Vanguard’s economic and investment The buck stopsoutlook here:

Vanguard money market funds Vanguard Research Brief

Key points

n Global growth will

remain frustratingly fragile in 2016 as the world’s structural deceleration converges towards a healthier equilibrium. n While unlikely to

accelerate over the next year, the US economy is on course for its longest expansion in nearly a century, underscoring our long-held view of its resiliency.

Our research examines this shift and its implications for the global stock and bond markets.

Vanguard economists see a somewhat more challenging and volatile investment environment in the years ahead with inflation-adjusted returns likely to be moderately below long-run historical averages.

China slowdown, no recession Our 2016 outlook for China points to a continued slowdown, notably slower than the pre-global financial crisis level of 10% growth. Vanguard’s proprietary economic indicators dashboard for China, shown in Figure 1a, suggests that stillremaining areas of concern for 2016 are manufacturing, financial conditions and housing. Figure 1b estimates a high (71%) probability that the country’s real GDP growth will fall below 7%. The odds of a “hard landing” in 2016 – where real GDP growth is 5% or less – are estimated at 14%.

This brief, based on research by The Vanguard Group, Inc.,1 outlines our view of a world not in “secular stagnation” – a sustained period of little or no growth – but, rather, in the midst of “structural deceleration”. Our view is that the global economy will converge over time towards a more balanced and healthier equilibrium once the debt deleveraging cycle in the global private sector is complete.

n We anticipate a

Vanguard’s outlook for global stocks and bonds is the most guarded since 2006, given the low-interestrate and low-earningsyield environment.

China: Slightly below consensus a. China: Economic indicators 100%

b. Estimated distribution of China’s growth outcomes, 2016 16% 14

75

12 10

50

8 6

25

4 2

0

0 1996 1998 2002 2004 2007 2009 2011 2013 2015

Above-trend growth: Consumption Below trend and positive momentum: Consumer and business sentiment, housing, labour market Below trend and negative momentum: Manufacturing, financial conditions, commodity markets Real GDP year-over-year (at right)

Real GDP growth (year-over-year)

n Although not bearish,

Figure 1. Vanguard global dashboard of leading economic indicators and implied economic growth for 2016

Indicators above/below trend

“dovish tightening” cycle by the US Federal Reserve, and we continue to view the global low-interest-rate environment as secular, not cyclical.

50%

Odds of a slowdown

Trend growth

Odds of an acceleration

36%

35%

29%

40 Probability



March 2016

30 20

22%

21%

14% 8%

10 0

Hard landing: Less than 5% Slowdown: 5% to 6% Trend: 6% to 7% Acceleration: 7% to 8% Acceleration to pre-crisis trend: Above 8%

Notes: Distribution of growth outcomes generated by bootstrapping the residuals from a regression based on a proprietary set of leading

economic indicators and historical data, estimated from 1990 to September 2015 and adjusting for the time-varying trend growth rate. “Trend growth” is the 2016 growth target set by Chinese officials. Sources: Vanguard calculations, based on data from Moody’s Analytics Data Buffet, Thomson Reuters Datastream, and CEIC. 1  Vanguard’s economic and investment outlook. Joseph Davis, PhD; Roger A. Aliaga-Díaz, PhD; Peter Westaway, PhD; Qian Wang, PhD; Andrew J. Patterson, CFA; and Harshdeep Ahluwalia, MSc; December 2015.

For Accredited Investors and Institutional Investors as defined in section 4A of the Securities and Futures Act (Cap.289). Not for public distribution.

During this period of economic rebalancing, China’s investment slowdown represents the greatest downside risk to the global economy. Our simulations reveal that a deep Chinese recession would be sufficient to drag down other economies. Nevertheless, we don’t anticipate an outright Chinese recession in the near term. Although a large-scale stimulus plan appears unlikely, we expect the Chinese authorities to provide further monetary and fiscal support in 2016, in a bid to cushion against the downside risks and stabilise growth. Chinese monetary policymakers have arguably the most difficult task of engineering a “soft landing” by lowering real borrowing costs and the real exchange rate without accelerating capital outflows.

Despite renewed threats of the euro area’s breakup in connection with Greece’s debt crisis in 2015, the European economy grew modestly stronger than some expected. We anticipate similarly modest growth in 2016. Overall expansion could potentially average a trend-like 1.5% before accelerating slightly for the two years following, in part because of further quantitativeeasing stimulus.

Inflation and monetary policy

At full employment, the US economy is unlikely to accelerate this year, yet is on course to experience its longest expansion in nearly a century, underscoring our long-held view of its resiliency. As in past outlooks, we maintain that US long-term (potential) GDP growth is near 2%, versus its historical average of 3.25% since 1950. This lowered projection is based on demographic headwinds and, to a lesser extent, on a more subdued expectation for labour productivity growth.

Policymakers around the world are likely to continue struggling to achieve 2% core inflation over the medium term. That’s despite key deflationary forces having receded as at December 2015 with the labour markets in many regions tighter than they were at the end of 2014 and price declines for many commodities slowing. Inflation trends in developed markets should firm, and even begin to turn higher, in 2016. That said, achieving more than 2% core inflation across developed markets could take several years and will ultimately require a more vibrant global rebound.

However, we see our 2% US trend growth estimation as neither “new” nor “subpar” relative to pre-crisis levels, if one both accounts for structurally lower population growth and removes the consumer debtfuelled boost to growth between 1980 and the global financial crisis that began in 2007. Specifically, US real GDP growth between 1980 and 2006 would have averaged nearly 2% had consumer debt (and hence the share of the economy dictated by consumer spending) not risen to drastic levels over time.

Convergence in global growth dynamics will continue to necessitate and generate divergence in responses by policymakers around the world. The US Federal Reserve is likely to pursue a “dovish tightening” cycle that removes some of the unprecedented accommodation that followed the global financial crisis. In our view, there is a high likelihood of an extended pause in interest rates around 1% that opens the door for balance-sheet normalisation and leaves the inflationadjusted federal funds rate negative through 2017.

In Japan, the outlook is not encouraging, despite aggressive monetary easing as part of the economic policies dubbed “Abenomics” after Japanese Prime Minister Shinzo Abe. Although the economy should be able to sustain higher levels of inflation at around 1%, given the tightening labour market and stabilisation in

Elsewhere, further monetary stimulus is highly likely. The European Central Bank and Bank of Japan are both likely to pursue additional quantitative easing and are unlikely to raise rates this decade. This view is another potential factor that could result in a pause for the US federal funds rate during this business cycle.

The outlook around the world

2

energy prices, real GDP growth should remain modest, as domestic investment and consumption have yet to gather momentum. This outlook is consistent with our view that monetary policy alone could be insufficient to achieve sustainable growth and inflation.

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Figure 2. Projected global equity ten-year-return outlook Vanguard Capital Markets ModelTM -simulated distribution of expected average annualised nominal return of global equity market, estimated as at September 2015 and June 2010 Global equity returns

1926–2015

25%

Probability

20 15

9.9%

1926–1969

9.7%

1970–2015

10.1%

2001–2015

5.2%

10 5 0

Less than 0%

0% to 4%

4% to 8%

8% to 12%

12% to 16%

15% to 20%

More than 20%

Ten-year annualised return Ten-year outlook as at September 2015 Outlook as at June 2010

Notes: Figure displays projected range of potential returns for a market-capitalisation-weighted equity portfolio in USD, rebalanced quarterly, from 10,000 VCMM simulations as at September 2015. Historical returns are computed using the following indices: US equities – S&P 90 Index from January 1926 through March 1957; S&P 500 Index from March 1957 through 1974; Dow Jones Wilshire 5000 Index from 1975 through April 2005; and MSCI US Broad Market Index thereafter; ex-US equities – MSCI World ex USA Index from January 1970 through 1987 and MSCI All Country World ex USA thereafter. Source: Vanguard.

Investment outlook: Still conservative Vanguard’s outlook for global stocks and bonds remains the most guarded since 2006, given fairly high equity valuations and the low-interest-rate environment. Bonds. The return forecast2 for fixed income remains positive, yet muted. We expect the ten-year median returns of the global fixed income market to be centred in the 2%–3% range. Our “fair value” estimate for the benchmark 10-year US Treasury yield still resides around 2.5%, even with Fed rate hikes. As we stated in our 2015 outlook, in a rising-rate environment, duration tilts are not without risks, given global inflation dynamics and our expectations for monetary policy. Still, bonds act as ballast in a portfolio, buffering losses from riskier assets such as stocks, and we encourage investors to evaluate the role of fixed income from a perspective of balance and diversification rather than return. Stocks. After several years of suggesting that low economic growth need not equate with poor equity returns, our medium-run outlook for global equities

remains guarded, in the 6%–8% range. That said, our long-term outlook is not bearish and can even be viewed as constructive when adjusted for the low-rate environment. As shown in Figure 2, the central tendency of our simulations for ten-year expected returns for a global equity portfolio is below both the long-run historical annualised average return (9.9%) and our own forecasts from just five years ago (based on the June 2010 distribution, in the figure). When returns are adjusted for future inflation, we estimate a 60% likelihood that a global equity portfolio will produce a 5% average real return over the decade ending 2025. Asset allocation. The global cross-currents of elevated valuations, structural deceleration, and the exit from or insufficiency of near-0% short-term rates imply that the investment environment is likely to be challenging and volatile. Figure 3 presents simulated real return distributions for 2015–2025 for three hypothetical multi-asset-class portfolios ranging from more conservative to more aggressive.

2 For more information on the asset-return distributions and the Vanguard Capital Markets Model™, see Vanguard’s economic and investment outlook. Davis, et al., December 2015.

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3

Amid widespread concern over low dividend and long-term US Treasury yields, Figure 3’s real long-run return profile for balanced portfolios may seem better than expected. However, Vanguard believes it’s important for investors to consider real-return expectations when constructing portfolios, because today’s low dividend and Treasury yields are, in part, associated with lower expected inflation than was the case 20 or 30 years ago.

A final thought Vanguard firmly believes the principles of portfolio construction remain unchanged, given the expected risk–return trade-off among asset classes. Investors with an appropriate level of discipline, diversification and patience are likely to be rewarded over the next decade with fair inflation-adjusted returns.

Our simulations indicate that the average annualised real returns of a 60% equity/40% bond portfolio for the decade ending 2025 are expected to centre in the 3%–5% range, below the actual average real return of 5.4% for the same portfolio since 1926.

Ten-year annualised returns

Figure 3. Projected ten-year real return outlook for balanced portfolios History Forecast

15%

Percentiles key:

10

95th 75th

5

Median 25th

0

5th

–5 1940 1950 1960 1970 1980 1990 2000 2010

20%/80%: Equity/bond portfolio 60%/40%: Equity/bond portfolio 80%/20%: Equity/bond portfolio Equity/bond portfolios

Bottom 5th percentile

25th percentile

20%/80%

60%/40%

80%/20%

History 1926–September 2015 History 2000–September 2015

50th percentile

75th percentile

95th percentile

History 1926–2015

History 2000–2015

20%/80%

–0.9%

0.8%

2.0%

3.2%

5.0%

3.5%

2.7%

60%/40%

–2.0%

1.8%

4.4%

7.1%

11.3%

5.4%

2.4%

80%/20%

–3.0%

2.0%

5.5%

9.0%

14.4%

6.2%

2.1%

Notes: Forecast displays 5th/25th/50th/75th/95th percentile range of 10,000 VCMM simulations for projected ten-year annualised real returns as at September 2015 in USD. Historical returns are computed using the following indices: US bonds – Standard & Poor’s High Grade Corporate Index from 1926 through 1968; Citigroup High Grade Index from 1969 through 1972; Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; and Barclays U.S. Aggregate Bond Index thereafter; ex-US bonds – Citigroup World Government Bond Ex-U.S. Index from 1985 through January 1989 and Barclays Global Aggregate ex-USD thereafter; US equities – S&P 90 Index from January 1926 through March 1957; S&P 500 Index from March 1957 through 1974; Dow Jones Wilshire 5000 Index from 1975 through April 2005; and MSCI US Broad Market Index thereafter; ex-US equities – MSCI World ex USA Index from January 1970 through 1987 and MSCI All Country World ex USA thereafter. The equity portion of the portfolio is 50% US equity and 50% global ex-US equity. The bond portion of the portfolio is 50% US bonds and 50% global ex-US bonds. Source: Vanguard.

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