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Our look ahead at 2022: Striking a better balance
Although health outcomes will remain important in 2022 given the emergence of the Omicron variant, the outlook for macroeconomic policy will be more crucial as support and stimulus packages enacted to combat the pandemic-driven downturn are gradually removed into 2022. The removal of policy support poses a new challenge for policymakers and a new risk to financial markets. Central banks will have to maintain the delicate balance between keeping inflation expectations anchored and allowing for a supportive environment for economic growth.
While the global economic recovery is likely to continue in 2022, we expect the low-hanging fruit of rebounding activity to give way to slower growth whether supply-chain challenges ease or not (see figure).
Sources: Vanguard calculations, as of September 30, 2021.
Global inflation: Lower but stickier
Inflation has remained high across most economies, driven both by a higher demand as pandemic restrictions were lifted and by lower supply resulting from global labor and input shortages.
A return to 1970s-style stagflation—stagnant economic activity amid high unemployment and inflation—is not in the cards. Vanguard continues to anticipate economic growth and, unlike in the 1970s, demand for workers is high. We expect inflation to remain elevated across developed markets as the forces of demand and supply take some time to stabilize (see figure).
Although inflation should cool in 2022, its composition should be stickier. More persistent wage-and shelter-based inflation should remain elevated given our employment outlook and will be the critical determinant in central banks' adjustment of policy.
How long will high inflation last?
Global capital markets outlook
Stocks: Valuations and projected returns
With valuations that have exceeded pre-pandemic highs, elevated inflation and the prospect of policy normalization are creating a fragile backdrop for markets. Our long-term outlook for global asset returns is guarded. This is especially true for equities, where high valuations and lower economic growth rates mean we expect lower returns over the next decade.
Low expected returns for global equities, but opportunities exist
Equity market 10-year outlook: Setting reasonable expectations
Valuations drifting higher
Global equity markets valuation relative to fair value
Bonds: Valuations and projected returns
For fixed income, low (by historical standards) interest rates mean that investors should expect lower returns. However, the fact that rates have risen modestly since 2020 means that our outlook is commensurately higher.
Against that backdrop of gradually rising rates, the fixed income return outlook in the next decade has been ticking up from last year's projections.
Valuation expansion has chipped away at investors' sources of extra yield
Higher rates have pushed expected fixed income returns higher
Aggregate fixed income appears to be fairly valued, but pockets are stretched
Bond markets valuation percentile relative to fair value
About our forecast: A probabilistic framework
To treat the future with the deference it deserves, Vanguard has long believed that market forecasts are best viewed in a probabilistic framework. Our primary objectives are to describe the projected long-term return distributions that contribute to strategic asset allocation decisions and to present the rationale for the ranges and probabilities of potential outcomes.
In the U.S., valuation changes and, to a lesser extent, earnings growth pushed realized returns 9.4 percentage points higher than our expectations on an annualized basis during the last decade. Low interest rates and inflation, along with higher-than-expected earnings, justify some, but not all, of the error in our forecast (see figure).
Investor psychology and higher earnings explain most of the error in our forecast
In order for the gap that defined the last decade to persist into the next, one would have to believe that economic growth will not be broad-based (that is, concentrated in a few sectors), that interest rates will decline further, that inflation pressures will completely subside, and that risk-seeking behavior will continue to push valuations away from fair value. These assumptions are inconsistent with our economic analysis and the market-based expectations that serve as inputs to our Vanguard Capital Markets Model (VCMM).
Although our economic outlook calls for modestly higher inflation and a normalization in interest rates over the next decade, it will not be enough to raise our returns forecast to historical averages. Achieving such returns will require a shift in the underlying secular forces that have kept rates low across developed economies since the late 2000s. For this reason, our confidence in our low-return outlook has only grown stronger (see figure), and we continue to caution investors against extrapolating future results from the past.
Returns on a 60/40 balanced portfolio are expected to be roughly half of what investors realized over the last decade
10-year annualized returns
Portfolio implications for Vanguard 2022 economic and market outlook
As policymakers look to strike a better balance in the years ahead, we believe that a balanced portfolio approach can serve your clients well.
Based on our economic and market outlook for 2022 and beyond, get a synopsis of our equity and fixed income projections broken down into separate asset class categories and see how our funds and ETFs can help you position client portfolios for the long term:
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. 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.
Diversification does not ensure a profit or protect against a loss.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
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.