The buck stops here: Vanguard’s economic Vanguard moneyoutlook market funds and investment

Vanguard Research

December 2015

■ Global growth will remain frustratingly fragile in 2016. Global trade and manufacturing

activity will likely struggle, and additional “growth scares” should be expected. Nevertheless, Vanguard’s non-consensus view is that the world’s ongoing structural deceleration is converging toward a more balanced growth equilibrium. This structural convergence is not yet complete, given the need for debt deleveraging in China and other emerging markets. ■ At full employment, the U.S. economy is unlikely to accelerate in 2016, yet is on course

to experience its longest expansion in nearly a century, underscoring our long-held view of its resiliency. We believe that those who see an even weaker future of U.S. secular stagnation are too pessimistic and overlook the benefits of an unlevered expansion. ■ As we have discussed in Vanguard’s past outlooks, policymakers are likely to continue

to face difficulties achieving 2% inflation over the medium term. As of December 2015, however, some of the most pernicious long-term deflationary forces are beginning to moderate cyclically for the first time since 2006. ■ We anticipate a “dovish tightening” cycle by the U.S. Federal Reserve, and we continue

to view the global low-rate environment as secular, not cyclical. ■ Although not bearish, Vanguard’s outlook for global stocks and bonds is the most

guarded since 2006, given the low-interest-rate and low-earnings-yield environment.

Lead authors

The Vanguard Group, Inc.’s Investment Strategy Group Vanguard Global Economics Team Joseph Davis, PhD Global Chief Economist

Joseph Davis, PhD

Roger A. Aliaga-Díaz, PhD

Global Chief Economist

Principal and Senior Economist

Americas Roger A. Aliaga-Díaz, PhD Principal and Senior Economist

Harshdeep Ahluwalia, MSc Michael DiJoseph, CFA Peter Westaway, PhD

Qian Wang, PhD

Chief Economist, Europe

Senior Economist

Vytautas Maciulis, CFA Zoe B. Odenwalder David Pakula Andrew J. Patterson, CFA Christos Tasopoulos, MSc

Andrew J. Patterson, CFA

Harshdeep Ahluwalia, MSc

Senior Investment Strategist

Senior Investment Strategist

Editorial note

Ravi Tolani Matthew C. Tufano Europe

This publication is an update of Vanguard’s annual Economic and Investment Outlook. We present our economic and market perspectives for 2016 for key economies around the globe. Aided by Vanguard Capital Markets Model™ simulations and other research, we also forecast future performance for a broad array of fixed income and equity asset classes.

Peter Westaway, PhD

Acknowledgments

Asia-Pacific

We thank Lara de la Iglesia for her significant contributions to this piece and the work of the Global Economics Team. Further, we would like to acknowledge the work of Vanguard’s broader Investment Strategy Group, without whose tireless research efforts this piece would not be possible.

Chief Economist, Europe

Biola Babawale, MSc Tom Kynge

Qian Wang, PhD Senior Economist

Alexis Gray, MSc Jessica Mengqi Wu, MSc

Contents Global outlook summary.................................................................................................................................................................................................... 4 I. Global economic perspectives..................................................................................................................................................................... 6

Global economic outlook: Sustained fragility, structural convergence .............................................................................................6



China: Sharp slowdown, but no recession.................................................................................................................................................................. 10



Euro area: Some bright spots emerging......................................................................................................................................................................... 11



United States: At full employment, trend-like growth......................................................................................................................................12



Canada: Not the best of times, not the worst of times.................................................................................................................................15



Emerging markets: Structural slowdown, although systemic crisis unlikely in 2016.......................................................17

II. Global capital markets outlook.................................................................................................................................................................. 19

Global fixed income markets......................................................................................................................................................................................................19



Global equity markets....................................................................................................................................................................................................................... 22



Alternative asset classes............................................................................................................................................................................................................... 24



Implications for balanced portfolios and asset allocation............................................................................................................................. 25

III. Appendix: Vanguard Capital Markets Model™ and index benchmarks........................28

Notes on asset-return distributions The asset-return distributions shown here represent Vanguard’s view on the potential range of risk premiums that may occur over the next ten years; such long-term projections are not intended to be extrapolated into a short-term view. These potential outcomes for long-term investment returns are generated by the Vanguard Capital Markets Model (VCMM—see also the description in the appendix) and reflect the collective perspective of our Investment Strategy Group. The expected risk premiums—and the uncertainty surrounding those expectations—are among a number of qualitative and quantitative inputs used in Vanguard’s investment methodology and portfolio construction process. IMPORTANT: The projections or other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as of September 30, 2015. Results from the model may vary with each use and over time. For more information, see the appendix. 3

Vanguard’s distinct approach to forecasting To treat the future with the deference it deserves, Vanguard believes that market forecasts are best viewed in a probabilistic framework. This publication’s 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. This analysis discusses our global outlook from the perspective of a Canadian investor with a Canadian dollar-denominated portfolio.

Global outlook summary Global economy: Structural convergence

World economic growth will remain frustratingly fragile. As in past versions of Vanguard’s Economic and Investment Outlooks, we view a world not in secular stagnation but, rather, in the midst of structural deceleration. Vanguard’s non-consensus view is that the global economy will ultimately converge over time toward a more balanced, unlevered, and healthier equilibrium, once the debt-deleveraging cycle in the global private sector is complete. Most significantly, the high-growth “Goldilocks” era enjoyed by many emerging markets over the past 15 years is over. We anticipate “sustained fragility” for global trade and manufacturing, given China’s ongoing rebalancing and until structural, business-model adjustment occurs across emerging markets. We do not anticipate a Chinese recession in the near term, but China’s investment slowdown represents the greatest downside risk to the global economy. The growth outlook for developed markets, on the other hand, remains modest, but steady. As a result, the developed economies of the United States and Europe should contribute their highest relative percentage to global growth in nearly two decades. Now at full employment, the U.S. economy is unlikely to accelerate in 2016, yet is on course to experience its longest expansion in nearly a century, underscoring our continuing view of its resiliency. Indeed, our long-held estimate of 2% U.S. trend growth is neither “new” nor “subpar” when 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. Our interpretation fully explains the persistent drop in U.S. unemployment despite below-average economic growth.

4

Inflation: Secular deflationary bias waning

As we have discussed in past outlooks, policymakers are likely to continue struggling to achieve 2% core inflation over the medium term. As of December 2015, however, some of the most pernicious deflationary forces (commodity prices, labour “slack”) are beginning to moderate cyclically. Inflation trends in the developed markets should firm, and even begin to turn, 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. Monetary policy and interest rates: A ‘dovish tightening’ by a lonely Fed

Convergence in global growth dynamics will continue to necessitate and generate divergence in policy responses. The U.S. Federal Reserve is likely to pursue a “dovish tightening” cycle that removes some of the unprecedented accommodation exercised due to the “exigent circumstances” of the global financial crisis. In our view, there is a high likelihood of an extended pause in interest rates at, say, 1%, that opens the door for balance-sheet normalization and leaves the inflation-adjusted federal funds rate negative through 2017. Elsewhere, further monetary stimulus is highly likely. The European Central Bank (ECB) and Bank of Japan (BoJ) are both likely to pursue additional quantitative easing and, as we noted in our 2015 outlook, are unlikely to raise rates this decade. This view is another potential factor that could result in a pause for the federal funds rate this business cycle.

Chinese 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. The margin of error is fairly slim, and policymakers should aggressively stimulate the economy this year in an attempt to stabilize below-target growth. 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. We continue to view the global low-rate environment as secular, not cyclical. Bonds. The return outlook for fixed income remains positive, yet muted. In line with our past outlooks, our long-term estimate of the equilibrium federal funds rate remains anchored near 2.5% and below that of the Fed’s “dot plots.”1 As a result, our “fair value” estimate for the benchmark 10-year U.S. Treasury yield still resides at about 2.5%, even with a Fed liftoff. As we stated in our 2015 outlook, even in a rising-rate environment, duration tilts are not without risks, given global inflation dynamics and our expectations for monetary policy.

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%–9% range. That said, our long-term outlook is not bearish and can even be viewed as constructive when adjusted for the low-rate environment. Our long-standing concern over “froth” in certain past high-performing segments of the capital markets has been marginally tempered by the general relative underperformance of those market segments in 2015. Asset allocation. Going forward, the global cross-currents of not-cheap valuations, structural deceleration, and the exiting from or insufficiency of near-0% short-term rates imply that the investment environment is likely to be more challenging and volatile. Even so, Vanguard firmly believes that the principles of portfolio construction remain unchanged, given the expected risk–return tradeoff among asset classes. Investors with an appropriate level of discipline, diversification, and patience are likely to be rewarded over the next decade with fair inflationadjusted returns.

Indexes used in our historical calculations The long-term returns for our hypothetical portfolios are based on data for the appropriate market indexes through September 2015. We chose these benchmarks to provide the best history possible, and we split the global allocations to align with Vanguard’s guidance in constructing diversified portfolios. Canadian bonds: Barclays Canadian Aggregate Bond Index since 2002. International bonds: Citigroup High Grade Index CAD Hedged from 1971 through 1972; Lehman Brothers US Long Credit AA Index CAD Hedged from 1973 through 1975; US Barclays Aggregate Bond Index CAD Hedged from 1975 through 1989; Barclays Global Aggregate Bond Index CAD Hedged from 1990 through August 2000; Barclays Global Aggregate ex Canada Bond Index (CAD Hedged) thereafter. Global bonds: From 1971 through 2002, international bonds as defined above. After 2002, 25% Canadian bonds and 75% international bonds, rebalanced monthly. Canadian equities: MSCI Canada Index since 1970. International equities: MSCI World Index from 1971 through 1988; and MSCI All Country World Index thereafter. Global equities: Through 1971, 100% Canadian equities as defined above. After 1971, 25% Canadian equities and 75% international equities, rebalanced monthly. Canadian inflation: Consumer price index for Canada since 1970.

1 “Dot plots” refers to charts published by the U.S. Federal Reserve’s Federal Open Market Committee (FOMC), in the Fed’s Summary of Economic Projections, showing points where FOMC participants, who are kept anonymous, believe the federal funds rate should be over the next few years, in the absence of economic shocks.

5

I. Global economic perspectives

sector is complete (this will not occur in 2016). We believe that those who see an even weaker future of secular stagnation are too pessimistic with respect to future productivity growth (which is cyclically depressed) and are overlooking the benefits of an unlevered expansion.

Global economic outlook: Sustained fragility, structural convergence Global growth will remain frustratingly fragile in 2016. As in past versions of Vanguard’s Economic and Investment Outlook, we view a world economy in the midst of structural deceleration (see Figure I-1). Indeed, Vanguard’s non-consensus view is that the global economy will ultimately converge over time toward a more balanced, unlevered, and healthier equilibrium, once the debt-deleveraging cycle in the global private

Based on unfavourable demographics worldwide and a lower or negative contribution from private-sector debt and credit expansion, the gap in gross domestic product (GDP) growth between emerging markets and developed economies should converge, a structural theme that is a reversal of the past 15 years (see Figure I-2). Adverse demographic projections have been anticipated for years, and are a drag on long-term growth affecting both developed and emerging market economies.2

Figure I-1. Most of the world is in structural deceleration A scorecard for growth convergence United States

Euro area

China

Japan

United Kingdom

Canada

Australia

22.4%

17.1%

13.3%

6.2%

3.7%

2.3%

1.9%

Pre-recession average (1990–2007)

3.0

2.0

10.0

1.4

2.9

2.5

3.4

Projected future (2016–2020)

2.1

1.5

6.3

0.5

2.1

2.0

2.8

Percentage of world GDP Estimated trend growth rates (%)

Growth headwinds Slowing growth of labour force

Slower population growth and aging of population

Private-sector debt deleveraging

Debt-deleveraging cycle, constraining willingness to spend

Sluggish capital investment

Falling cost of technology and demographic effects on businesses’ growth plans

Fiscal sustainability and committed fiscal austerity

Unsustainable debt dynamics may result in suboptimal policies and uncertainty

Commodity exports dependency Weak commodity price outlook

Currency strength

Tighter financial conditions, weaker manufacturing and exports

Rising income inequality

Falling purchasing power of consumers with highest propensity to spend

n

Highly significant factor

n

Moderately significant factor

n

Factor not present

Notes: Slowing growth of labour force: Birth rates minus mortality rates (slope of the trend line, 1960–present); Private-sector debt deleveraging: Percentage increase in household debt (% of GDP) from 2008 to December 2015; Sluggish capital investment: Difference between average fixed capital formation as percentage of GDP, 2000–2007 and 2008–latest; Fiscal sustainability and committed fiscal austerity: Fiscal space estimates based on Moody’s Economy.com model, as of February 2015 and difference in structural government budget balance over next two years (2016–2017); Commodity exports dependency: Qualitative assessment of commodity export dependence; Currency strength: Level of real effective exchange rate as of September 2015 (>100, overvalued/ vanguardcanada.ca Important information: The views expressed in this material are based on the authors’ assessments as of the first publication date (December 2015), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The authors may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise. Certain statements in this material may be considered “forward-looking information” which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein. While this information has been compiled from proprietary and non-proprietary sources believed to be reliable, no representation or warranty, express or implied, is made by The Vanguard Group, Inc., its subsidiaries or affiliates, or any other person (collectively, “The Vanguard Group”) as to its accuracy, completeness, timeliness or reliability. The Vanguard Group takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this material. This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and thus, should not be used as the basis of any specific investment recommendation. Investors should consult a financial and/or tax advisor for financial and/or tax information applicable to their specific situation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation. Information, figures and charts are summarized for illustrative purposes only and are subject to change without notice. In this material, references to “Vanguard” are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc. This material does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

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