Being comfortable with uncertainty, being prepared, and not being overconfident are essential life skills.
It is no coincidence that these skills serve as strong investment principles and help us look at the markets and economy with a healthy dose of realism. Heading into 2014, I emphasized the importance of humility in predicting the future, so in light of the New Year, I would like to offer a resolution: Invest with purpose. Forecasters (including us) will set expectations about what lies ahead, and it is important to keep your portfolio immune from assuming that one forecast will be right at the expense of reaching your goals on time. By definition, we will never be completely “right”—but if we are careful and responsible, we will probably be very close.
At Vanguard, we develop our forecasts and portfolio recommendations with a long-term, distributional focus to minimize our own biases. With this perspective in mind, I will revisit the projections we made for 2014 in our Economic and investment outlook. Reviewing our predictions is much like watching the tape with the football team and coaches after a game: We can review our performance, see patterns with new perspective, and prepare for the next kickoff with the necessary self-reflection.
Outlook (January 2014): We anticipated a slight pickup in near-term growth, approaching 3%, for the United States for the first time since the financial crisis. The most positive leading indicators were associated with the housing market, manufacturing activity, and financial conditions.
Current state: Excluding the unforeseeably rough winter and inventory cycles that affected the first quarter, gross domestic product growth has been above expectations. Growth through the first three quarters of 2014 was around 2.4% annualized; however, growth in the second and third quarters was north of 4.5% annualized. Our outlook anticipates the United States will remain resilient despite the global slowdown, with cyclical risks tilted toward above-trend growth of 2.5%–3.0%.
Biggest surprises: The polar vortex and the unprecedented fall in production took everyone by surprise. On a positive note, however, the unemployment rate fell below 6%, hitting a new postrecession low.
Outlook (January 2014): We expected the reflationary monetary policy to counteract the deflationary bias of a high-debt world and predicted that core inflation was likely to remain within the 1.0%–3.0% targeted range.
Current state: We were pretty close to the mark. The Consumer Price Index grew at an annualized rate of around 1.6% through October. Europe and Japan continued to have a greater risk of deflation. Our long-term inflation outlook for the United States, the euro area, and Japan is slightly lower, centering in the 1.5%–2.0% range.
Biggest surprise: An unexpected fall in oil prices in the fall and early winter put downward pressure on global prices.
U.S. monetary policy
Outlook (January 2014): Tapering of the Federal Reserve’s quantitative easing (QE) program had began, although an actual tightening continued to be some time off. The target federal funds rate was predicted to remain near 0% through mid-2015.
Current state: Although the Federal Reserve signaled the end of QE, our outlook remains the same. The Fed is likely to keep short-term interest rates near 0% through mid-2015. That said, new information suggests the anticipated rate rise will likely be more gradual and will end at a lower level. Globally, the burdens on monetary policymakers are varied, and we anticipate central bank policies will diverge over the next several years.
Biggest surprises: The European Central Bank (ECB) was slow to enact an asset-purchasing program, and Japan suddenly increased its level of asset purchases.
Outlook (January 2014): We predicted that the return outlook for fixed income securities would be muted, with an expected ten-year median nominal return between 1.5%–3.0%. The macroeconomic environment justified a ten-year yield in the range of 2.75%–3.75%. However, we anticipated that a more normalized environment in which rates moved toward 5% would not happen.
Current state: Similar to last year’s outlook, the return outlook for fixed income securities is positive but muted. The expected long-run median return has been revised slightly higher, to around 2.0%–3.5%. Our central belief that fixed income serves primarily as a diversifier, however, is unchanged. Given this backdrop, we see credit risk as the main threat to investors in light of compressed credit spreads and a continued reach for yield, with the 10-year Treasury yield at approximately 2.5%.
Biggest surprise: Long-term rates came down in spite of expectations of a rate increase. This was largely the result of heightened geopolitical risks (including the Ukrainian conflict and ISIS) and concerns over growth in East Asia and Europe, as well as the weakening European outlook and the ECB’s decision to hold off on implementing QE.
Outlook (January 2014): Our equity outlook became more guarded. We were uneasy about signs of froth in certain segments of the global equity markets. Our expected ten-year median return was below the historical average, shifting to the 6%–9% range.
Current state: In a scenario of structural deceleration and a lower ending level for policy rates, we expect all asset yields to be lower relative to historical norms, echoing last year’s outlook. The long-term median nominal return for global equity markets, centered in the 5%–8% range, is below the historical average. Since the equity risk premium endures at lower yield levels, we encourage investors to exercise caution in making drastic strategic portfolio changes.
Biggest surprise: The S&P 500 Index ascended past 2000 points despite concerns of froth and slower economic growth.
Outlook (January 2014): Investors, on average, continued 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.
Current state: The risk appetite remains elevated as investors continue to chase expected return in a world of structural deceleration.
Biggest surprise: Investors remained “risk on” in light of uncertainty over rate increases and global economic growth.
For more on the current state and our views on the future, read our updated outlook for global economic growth, inflation, monetary policy, interest rates, and returns for stocks and bonds over the next decade in our 2015 outlook.