Vanguard’s economic and capital markets outlook Vanguard research June 2010 Executive summary. In this new annual publication, Vanguard presents its secular outlook for inflation, interest rates, and the returns on stocks, Authors bonds, and other asset classes. This publication is intended to assist Joseph H. Davis, Ph.D. Daniel W. Wallick investment committees, financial advisors, plan sponsors, and other Roger Aliaga-Díaz, Ph.D. investors when making strategic asset allocation decisions. In this issue, the global outlook is discussed from the perspective of a U.S. investor with a dollar-denominated portfolio. Vanguard strongly believes that investors should consider market forecasts only in a probabilistic framework. Thus, the primary objectives of this publication are to describe the projected return distributions that contribute to strategic asset allocation decisions and to discuss the rationale for the ranges and probabilities of potential outcomes. Readers will observe that this publication is devoid of short-term “point forecasts” of the kind that, unfortunately, are the cornerstone of most market outlook publications in the investment industry. (over, please) Connect with Vanguard > Vanguard.com > global.vanguard.com (non-U.S. investors) The asset-return distributions shown here represent Vanguard’s current views on the potential distribution of risk premiums that may occur over the next ten years. These potential outcomes are generated by the Vanguard Capital Markets Model® (VCMM), a proprietary financial- simulation tool developed and managed by our investment research teams. The expected risk premiums—and the uncertainty surrounding those expectations—are among a number of important qualitative and quantitative inputs used in Vanguard’s investment methodology and portfolio-construction process. Global market outlook summary s 4HE STILL FRAGILE 53 ECONOMIC RECOVERY IS LIKELY TO BE MUTED UNEVEN AND ultimately U-shaped. Near-term risks remain tilted toward the downside owing to important headwinds involving real estate, consumer balance-sheet repair, and, most recently, the sharp transition toward fiscal austerity in Europe. Our proprietary index of leading indicators estimates the probability of a “double- dip” recession at approximately 20%. s /VER THIS DECADE THE GLOBAL EXPANSION SHOULD OCCUR AT VARIED SPEEDS WITH emerging markets and Australia generally expanding at the fastest pace; the United States growing more modestly; and Europe, the United Kingdom, and Japan generally posting sluggish growth. However, this widely expected global growth scenario is broadly priced in by the financial markets and thus has little impact on the projected stock returns in these regions. s 4REND INFLATIONARY PRESSURES IN THE 5NITED 3TATES AND MOST OTHER DEVELOPED markets are currently minimal, with the risks tilted toward deflation over the next several quarters. For the longer term, we anticipate modest inflation with a central tendency near 3%. Over the next ten years, the risks are mildly asymmetric toward higher inflation rates stemming from recent policy actions and continued global industrialization. We estimate the probability of a double- digit inflationary regime occurring in the U.S. at approximately 10%. s 4HE 53 4REASURY YIELD CURVE IS EXPECTED TO REMAIN STEEP IN THE NEAR TERM as the Federal Reserve probably will not raise short-term rates meaningfully until late 2011 or early 2012, at the earliest. Over the 10-year outlook horizon, our projections generally show a gradual “bear flattening” of the Treasury yield curve, although dispersion around this median path remains considerable. With inflation expectations anchored under most return simulations, long-term U.S. interest rates are expected to eventually normalize toward the 4.5%–5.5% range, a central tendency near historical long-run averages. 2 s 4HE EXPECTED LONG RUN MEDIAN RETURN OF THE BROAD TAXABLE 53 FIXED INCOME market is slightly skewed below current benchmark yields. Nevertheless, the bottom decile of expected U.S. bond returns over the next ten years is positive, and it is higher than the bottom-decile expected returns on equities. Importantly, the diversification benefits of fixed income in a balanced portfolio remain under most scenarios. We also discuss the outlook for corporate bonds and TIPS. s 4HE LONG TERM MEDIAN RETURN FOR GLOBAL EQUITY MARKETS IS NEAR HISTORICAL averages given current market valuations and the projected equity risk premium. This may surprise some readers given the expected headwinds to long-run economic growth. However, as we will discuss, it is market valuations—not lower consensus growth forecasts—that generally correlate with future stock returns. The projected distribution of the equity risk premium is wide. Under most VCMM scenarios, the expected return differential between U.S. and non-U.S. equity portfolios is statistically insignificant. Notes on risk: IMPORTANT: The projections or 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. All investments are subject to risk. Investments in bonds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Investments that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Diversification does not ensure a profit or protect against a loss in a declining market. 3 Figure 1. Consensus view: An uneven global recovery Real GDP growth in 2009 and projected growth in 2010, based on compiled forecasts (%) China Emerging markets: India Generally strong Brazil World Australia United States: United States Reasonable? Japan United Kingdom Europe: Sluggish, with downside Eurozone risks; debt contagion? Spain –6 –4 –2 0 2 4 6 8 10 2009 2010 Sources: International Monetary Fund and Vanguard. Global growth outlook Figure 2. Recoveries from financial crisis are Over this decade, the global expansion should often U-shaped occur at varied speeds, with emerging markets and Shape of recovery: Indices based on real GDP Australia generally expanding at the fastest pace; the United States growing more modestly; and Europe, 110 the United Kingdom, and Japan generally posting Economic Cycle Peak = 100 more sluggish growth. As illustrated in Figure 1, this global growth pattern is expected for 2010 and beyond by many, including the International Monetary 105 Fund. Since the uneven recovery scenario is broadly priced in by the financial markets, it should have little impact on the projected stock returns in 100 these regions. In the United States, the still-fragile economic recovery is likely to be modestly U-shaped, yet 95 self-sustaining. As discussed in several previous 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Vanguard papers, including Which Path Will the Quarters since start of recession U.S. Economy Follow? (Davis et al., 2009), economic Typical U-shaped recovery after financial crises recoveries following financial crises and home-price (combined GDP for developed markets) busts are typically U-shaped (Figure 2 ), as bank credit Typical V-shaped recovery (based on U.S. recessions after World War II) creation often remains sluggish and consumers tend Shape of expected U.S. recovery 2010–2012 to reduce debt and household leverage over time. Source: Vanguard, based on statistics from the International Monetary Fund and the Organisation for Economic Co-Operation and Development (OECD). 4 Figure 3. Government debt: The major investment Figure 4. Sovereign risk dashboard issue of the next decade Net Direct Sovereign debt/GDP ratios in G-7 countries, 1950–2009 government Debt Reliance banking and 2010 (projected) Structural debt-to-GDP rollover on external system deficit ratios risk funding holdings Low risk Sweden 140% Australia Canada Unsustainable 120 Elevated risk, but fiscal crisis not necessarily imminent path United Kingdom 100 Percentage of GDP United States Japan 80 Europe: Elevated risk of contagion, but fundamentals relatively stable 60 Germany Ireland 40 Spain Europe: Fiscal austerity measures needed immediately 20 Italy Portugal 0 Greece 1950 1960 1970 1980 1990 2000 2010 (p) Sources: International Monetary Fund and Vanguard. Sources: International Monetary Fund and Vanguard. Risks to the consensus view for the U.S. economy In our view, the long-term sustainability of remain tilted toward the downside for the next government debt levels in developed markets 12 months. The most prominent headwinds involve is the most important macroeconomic risk factor the real estate market, consumer deleveraging, and, for the investment outlook over the next decade. most recently, the sharp transition toward fiscal Gross government debt for G-7 countries has austerity in Europe. Indeed, our proprietary Economic already reached levels not seen since the years of Momentum Index of leading indicators suggests that World War II military spending and reconstruction future U.S. economic growth will be more uneven financing (Figure 3 ). However, the war financing and volatile than presently expected. As we discuss was temporary, whereas current government in a recent Vanguard research note, Assessing the financing needs are largely structural in nature Risks to the U.S. Economic Recovery (Davis et al., and thus not likely to decline significantly in the 2010), the odds of a so-called double-dip U.S. near future. Such structural challenges include recession are approximately 20%. These odds are social entitlement programs in conjunction with unusually high given the early stage of the economic demographic trends typical of mature economies. recovery. The odds would be higher if not for record- European fixed income markets have been pricing high U.S. productivity, which remains positive for in the unsustainable debt dynamics of Greece, corporate earnings and should support modest job Portugal, and Spain, but concerns about the growth going forward. sustainability of government debt extend to Italy and the United Kingdom as well (Figure 4 ). 5 Ultimately, the most effective solution to the Outlook for inflation problem of government debt levels involves a Trend inflationary pressures in the U.S. and most credible commitment to fiscal austerity through other developed markets are currently minimal, a combination of reduced government spending with the risks tilted toward deflation over the and higher tax rates. Of course, how preemptive next several quarters. As we discussed in a 2009 government officials around the world will be in Vanguard research paper, Recent Policy Actions and addressing such issues is a critical risk factor going the Outlook for U.S. Inflation (Davis and Cleborne), forward. Therefore, alternative means of financing key core inflation drivers such as labor costs, government debt—whether through higher inflation economic slack, and the velocity of money are still or even debt restructuring—will remain important tail showing disinflationary pressures (Figure 5 ). The risks in the investment landscape for the foreseeable U.S. output gap should remain wide until at least future. Indeed, it would not be very surprising if the 2012 owing to high unemployment rates and low next global recession is spawned by a fiscal crisis capacity utilization. in some major economy. Figure 5. High inflation is not an immediate threat Core inflation momentum drivers Wage inflation factor (year over year %) Percentage of small businesses raising prices 6% 40% 5 30 4 20 3 10 2 0 1 –10 0 Stagnant wage growth –1 –20 Weak pricing power –2 –30 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. 1985 1990 1995 2000 2005 2010 1987 1991 1995 1999 2003 2007 2010 U.S. output gap (% deviation from potential) Money multiplier (M2/base) 3% 14 2 12 1 10 0 8 –1 6 –2 4 Low velocity of money –3 Output far short of potential 2 –4 –5 0 Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. Jan. 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Vanguard; for additional information, see Recent Policy Actions and the Outlook for U.S. Inflation (Davis and Cleborne, 2009). 6 Over the next ten years, our simulations project Figure 6. Longer-term inflation risk is asymmetric a median inflation rate averaging near 3% per year for the U.S. Consumer Price Index. This central Actual historical and projected future U.S. CPI inflation rates tendency is roughly consistent with the Federal Reserve’s long-term inflation goal, although slightly 14% History Forecast above longer-term break-even inflation rates in the 12 Treasury Inflation-Protected Securities market. 10 High-inflation tail risk For the long term, the inflation risks are 8 distributed asymmetrically toward rates higher 90th% 6 than the projected median. As noted earlier, the 4 75th% massive monetary policy interventions to backstop 50th% the financial crisis as well as concerns about U.S. 2 25th% government debt levels generate uncertainties on 0 the upside (Figure 6 ). We estimate the probability 10th% of a double-digit inflationary regime occurring in –2 1960 1970 1980 1990 2000 2010 2020 2030 the United States at slightly less than 10%. Annual CPI inflation rate Trend in CPI inflation Outlook for U.S. interest rates Source: For details, see Recent Policy Actions and the Outlook for U.S. In the near term, the U.S. Treasury yield curve is Inflation (Davis and Cleborne, 2009). expected to remain steep given the likelihood that the Federal Reserve will keep monetary policy on hold. Expectations derived from the bond market Over the ten-year outlook horizon, our U.S. suggest that near-zero overnight rates are warranted interest rate projections generally show a gradual though at least late 2011, in view of subdued bear-flattening of the yield curve. With a median inflationary pressures together with still-elevated expected average inflation rate near 3%, long-term unemployment rates. U.S. interest rates are expected to eventually normalize toward the 4.5%–5.5% range, a central Because macroeconomic risks appear to tilt slightly tendency near their historical long-run averages. This toward below-consensus growth and deflation over mean-reversion tendency reflects the differentials the next 12 months, Fed policy is more likely to stay between the current and expected future values for on hold longer than expected than to become more the fundamental components of long-term interest aggressive than expected. As discussed in a recent rates: inflation expectations, real yields, and inflation Vanguard research paper, Deficits, the Fed, and and other rate premiums. Short-term rates tend to Rising Interest Rates: Implications and Considerations rise more than long-term rates in more than one-half for Bond Investors (Davis, Aliaga-Díaz, et al., 2010), of our VCMM scenarios as Federal Reserve policy the federal funds futures market has tended to price becomes less accommodative over time. The median in interest-rate tightening cycles too early. 3-month Treasury bill rate in 2020 is above 3%. 7 Figure 7. U.S. yield curve Figure 8. With deficits rising, why aren’t long-term rates higher? Current and expected distribution of U.S. Treasury yield curve in 2020 Contribution of the components of 2009/2010 average 10-year U.S. Treasury yield 8% 4% 7 3.5 10-year Treasury yield in percentage points 6 3 2.7 2.4 5 2 Yields 4 1 0.6 3 0.2 2 0 1 –0.6 –0.6 –1 0 –1.2 3-month 1-year 5-year 10-year 20-year 30-year –2 Maturity Household purchases of Treasury securities Current spot yield curve—April 2010 Foreign purchases of Treasury securities Real federal funds rate VCMM projections of the Treasury yield curve in 2020: GDP growth forecast 25th percentile Inflation volatility premium 50th percentile (median) Inflation expectations 75th percentile Structural deficit Source: Vanguard. Average yield Source: Vanguard calculations, based on methodology in Davis, Aliaga-Díaz et al., Deficits, the Fed, and Rising Rates (2010). We stress, however, that the dispersion around this median interest-rate path remains considerable. Figure 7 displays the 25th, 50th (median), and 75th upward pressure on long bond rates from increasing percentiles of the projected yield-curve distribution structural fiscal deficits has been offset by increased for 2020. In at least one-fourth of our scenarios, U.S. investor demand for fixed income investments U.S. interest rates ten years from now remain at or arising from higher U.S. domestic savings. slightly above current spot yields. It is also important to stress that the projections in Figure 7 reflect the Figure 8 reveals that household Treasury simulated distribution of 10,000 yield curves in one purchases stand out as the key force countering specific year, 2020; as we discuss in the Appendix, the budget deficits, holding back 10-year yields by the individual paths for each yield curve between 1.2 percentage points. Foreign central bank demand 2010 and 2020 vary markedly across VCMM and the near-0% federal funds rate are additional simulations. factors restraining 10-year Treasury yields from the levels that could have been expected in the wake An explanation for the uncertainty surrounding of higher government debt levels. A key question our interest-rate projections lies in the number for coming years is whether domestic savings rates of important—and at times offsetting—drivers will persist at current levels. If they do, future long of long-term Treasury yields. Figure 8 shows a bond rates may not rise as much as many investors decomposition of the average yield on the 10-year now fear. Also critical to restraining rates will be the Treasury bond between 2009 and the first quarter government’s ability to achieve a sustained reduction of 2010 into its primary drivers. As the authors in structural budget deficits. report in Deficits, the Fed, and Rising Rates, the 8 Asset class outlook: U.S. fixed income Figure 9. Projected total bond market returns Under the bear-flattening scenario for the yield curve, and with moderate increases bringing VCMM simulated distribution of expected annualized 10-year returns long-term interest rates to normal levels, the expected median return on the taxable U.S. fixed 25% income market is slightly skewed below current benchmark yields (Figure 9 ). Under our median 20 simulation scenario, wider-than-average risk Probability premiums for corporate bonds partially offset 15 rising Treasury yields. Despite the general tendency for Treasury yields 10 to rise in the VCMM simulations, it is important to stress that we expect the key benefits of fixed 5 income investing—diversification and income— to remain in the years ahead. Significantly, these 0 benefits are apparent in most VCMM scenarios. As Less 2.0%– 2.5%– 3.0%– 3.5%– 4.0%– 4.5%– More 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% discussed in the Appendix, the median correlation Geometric returns for broad U.S. bond market between the returns on U.S. bonds and U.S. stocks is expected to be low, with a correlation coefficient Source: Vanguard. of approximately 0.13. In addition, the downside risk to U.S. fixed income returns over the full forecast horizon is less pronounced than that to U.S. equity The expected median long-term return on a returns. Specifically, the bottom decile of expected U.S. TIPS portfolio trails that on a similar-duration U.S. bonds returns is positive and higher than that nominal U.S. Treasury portfolio by a modest amount of the bottom-decile returns on stocks. that represents the estimated inflation risk premium. Our distribution of TIPS returns is wider than that Within the broad taxable bond universe, the for nominal U.S. Treasury bonds. TIPS generally median expected total return on an investment- outperform nominal Treasuries in those VCMM grade corporate bond index modestly exceeds that scenarios with higher-than-average inflation rates for a similar-duration U.S. government bond portfolio. over the ten-year outlook horizon. TIPS display a This expected positive risk premium for investment- higher probability of negative returns over shorter grade corporate bonds is a function of the current investment horizons given the sensitivity of these level of corporate bond spreads. Of course, this securities to a rise in real rates. expected corporate bond risk premium is not realized in all scenarios. 9 Figure 10. Low growth does not necessarily correlate with poor future stock returns Prediction power of various determinants of stock returns, 1872–2008 40% 32% 30 Regression R2 23% The price stock investors pay for economic growth (i.e., earnings yield) 20 tends to matter much more than any expected growth rate. 10 7% 4% 1% 0% 0% 1% 0% 0% 0% 0% 0 Trailing Consensus Mean reversion: Market valuations: GDP growth macro Previous year’s Trailing P/E ratio expectations stock return 1-year-ahead stock return 5-year-ahead average return 10-year-ahead average return Statistically insignificant factors in long-run stock returns Source: Davis, Aliaga-Díaz, and Ren (2009). Note: Trailing P/E ratio reflects the so-called Graham P/E ratio as used by Robert Shiller, calculated as previous year-end price divided by 10-year average earnings. The R 2 statistics here represent the percentage of the volatility in the average annualized U.S. stock return that has been historically explained over the 1872–2008 period by each of the independent variables listed along the bottom axis. Asset class outlook: Global equities Indeed, numerous studies on the drivers of stock The expected median return for global equity returns show that market valuations are the most markets is near long-run historical averages, based important factor for forecasting long-term returns. on current market valuations and the projected Figure 10 reproduces the analysis from Vanguard equity risk premium. In light of the secular economic research by Davis, Aliaga-Díaz, and Ren (2009) headwinds previously discussed, this expectation showing that market valuations (dividend yields for stock returns may come as a surprise to some or earnings yields) have historically exhibited readers. the highest forecast power (measured by the regression R2) among various macroeconomic However, investors must recognize that low growth and expectations variables. expectations for the U.S. and developed markets do not necessarily correlate with low stock returns Based on this assessment, Figure 11 displays the going forward. As discussed in detail in several historical relationship between trailing cyclically Vanguard research papers, including Davis (2008) adjusted P/Es and subsequent ten-year U.S. stock and Davis, Aliaga-Díaz, and Ren (2009), consensus returns. The magnitude of the market’s overvaluation macro expectations tend to be priced in by markets during the late 1990s is striking (with P/Es of 39x in and so have effectively zero correlation with future 1998 and 44x in 1999). The so-called “lost decade” stock returns at both short- and longer-term for U.S. stocks can be better understood in this investment horizons. context. In contrast, during 2009 the average trailing P/E was approximately 20x. If we read the implied 10 Figure 11. U.S. equity valuations and returns Figure 12. Projected U.S. equity returns Trailing P/E ratios and subsequent annualized VCMM simulated distribution of expected annualized 10-year returns, 1871–2009 10-year returns 25% 25% 2009 P/E 20 20 Annualized 10-year projected Notable dispersion around the median U.S. stock returns 15 Probability 15 10 10 5 5 0 1999 P/E; 2000–2010 projected return –5 0 0 4 8 12 16 20 24 28 32 36 40 44 48 Less 0–4% 4%– 8%– 12%– 16%– More Trailing price/earnings ratio 8% 12% 16% 20% Geometric returns for broad U.S. stock market Source: Davis, Aliaga-Díaz, and Ren (2009). Source: Vanguard. ten-year stock return out of the regression fitting Figure 13. Projected international equity returns line by starting with 2009 P/Es, we obtain a median expectation close to the historical average for U.S. VCMM simulated distribution of expected annualized equities. The VCMM incorporates market valuations 10-year returns along with other market volatility measures as key core drivers of its U.S. equity module. Accordingly, 25% the model’s current equity-market expectations are near long-term historical averages (Figure 12 ). 20 The observant reader will also note that the Probability 15 projected distribution of annualized ten-year U.S. stock returns displays wide symmetric tails. The 10 projected distribution for international equities shown in Figure 13 exhibits tails that are similarly 5 wide. A key reason is that, despite the importance of market valuations as shown in Figures 10 and 11, more than one-half of the volatility in long-run stock 0 Less 0–4% 4%– 8%– 12%– 16%– More returns is unexplained by valuations. As a result, our 8% 12% 16% 20% VCMM simulations in Figure 12 reveal that, while Geometric returns for international developed markets there is roughly a 25% probability of U.S. stocks achieving an average annual return between 8% Source: Vanguard. and 12% over the next ten years, there are even greater odds favoring average returns outside of this central tendency. 11 Figure 14. A caution regarding the allure of Figure 15. Some growth metrics matter more high economic growth than others Stock returns and GDP growth rates, 1900–2009 Average annual growth rates, 1995–2009 (average annualized real data) 12% 9% 8 Sweden Australia Geometric real stock returns Most important South Africa 8 of all for projecting 7 Canada long-term returns United States 6 Netherlands Correlation ~0% United Kingdom 5 Switzerland Denmark Germany 4 Japan 4 Spain Ireland 3 France Italy 0 Belgium 2 Nominal Real GDP Real growth Earnings yield GDP growth growth in corporate (earnings/price) 1.0% 1.2% 1.4% 1.6% 1.8% 2.0% 2.2% 2.4% 2.6% 2.8% 3.0% per capita earnings Real GDP per-capita growth rates per capita Source: Davis, Aliaga-Díaz, et al., Investing in Emerging Markets (2010). United States Emerging markets Source: Davis, Aliaga-Díaz, et al., Investing in Emerging Markets (2010). The allure of rapid economic growth in emerging markets has recently attracted many stock investors. However, a recent Vanguard research Figure 15 decomposes the key building blocks of paper, Investing in Emerging Markets: Evaluating stock returns. As foreign investment in emerging the Allure of Rapid Economic Growth (Davis et al., market stocks increases, a rising proportion of 2010), highlights a historical zero correlation corporate profits in developed markets are earned between long-term average economic growth and abroad, and thus a country’s GDP growth becomes long-term stock returns across various developed less relevant as a benchmark of earnings-growth and emerging countries (Figure 14 ). Overall, including expectations. Competition in emerging economies a strategic allocation to emerging markets in a global via foreign direct investment tends to equalize equity portfolio is a sound investment strategy. earning yields of public companies across the globe. However, we caution investors against significantly For these and other related reasons, the expected overweighting emerging markets in the years ahead return differential between U.S. and non-U.S. equity solely on the basis of the widely held view that they portfolios is neither statistically nor economically will grow faster than developed economies over the significant under most VCMM scenarios. next few years. 12 The challenges of short-term market forecasts Vanguard does not focus on near-term market The lack of predictability of the VCMM statistical forecasts, in large part because predicting such model at shorter horizons is evident when we short-term movements is difficult at best. As compare the 1-year simulated distribution against shown by the regression statistics in Figure 10, a similar distribution of annualized 10-year returns. the predictability of stock market returns at short horizons is low. Thus, the simulated return distribution for U.S. equities over a 1-year horizon in Figure 16 is extremely wide, with little central mass to the return distribution. Figure 16. Outlook for U.S. equities: Expected return distributions over 1-year and 10-year horizons 25% 20 15 Probability 10 5 0 –24% to –20% Less –36% to –32% –32% to –28% –28% to –24% –20% to –16% –16% to –12% –12% to –8% –8% to –4% –4% to 0% 0% to 4% 4% to 8% 8% to 12% 12% to 16% 16% to 20% 20% to 24% 24% to 28% 28% to 32% 32% to 36% 36% to 40% 40% to 44% 44% to 48% 48% to 52% 52% to 56% More 1-year returns 10-year returns 13 Figure 17. REITs returns Asset class outlook: Alternatives Real estate investments VCMM simulated distribution of expected annualized 10-year returns Commercial real estate is a unique and significant asset class. As discussed in the Vanguard research 30% paper Commercial Equity Real Estate (Philips, 2009), a broad REIT index should serve as a long-term 25 proxy for the commercial real estate market. REIT valuations have been high over the past several 20 years; we expect them to return to more normal Probability levels over the coming decade. As a result, the 15 VCMM’s projected median return for the MSCI US REIT Index is lower than the historical average 10 and slightly below the median expected return on 5 a global equity portfolio (Figure 17). The median expected correlation between U.S. equities and 0 U.S. REITs is similar to that observed between Less 0–4% 4%– 8%– 12%– 16%– More U.S. and international equity portfolios (see the 8% 12% 16% 20% Geometric returns for U.S. REIT market Appendix for details). Source: Vanguard. Commodities Because investors typically gain exposure to this asset class through commodity futures rather than Figure 18. Investable commodity futures index returns commodities themselves, we model returns using a futures benchmark, the Dow Jones UBS Commodity VCMM simulated distribution of expected annualized Index. Long-only investors in commodity futures 10-year returns have historically been able to expect to earn a risk 30% premium because they are providing price insurance to the producers of commodities, who hedge price 25 risk by taking the short side of positions in the futures market. For further details, see the Vanguard 20 research paper Investment case for commodities? Probability myths and realities (Bhardwaj, 2010). 15 The annualized median return of a commodity futures 10 index over the next decade is expected to be in the 5 4%–8% range, as shown in Figure 18. This is lower than the historical average return, in part because of 0 uncertainty about how risk premiums will be affected Less 0–4% 4%–8% 8%–12% 12%–16% More by the shift toward a large, institutionally dominated Geometric commodity returns market. Our VCMM-projected correlations between commodities and U.S. equities are both positive and Source: Vanguard. higher than historical averages; however, commodities continue to provide diversification benefits under the median simulation scenario. We stress that the expected return distribution of commodity futures over the next decade is wider than that projected for U.S. equities. 14 Private equity Davis, Joseph H., Roger Aliaga-Díaz, Julieann We do not forecast asset-class returns for private Shanahan, and Charles Thomas, 2009. Which equity investments. Individual private equity returns Path will the U.S. Economy Follow? Lessons From are widely dispersed, and no investable index exists. the 1990s Financial Crises of Japan and Sweden. As a result, Vanguard believes that any portfolio Valley Forge, Pa.: The Vanguard Group. mean-variance optimization that treats median or Davis, Joseph H., Roger Aliaga-Díaz, and Charles mean private equity returns as a typical quantitative Thomas, 2009. When Will the Recession End? input is fundamentally flawed. In portfolio construction Analysis Based on a Proprietary Index of Economic decisions regarding private equity, Vanguard believes Momentum. Vanguard Research Note. Valley Forge, that the analysis needs to be largely qualitative rather Pa.: The Vanguard Group, June. than quantitative, with special attention paid to the importance of idiosyncratic risk. For a discussion Davis, Joseph H., and Jonathan Cleborne, 2009. of the potential role of private equity in a broader Recent Policy Actions and the Outlook for U.S. portfolio, see the Vanguard research paper Inflation, Valley Forge, Pa.: The Vanguard Group. Evaluating private equity (Shanahan, Marshall, Philips, Christopher B., 2009. Commercial Equity and Shtekhman, 2010). Real Estate: A Framework for Analysis. Valley Forge, Pa.: The Vanguard Group. References Shanahan, Julieann, Jill Marshall, and Anatoly Bhardwaj, Geetesh, 2010. Investment Case for Shtekhman, 2010. Evaluating Private Equity. Commodities? Myths and Reality. Valley Forge, Pa.: Valley Forge, Pa.: The Vanguard Group. The Vanguard Group. Wallick, Daniel W., Roger Aliaga-Díaz, and Joseph Davis, Joseph H., 2008. Macroeconomic H. Davis, 2009. Vanguard Capital Markets Model. Expectations and the Stock Market: The Importance Valley Forge, Pa.: The Vanguard Group. of a Longer-Term Perspective. Valley Forge, Pa.: The Vanguard Group. Davis, Joseph H., and Roger Aliaga-Díaz, 2009. The Global Recession and International Investing. Valley Forge, Pa.: The Vanguard Group. Key terms M2. A measure of the money supply that Davis, Joseph H., Roger Aliaga-Díaz, C. William Cole, consists of M1—the most liquid assets, and Julieann Shanahan, 2010. Investing in Emerging including currency, traveler’s checks, and bank Markets: Evaluating the Allure of Rapid Economic accounts on which checks can be written—plus Growth. Valley Forge, Pa.: The Vanguard Group. other assets that are very liquid, such as money Davis, Joseph H., Roger Aliaga-Díaz, Donald G. market accounts, savings accounts, and Bennyhoff, Andrew J. Patterson, and Yan Zilbering, overnight repurchase agreements. 2010. Deficits, the Fed, and Rising Interest Rates: Price/earnings ratio. The ratio of a stock’s Implications and Considerations for Bond Investors. current price to its per-share earnings over a Valley Forge, Pa.: The Vanguard Group. designated period. Davis, Joseph H., Roger Aliaga-Díaz, Andrew J. R 2 or R-squared. A measure of how much of Patterson, and Charles Thomas, 2010. Assessing the past performance of a portfolio or another the Risks to the U.S. Economic Recovery. Vanguard asset can be explained by the returns from Research Note. Valley Forge, Pa.: The Vanguard the market in general, as measured by a given Group, June. index. If the asset’s returns were precisely Davis, Joseph H., Roger Aliaga-Díaz, and Liqian Ren, synchronized with an index’s returns, its R2 2009. What Does the Crisis of 2008 Imply for 2009 would be 1.00. and Beyond? Valley Forge, Pa.: The Vanguard Group. 15 Appendix Figure A1. Sample paths for a 60%/40% stock-bond portfolio The Vanguard Capital Markets Model (VCMM) is a proprietary, state-of-the-art financial simulation tool VCMM simulation developed and maintained by Vanguard’s Investment Counseling & Research and Investment Strategies $350 Groups. The VCMM uses a statistical analysis of Lines = Examples of individual Portfolio value adjusted for inflation historical data for interest rates, inflation, and other 300 random paths among the 10,000 simulated possible scenarios. risk factors for global equities, fixed income, and 250 commodity markets to generate forward-looking distributions of expected long-term returns. The 200 asset return distributions shown in this paper are 150 drawn from 10,000 VCMM simulations based on market data and other information available as of 100 March 31, 2010. 50 Yellow area = Range between the 5th and 95th percentiles of annual distribution of outcomes. The VCMM is grounded on the empirical view 0 that the returns of various asset classes reflect 0 1 2 3 4 5 6 7 8 9 10 the compensation investors receive for bearing Simulation (year) different types of systematic risk (or beta). Using Source: Vanguard. a long span of historical monthly data, the VCMM estimates a dynamic statistical relationship among global risk factors and asset returns. Based on The primary value of the VCMM is in its application these calculations, the model uses regression- to analyzing potential client portfolios. VCMM asset- based Monte Carlo simulation methods to project class forecasts—comprising distributions of expected relationships in the future. By explicitly accounting returns, volatilities, and correlations—are key to the for important initial market conditions when evaluation of potential downside risks, various risk- generating its return distributions, the VCMM return trade-offs, and diversification benefits of framework departs fundamentally from more basic various asset classes. Although central tendencies Monte Carlo simulation techniques found in certain are generated in any return distribution, Vanguard financial software. The reader is directed to the stresses that focusing on the full range of potential research paper Vanguard Capital Markets Model outcomes for the assets considered, such as the (Wallick et al., 2009) for further details. data presented in this paper, is the most effective way to use VCMM output. IMPORTANT: The projections or 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. 16 As Figure A1 illustrates, the VCMM seeks to Figure A2 further illustrates this point by showing represent the uncertainty in the forecast by the full range of scenarios created by the model. generating a wide range of potential outcomes. The scatter plot displays 10,000 geometric average It is important to recognize that the VCMM does ten-year returns and standard deviations for U.S. not impose “normality” on the return distributions, equities. The dispersion in returns and volatilities but rather is influenced by the so-called “fat tails” is wide enough to encompass historical market and “skewness” in the empirical distribution of performance for various decades. modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths. Figure A2. VCMM simulation output for the broad U.S. stock market 50% 40 Annual market volatility 30 30 10 0 –20% –10% 0% 10% 20% 30% 40% Annualized 10-year returns Each of 10,000 VCMM return simulations 1970s 1980s 1990s 2000s VCMM median simulation Source: Vanguard. 17 Figure A3. VCMM asset return correlation matrix Dow Jones AIG Total bond Domestic International Commodity market Inflation equity equity REITs Index Total bond market 1.00 Inflation 0 1.00 Domestic equity 0.13 –0.07 1.00 International equity 0.02 –0.02 0.69 1.00 REITs 0.12 –0.06 0.65 0.48 1.00 Dow Jones AIG Commodity Index 0.07 0.02 0.34 0.23 0.21 1.00 Source: Vanguard. Figure A4. VCMM asset return annual volatility Commodities REITs International equities U.S. equity U.S. total bond market –40% –20% 0% 20% 40% 60% 0 0.05 0.10 0.15 0.20 0.25 Return percentiles: 5th, 10th, 90th, 95th Annual volatility (standard deviation) Source: Vanguard. 18 P.O. Box 2600 Valley Forge, PA 19482-2600 Connect with Vanguard® > Vanguard.com > global.vanguard.com (non-U.S. investors) Vanguard research > Vanguard Center for Retirement Research Vanguard Investment Counseling & Research Vanguard Investment Strategy Group E-mail > research@vanguard.com © 2010 The Vanguard Group, Inc. All rights reserved. ICRECM 052010
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