zero or reaching its long-term neutral level in coming years are balanced. Overall, the risk of a correction for equity and other high-beta assets is projected to be considerably higher than for high-quality fixed income portfolios, whose expected returns are only positive in nominal terms over the next five years.