The economic outlook for the next 10 years will be one of resiliency, with the U.S. in 2014 and 2015 facing cyclical risks tilted toward better-than-trend growth for the first time since the onset of the global financial crisis, Vanguard said Thursday.

In releasing its economic and investment outlook for the next decade, Vanguard makes its predictions for seven key areas: the global economy, inflation, monetary policy, interest rates, the bond market, the global equity market and asset allocation strategies.

The fund firm said that as in past outlooks, “we anticipate that the modest global recovery will likely endure at a below-average pace through a period of low interest rates, continuing high unemployment and debt levels and elevated policy uncertainty.”

Last year's “unease” about the “reach for yield” is now joined by concern about “froth” in certain equity markets, Vanguard notes. “Market volatility is likely as the Federal Reserve undertakes the multistep, multiyear process of unwinding its extraordinarily easy monetary policy,” Vanguard said. “Rather than frame this process as a negative,” Vanguard believes it's “an indication of increasing economic strength.”

Vanguard president and CEO Bill McNabb said on a recent conference call that the U.S. is in “unprecedented territory” in terms of what the changes in Fed policy and quantitative easing could mean. “When something slightly unexpected happens, a lot of volatility enters the market, and there are likely to be disruptions as the end [of QE] works out,” McNabb said. “There are likely to be surprises.”

Indeed, Vanguard says that investors should expect “less compensation for taking on additional risk than a few years ago.”

Read more about Vanguard's predictions for the next decade …

1. Global economy. For the first time since the financial crisis, Vanguard's leading indicators point to a slight pick-up in near-term growth for the United States, parts of Europe, and other select developed markets. Continued progress in U.S. consumer deleveraging, strong corporate balance sheets, firmer global trade and less fiscal drag point to U.S. growth approaching 3%. Those positives, however, need to be considered alongside high unemployment and government debt; ongoing structural reforms in Europe, China, and Japan; and extremely aggressive monetary policies whose exit strategies have yet to be tested.

2. Inflation. In the near term, monetary policies designed to achieve a desirable level of inflation will continue to counteract the deflationary pressures of a high-debt world still recovering from a deep financial crisis. Key drivers of U.S. consumer inflation generally point to higher-but-modest core inflation in the 1.5% to 3% range over the next several years. In parts of Europe and in Japan, deflation remains a greater risk.

3. Monetary policy. Tapering in the Federal Reserve's QE program has begun, although an actual tightening by the Fed is likely some time off. The federal funds rate appears likely to remain near 0% through mid-2015. That said, real (inflation-adjusted) short-term interest rates are likely to remain negative through perhaps 2017. Globally, the burdens on monetary policymakers are high as they contemplate extricating from QE policies to prevent asset bubbles on one hand and being mindful of raising short-term rates too aggressively on the other. The exit may induce market volatility at times, but long-term investors should prefer that to no exit at all.

Read more: 4. Interest rates …

4. Interest rates. The bond market continues to expect Treasury yields to rise, with a bias toward a steeper Treasury yield curve until the Federal Reserve raises short-term rates. Vanguard's estimates of the fair value range for the 10-year Treasury bond have risen and suggest that the 10-year yield may range from 2.5%-3.5% over the next year. Vanguard believes that a more normalized environment, where rates move toward 5%, may be several years away.

5. Bond market. The return outlook for fixed income is muted, although it has improved somewhat given the recent rise in real rates. The expected long-run median return of the broad taxable U.S. fixed income market is in the 1.5%–3% range, versus the 0.5%-2% range this time last year. Nevertheless, the diversification benefits offered by fixed income in a balanced portfolio continue to be very important. Vanguard believes that the prospects of losses in bond portfolios should be weighed against the magnitude of potential losses in equity portfolios as the latter have tended to exhibit much larger swings in returns.

6. Global equity market. Vanguard's medium-term outlook for global equities has become more guarded. In the 6%-9% return range, the long-term median nominal return for global equity markets is below historical averages, and has shifted toward the bottom of this range. In addition, concern over the reach for yield in bonds is now joined by signs of “froth” in certain segments of the global equity market. Vanguard therefore encourages investors to be cautious about increasing equity risk in the current environment.

7. Asset allocation strategies. Investors should expect less compensation for taking on additional risk than a few years ago. Vanguard's simulations indicate that balanced portfolio returns over the next decade are likely to be below long-run historical averages, with those for a 60/40 stock/bond portfolio tending to fall in the 3%-5% range after inflation. Even so, Vanguard still firmly believes that a balanced and diversified low-cost portfolio can remain a high-value proposition in the decade ahead.

Instant Insights /

7 Big Economic Predictions: Vanguard

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