A look back before looking ahead

Posted by on December 9, 2013 @ 10:25 am in Economy & markets

I learned early in my life that humility is an important virtue regardless of the endeavor. Receiving the occasional B when I had expected an A or enduring a loss when my team was a heavy favorite taught me that no matter how convinced I was about something, there was always a chance I was wrong. It is important to understand the uncertainties life has in store for us, but it seems that forecasters many times forget the uncertainty inherent in any economic or market outlook, or at least they don’t convey it in their forecast.

At Vanguard, we acknowledge and embrace the uncertainty inherent in predicting the future. This shapes our beliefs on the benefits of diversification and leads us to present our views of the future in a distributional, long-term framework. It is with this in mind that I have outlined our projections from the 2013 Vanguard economic and investment outlook below, along with an update of how things actually played out. Many of these projections, which can be found primarily on pages 2 and 3 of the 2013 version of Vanguard’s economic and investment outlook, are longer-term in nature. However, revisiting these periodically is an important exercise, which can help inform future analysis. For example, our revised outlook for stock returns would be much different if we did not incorporate the recent deterioration in market valuations such as price/earnings (P/E) ratios. Look for these and our broader views on the global economic and financial markets in the forthcoming 2014 edition of our flagship piece.

U.S. economic growth: 

JD blog_VEMO_Look ahead chart_12.9.13Outlook (January 2013): The U.S. economic recovery should persist, but at an uneven and reduced 2% trend real GDP growth rate in a demand-constrained world. Risks to the consensus growth of 2.5% in 2013 are tilted toward the downside.

Current state: We have been pretty close to the mark. Growth through the first three quarters of 2013 was about 2.4% annualized, and it is likely to end the year averaging approximately 2%.

Biggest surprise: Although we said it was very likely the housing market had bottomed, the very strong growth in home prices was somewhat unforeseen, with the S&P/Case-Shiller Home Price Indexes up 11.2 % from September 2012 to September 2013.

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Global inflation:

Outlook (January 2013):  Trend inflationary pressures are currently modest, with a low risk of high inflation. Despite aggressive monetary policy, core inflation is likely to remain within its recent 1.5%–3.0% range over the next one to two years given limited wage pressures and economic slack.

Current state: If anything, inflation has come in somewhat lower than what many expected. The U.S. Consumer Price Index grew at an annualized rate of around 1.4% from December 31, 2012 through October 31, 2013 and core inflation (excluding food and energy prices) was about 1.7%. Our long-term outlook for U.S. inflation to center in the 2.0%–2.5% range remains consistent with long-term break-even rates of inflation in the U.S. Treasury Inflation-Protective Securities market.

Biggest surprise:  After years of deflation, Japan expects positive price inflation following the announcement of so-called Abenomics.  _____________________________________________________

U.S. monetary policy:

Outlook (January 2013): The target federal funds rate is likely to remain near 0% through at least 2014, with a bias toward the Federal Reserve remaining on hold even longer. As such, U.S. long-term interest rates are not likely to rise meaningfully this year with a Fed on hold. That said, the eventual removal of U.S. monetary policy accommodation may prove to be more volatile than currently anticipated.

Current state: The timeline may have changed, but the risk assessment was on point. New information regarding potential policy changes points toward the target federal funds rate remaining near 0% through mid- to late 2015 (with, again,  the risk being that the Fed may keep short-term rates near 0% even longer). A large upward move in yields in the weeks after the Fed’s discussion of its unwinding framework  signaled the potential for volatility during this multistep, multiyear process.

Biggest surprise: Our expectations for tapering of the Fed’s asset purchases in September proved premature.

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Bond markets:

Outlook (January 2013): The long-term return outlook for the broad taxable fixed income market is much muted, centered in the 1.0%–3.0% range. We would expect the diversifying properties of bonds to endure in the event of a stock market sell-off in the years ahead. That said, bond investments possess an elevated risk of loss given the present low income levels.

Current state: Relatively low income combined with capital losses following the summer spike in yields has resulted in bond returns (–1.6% for Vanguard Total Bond Market Index Fund from the beginning of the year through November 30, 2013) that many investors have not experienced in their lifetimes. That said, our research continues to show the potential benefits of holding high-grade bonds in a diversified portfolio to help moderate equity volatility.

Biggest surprise: The increase in yields following initial discussions of the possibility of the Fed’s beginning to unwind its extraordinarily easy monetary policy was larger than many expected, including the Fed.

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Equity markets:

Outlook (January 2013): Our long-held view is that the global stock markets could very well post solid returns, even in an extended period of low or disappointing economic growth. This formative outlook on the equity risk premium is primarily based on the current level of market valuations, such as P/E ratios.

Current state: Although our return outlooks are typically much longer-term in by design, the outperformance of developed markets (+23.2%), including that of the United States (+33.2%), relative to emerging economies (–3.3%) lends credence to our view that valuations should be pivotal in shaping return outlooks, not consensus economic growth forecasts.

Biggest surprise: It was not necessarily the direction of equity market returns over the past several years, but rather the sheer magnitude of cumulative returns over period. In fact, the recent deterioration in valuations suggests some “frothiness” in the U.S. stock market.

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Investor behavior

Outlook (January 2013): On page 17, we say we are concerned that the low nominal rate environment may encourage some investors to very aggressively reach for yield,  substituting more aggressive high-yield investments (such as junk bonds or REIT funds) for high-grade conservative bond portfolios or savings vehicles.

Current state: Investors, on average, continue to gravitate toward more aggressive asset allocations, either passively by not rebalancing or actively by investing in riskier segments of the stock and bond markets.

Biggest surprise: It was that recently, after years of cash flowing into taxable and municipal bonds,  net cash flows into U.S. stock mutual funds and ETFs were exceptionally strong.

Our views on the future path of these and other variables will be included in our soon-to-be-released 2014 edition of Vanguard’s economic and investment outlook. Going forward, some of our forecasts are likely to prove more accurate than others. That said, regardless of the results of any predictions, our research continues to show that in any environment, a continued focus on goals, balance, cost, and discipline provides the best framework for investor success.

I would like to thank Andrew Patterson, Charles Thomas, Miriam Hill, and John Tierno for their contributions to this post.

Notes:

All returns are annualized from December 31, 2012 , through November 30, 2013. Fixed income returns reflect those of the  Barclays U.S. Aggregate Float Adjusted Index, developed market equity returns reflect those of the MSCI EAFE Index through April 16, 2013; FTSE Developed ex North America Index thereafter, U.S. equity returns reflect the MSCI US Broad Market Index through June 2, 2013, and the CRSP US Total Market Index thereafter, and emerging market returns reflect the MSCI Emerging Markets Index through January 9, 2013; the FTSE Emerging Transition Index through June 27, 2013; and the FTSE Emerging Index  thereafter. Inflation represents the annualized change in the U.S. Bureau of Labor Statistics’ Consumer Price Index for All Urban Consumers (CPI-U)—all items, while core inflation is measured using the CPI-U—all items less food and energy.

All investing is subject to risk, including possible loss of principal.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

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