June 2, 2020 | Vanguard Perspective
The COVID-19 pandemic has drastically altered the economic landscape, and with it our forecasts for long-term market returns.
Compared with our forecasts at the beginning of 2020, our long-term return outlook for stocks is higher as valuations have fallen amid market declines. On the other hand, an already-challenging environment for bonds is perhaps more so given that yields have dropped even lower.
"When we evaluate the effectiveness of the Vanguard Capital Markets Model® (VCMM), we've had a fairly good record of anticipating average returns over the coming ten years," said Vanguard Senior Investment Strategist Kevin DiCiurcio, who runs the model.
The VCMM is a proprietary statistical tool that analyzes historical relationships among the macroeconomic and financial market data that drive asset returns, such as inflation, interest rates, and equity valuations. Vanguard strategists apply simulation techniques that assign probabilities to future asset return outcomes based on current market conditions. The modeling process results in projected probability distributions for asset-class returns and a correlation structure among the assets, which can be used to simulate the behavior of portfolio returns.
"It's worth noting a few things that set our market forecasts apart," DiCiurcio said. "We don't play the pundit, offering guesses about where the markets might be in one or three months' time." Rather, he said, the VCMM forecasts are for annualized returns over a ten-year horizon, which reflects Vanguard's longstanding view that investors should have long-term outlooks. Moreover, our research shows that we can expect to have a reasonable degree of accuracy over this time frame.
"We don't make pinpoint forecasts, either," DiCiurcio pointed out. "Instead, we offer likely ranges of potential returns. We believe that forecasts are best viewed in a probabilistic framework that acknowledges the uncertainty inherent in predicting the future."
The VCMM models asset return distributions and their relationships with other asset categories realistically simulate how a portfolio might behave through time. It can therefore be a valuable resource for interpreting risk-return trade-offs of various portfolio choices, which can help inform investors' asset allocation decisions. It can also help investors set reasonable return expectations and gauge the likelihood they'll achieve their investment goals.
When we published our economic and market outlook for 2020, we expected most major economies to grow more slowly than in recent years but not stall. Since then, the pandemic has led to large swaths of those economies shutting down, putting them on track for historic declines in output and surges in unemployment. That's set the stage for most major economies, including the United States, to contract for the full year.
We take a long-term view on investing, and we encourage our clients to do so as well. That's part of the reason we look at annualized returns over a ten-year period. Typically, you wouldn't expect our forecasts to change much quarter to quarter or even year to year.
However, when we ran the VCMM with data through the end of March 2020, the outlook for equities had improved from our forecast in December, thanks to more favorable valuations given the drop in stock prices since then. The table below shows that our annualized nominal return projections over the next ten years for U.S. equities are in the range of 5.5% to 7.5%.
Returns for non-U.S. equities over the next ten years are likely to be higher, too, around 8.5% to 10.5%, a differential versus U.S. stocks that underscores the benefit of international diversification. (Though equity markets have gained back some ground since the end of March, their valuations remain substantially lower than at the end of last year.)
On the other hand, the range of returns for fixed income was lower than what we had published in December, reflecting declines in both central bank policy rates and bond yields. The table below shows our ten-year annualized nominal return projections. They stand at a range of 0.9% to 1.9% for U.S. bonds and a little less for non-U.S. bonds, at 0.7% to 1.7%.
Stocks may perform better over the next decade than we had forecast at the end of last year, while fixed income returns may be even more muted.
Our update, however, shouldn't be taken as a timing signal or a call to change portfolios beyond regular rebalancing or changes in your clients' risk tolerance. Nor is it a call to abandon high-quality bonds, which we expect will continue to play an important role in diversified portfolios as a ballast to riskier assets.