Join us on 16 December when our chief economist Dr. Peter Westaway will be joined by colleagues from Vanguard’s Investment Strategy Group for a live presentation of the Vanguard economic and markets outlook 2022. We invite you to join us and find out more about our expectations for economies and markets for next year and beyond.
The recent emergence of the Covid-19 Omicron variant underscores the extent to which healthy economies still depend on keeping populations healthy. As we approach the end of 2021, we take a look at the key topics that could drive the economic and market outlook in the year ahead.
Before the potential seriousness of Omicron became known, Vanguard believed that developed markets in the northern hemisphere were in for a difficult winter, owing to a combination of waning vaccination immunity and slow uptake of booster shots. Yet we believed these economies would be less likely to resort to shutdowns than during earlier waves, emboldened by reasonably high levels of infection-acquired immunity and the knowledge that infection fatality rates have fallen with each successive wave.
Omicron may yet change our views on the global economy in 2022. It remains unclear whether Omicron will outcompete the Delta variant. If the Delta variant remains the predominant strain, our economic forecasts are likely to remain intact. But we still don’t know whether the new variant is more transmissible than Delta and the extent of its immune evasiveness.
An Omicron strain that outcompetes Delta would be felt around the world, with the effect especially pronounced in Asia. Both developed and emerging Asia benefit from the recency of their vaccination efforts—a benefit that would succumb to a Covid-19 strain resistant to current vaccines. Asia’s low levels of infection-acquired immunity would add to the risk.
The world is eager to move on from Covid-19. When it can do so—and the extent to which economic shutdowns occur in the interim—relies on the course of Covid-19 variants.
We’ve said for a few years that US equity valuations were approaching “stretched” territory. A strong 2021 run-up in prices driven more by valuation expansion than by increased profits makes US equities more overvalued than at any other time since the dot-com bubble.
Our assessment is based on the latest quarterly running of the Vanguard Capital Markets Model® (VCMM), as at 30 September 2021. Our model considers equity valuations relative to their fair value, conditional on interest rates and inflation. Rising interest rates erode the present value of future cash flows, so interest rates and inflation tend to influence equity market valuations—and, by extension, prices.
US equity valuations are well above their fair-value range
Past performance is not a reliable indicator of future results.
Notes: The US fair-value CAPE (cyclically adjusted price/earnings ratio) is based on a statistical model that corrects CAPE measures for the level of inflation expectations and interest rates. The statistical model specification is a three-variable vector error correction, including equity-earnings yields, 10-year trailing inflation and 10-year US Treasury yields estimated over the period January 1940 to September 2021. The solid blue line extending above the grey band suggests overvaluation of US equities.
Sources: Vanguard calculations in USD, as at 30 September 2021, based on data from Robert Shiller’s website at aida.wss.yale.edu/~shiller/data.htm, the US Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv and Global Financial Data.
The illustration makes the extent of the overvaluation clear. The solid blue line representing US equities’ cyclically adjusted price/earnings ratio leaps from its fair-value range, represented by the grey band, just as it did for an extended period before the dot-com bubble burst1.
Although our model provides a 10-year outlook for equity returns, it doesn’t provide insight as to when and how a return to fair value may occur. An overvalued market can continue on to greater highs, as it did in the late 1990s; then, the deviation lasted five years before it returned to fair value.
Vanguard’s VCMM research team has observed that past reversions from overvaluation to a fair-value range have been a function more of prices falling than of earnings rising, and that market corrections of 10% or more have occurred with greater frequency when equities were overvalued as opposed to when they were valued fairly.
Investors may find this to be a good time to assess whether recent equity price run-ups have left their asset mix out of proportion to their risk comfort level.
Financial markets have focused recently on when developed-market central banks will likely raise interest rates. Just as important is the terminal rate, or how high central banks will ultimately raise rates.
Vanguard believes that markets are underestimating the US Federal Reserve’s terminal rate. To understand why, it’s useful to understand the terminal rate’s relationship with the neutral rate, a long-term equilibrium that roughly depicts monetary policy that is neither accommodative nor restrictive.
Short-term changes in the economy—headwinds or tailwinds—will push interest rates above or below neutral. If the economy experiences tailwinds, interest rates might rise above neutral.
Policymakers face a number of challenges in removing accommodative measures that were essential to economies’ surviving the Covid-19 pandemic but that, left unchecked, could produce too-strong tailwinds.
Market expectations for a terminal rate around 1.5% are more than a percentage point higher than the Fed’s current federal funds rate target of 0% to 0.25%. But they’re below the Fed’s 2.5% neutral-rate estimate and Vanguard’s 2% to 3% neutral-rate estimate.
We emphasise that the neutral rate has fallen for several decades, in part a function of global savings and investment relationships. We don’t anticipate a return to interest rates higher than those that prevailed before the 2008 global financial crisis, and the journey to the terminal rate could take several years.
The risk exists that run-ups in inflation and tight labour markets could cause the Fed to raise rates not only sooner than anticipated, but somewhat more sharply, which could spook the markets. This highlights the importance of investors remaining disciplined and focused on their long-term goals.
Defaults among private housing developers in China have risen in 2021, but Vanguard doesn’t foresee global financial market contagion from the sector for several reasons.
The default rate for private enterprises in China rose to 7% during the first 10 months of 2021. That’s largely attributable to property developers and compares with a 5% default rate at the start of the year. But it’s not unfamiliar territory; the default rate for private enterprises reached 8% at the peak of a deleveraging cycle in 20182.
The risk of defaults may grow in 2022 as principal repayments become due for some of the largest private developers and as policymakers structurally shift toward a new policy regime that is dependent on more sustainable growth drivers. However, we think policymakers will do enough to prevent excessive contagion in the financial system.
The composition of property-related loans may also mitigate contagion concerns. Though such loans accounted for more than a quarter of outstanding bank loan balances in the first half of 2021, the vast majority was in mortgage loans, where credit risk is lower given hefty down-payment requirements. Non-public housing developer loans, which arguably bear greater credit risk than public housing developer loans, accounted for just 4% of total bank loans.
Vanguard believes that any fallout from the property sector is more likely to be realised through slower economic growth, with a reduction in Chinese property investment likely to lessen demand for commodity imports from countries including Australia, Brazil and Canada.
The takeaway for investors is to remain disciplined and not to read too much into headlines about defaults that may be inevitable.
The Vanguard Economic and Market Outlook for 2022: Striking a Better Balance looks in depth at what 2022 may hold for investors. It is scheduled to be published on 16 December.
1 The Nasdaq Composite Index fell 78% from its March 10, 2000, high until its October 9, 2002, post-bubble low. The Standard & Poor’s 500 Index fell 49% from its March 24, 2000, high until its October 9, 2002, post-bubble low.
2 Source: Wind Economic Database.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® (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 at 30 September 2021. Results from the model may vary with each use and over time. For more information, please see important information below.
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 US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US 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.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Simulated past performance is not a reliable indicator of future results.
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
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