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Vanguard's long-term outlook for asset returns

03 June 2020 | Investing

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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. 

Our approach to forecasting 

“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. 

Taking predictability and uncertainty into account

“It's worth noting a few things that set our market forecasts apart,” Mr. 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 timeframe. 

“We don't make pinpoint forecasts, either,” Mr. 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.” 

Relevance for portfolio construction 

The VCMM models asset return distributions and their relationships with other asset categories to 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.

The difference a few months has made to our economic outlook

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. 

What our model is telling us now about asset returns

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.)

Expected ten-year annualized stock returns and volatility levels

The image shows that the median projected volatility over the next decade is as follows:  23.0% for U.S. small-capitalization stocks, 22.9% for U.S. growth stocks, 20.3% for U.S. value stocks, 19.7% for U.S. REITs, 18.4% on an unhedged basis for international stocks, 17.9% for U.S. large-capitalization stocks, and 17.2% for U.S. stocks. 

It also shows that the expected annualized nominal median projected return range over the next decade is as follows:  6.2% to 8.2% for U.S. small-capitalization stocks, 4.0% to 6.0% U.S. for U.S. growth stocks, 7.6% to 9.6% for U.S. value stocks, 4.1% to 6.1% for U.S. REITs, 8.5% to 10.5% on an unhedged basis for international stocks, 5.4% to 7.4% for U.S. large-capitalization stocks, and 5.5% to 7.5% for U.S. stocks.

Notes: Forecast corresponds to distribution of 10,000 VCMM simulations for ten-year annualized nominal returns as of March 31, 2020, in U.S. dollars. Median volatility is the 50th percentile of an asset class's distribution of annualized standardized deviations of returns. 
Source: Vanguard
IMPORTANT: The projections and 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 VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of March 31, 2020. Results from the model may vary with each use and over time. For more information, please see the important information section at the bottom of the page.

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%-1.7%.   

Expected ten-year annualized fixed income returns and volatility levels

The image shows that the median projected volatility over the next decade is as follows:  2.4% for U.S. inflation, 1.0% for U.S. cash, 4.3% for U.S. Treasuries, 6.1% for U.S. credit, 11.4% for U.S. high-yield corporate bonds, 4.3% for U.S. aggregate bonds, 2.2% for global ex-U.S. bonds hedged in U.S. dollars, and 6.7% for U.S. Treasury inflation-linked bonds. 

It also shows that the expected annualized nominal median projected return range over the next decade is as follows:  0.5% to 1.5% for U.S. inflation, 0.6% to 1.6% for U.S. cash, 0.4% to 1.4% for U.S. Treasuries, 1.8% to 2.8% for U.S. credit, 4.8 % to 5.8% for U.S. high-yield corporate bonds, 0.9% to 1.9% for U.S. aggregate bonds, 0.7% to 1.7% for global ex-U.S. bonds hedged in U.S. dollars, and 0.2% to 1.2% for U.S. Treasury inflation-linked bonds.

Notes: Forecast corresponds to distribution of 10,000 VCMM simulations for ten-year annualized nominal returns as of March 31, 2020, in U.S. dollars. Median volatility is the 50th percentile of an asset class's distribution of annualized standardized deviations of returns. 
Source: Vanguard.

Different outlook, familiar investment advice

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 your portfolio beyond regular rebalancing (which might be warranted given recent market movements) or changes in your 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.

We hope that investors who already have a sensible investment plan designed to carry them through good markets and bad will have the discipline and perspective to remain committed to it. 

Important information:

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Investments in bonds are subject to interest rate, credit, and inflation risk. International investing is subject to additional risks, including the possibility that returns will be hurt by a decline in the value of foreign currencies or by unfavorable developments in a particular country or region.

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.

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