Vanguard Economic and market outlook: mid-year update
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By Giulio Renzi-Ricci, Head of Asset Allocation, Vanguard Europe.
Headline inflation is rising and central banks are hiking interest rates across most key economies. This has understandably worried multi-asset investors, particularly with equity and bond markets falling simultaneously in the first half of 20221.
On the one hand, there are worries that higher inflation could erode the diversification benefits of bonds and diminish real returns (inflation-adjusted returns). On the other hand, there is a reasonable concern that expected interest-rate hikes could push economies into recession, which could further hurt equity market valuations.
The key thing for investors to remember is that inflation is one of the main reasons why investors invest, because holding cash reduces your future spending power. This point is even more pertinent in today’s high inflationary environment.
Investing when inflation is high, in principle, is no different to investing in a ‘normal’ inflationary environment. However, the urge to ‘do something’ in response to high inflation might be strong, so here are a few key points that multi-asset investors should bear in mind before taking any action.
The double-digit drop in both equity and bond markets this year2 is a real worry for multi-asset investors. The primary reason for holding high-quality fixed income in a broadly diversified portfolio is to counter equity market volatility. That’s because in recent history bonds have tended to move in the opposite direction to equity markets3.
That said, Vanguard research found that roughly 30% of stock market falls in the past 20 years were accompanied by a drop in global bond markets4. Importantly, the research also found that the longer equity markets decline, the more likely bonds are to play a stabilising role in a portfolio. In other words, an allocation to global bonds comes in handy the more severe an equity market downturn is.
Bond markets don’t tend to react to ‘expected’ changes, but ‘unexpected’ changes can provoke a reaction. Fixed income yields have risen this year largely due to unexpected changes, including higher-than-expected inflation and energy prices, as well as the war in Ukraine.
The tightening of monetary policy by central banks to tackle inflation has added fuel to the fire, with global bonds falling significantly in the first 6 months of the year. As of today, persistently high inflation and rising interest rates are arguably already factored into bond prices. More recently, markets have started to consider the possibility of a recession and, later on, rate cuts as well.
Investors might be concerned about bond returns year-to-date, but yields are now broadly above longer-term inflation expectations. Most importantly, bonds have also started to behave once again as a stable hedge against equity risk after having spent most of the year correlated with risk assets.
Put simply, the long-term outlook for global bond investors has improved since the beginning of the year. Our latest 10-year return forecasts suggest euro-area investors can expect around 1.4% to 2.4% each year over the next decade from local bonds, and 1.3% to 2.3% from global hedged bonds (ex-euro area). That’s up from -0.5% to 0.5% at the beginning of the year for both local and international bonds, as shown in the chart below.
An improved return outlook for bond investors
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 modelled asset class. Simulations as at 31 December 2021 and 30 June 2022. Results from the model may vary with each use and over time. For more information, please see the ‘Investment risk information’ section below.
Notes: The figures are based on a 0.5-point range around the 50th percentile for bonds. Indices used in VCMM simulations: for euro-area aggregate bonds, the Bloomberg Euro-Aggregate Bond Index; and for global ex-euro-area bonds, the Bloomberg Global Aggregate ex Euro Index. Total returns calculated in EUR.
Headline inflation is expected to remain high relative to recent history – in the euro area we think inflation readings will come down only slightly to around 8% to 8.5% by year-end. The sharp rise in inflation has led to calls for investors to reallocate capital from equity markets to alternatives, like gold and commodities, to hedge against rising inflation.
Our research found that gold and commodities offered a better hedge in the short-term (one year) against inflation relative to equities, with inflation betas higher than 1 (a beta score of 1 means the asset moves, on average, in lockstep with inflation). However, allocating to gold and commodities as a hedge against short-term inflation comes at a price – far higher volatility, as the chart below illustrates.
Past performance is not a reliable indicator of future results.
Sources: Vanguard calculations, based on data from Bloomberg and the OECD, as at 31 October 2021. Notes: Volatility is calculated as the standard deviation of rolling one-year annualised returns, at monthly frequency. Inflation beta is defined as how much an asset's return increases when inflation goes up by 1 percentage point. The sample period is 31 January 1976 to 31 October 2021. Due to data availability, the sample for global and euro aggregate bonds, inflation-linked bonds and government bonds starts on 31 December 2000. Prior to the launch of the MSCI EMU in 1998, we use MSCI Europe returns data. For euro area inflation, we use GDP-weighted inflation of Germany, France, Italy and Spain before 1990 as a proxy. We show the analysis of commodities for both the sample starting in 31 January 1972 and 31 January 1992 to highlight the regime-dependence of the inflation-hedging properties of commodities. Indices used: global equities - MSCI World Net Total Return Index; euro-area equities = MSCI EMU Net Total Return Index; global aggregate bonds (hedged) = Bloomberg Global Aggregate Total Return Index (Hedged EUR); euro area aggregate bonds = Bloomberg EuroAgg Total Return Index; inflation-linked bonds = Bloomberg Euro Govt Inflation-Linked Bond All Maturities Total Return Index; government bonds = ICE BofA Euro Government Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.
So, while these investments might outpace inflation – at least initially – they come with increased risk. Also, it’s worth noting that while commodities and gold can mitigate the impact of unexpected jumps in inflation, investors must hold them ahead of time, before the shocks to inflation happen.
Over longer-term horizons of five, 10 and 20 years, equities provided the greatest chance of achieving a positive real return with a lower level of risk relative to gold and commodities more broadly, as the next chart shows. That means long-term investors who are worried about the corrosive effect of inflation might want to consider a portfolio with a greater exposure to equities.
Proportion of long-term positive real returns for gold, commodities and equities
Past performance is not a reliable indicator of future results.
Sources: Vanguard calculations, based on data from Bloomberg and the OECD, as at 31 October 2021.
Notes: Total returns calculated in EUR. The chart shows the proportion of real five-, 10- and 20-year returns that have been above 0%. The sample period for the monthly data is 31 January 1975 to 31 October 2021. Volatility is calculated over monthly returns of the entire sample period. Indices used: global equities = MSCI World Net Total Return Index; euro-area equities = MSCI EMU Net Total Return Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.
Clients concerned about the impact of inflation on their investment returns ought to consider their investment horizon and tolerance for risk before making any changes to asset allocation. For many investors, the best course of action will be to maintain a globally diversified portfolio of equities and bonds, perhaps tweaking the mix of equities and bonds should individual circumstances or objectives change.
Visit the Vanguard economic and market outlook: Mid-year 2022 update page for more insights from our economists on the outlook for growth, inflation, monetary policy and long-term asset return expectations.
1, 2 Source: Vanguard calculations, based on data from MSCI and Bloomberg. Global equities represented by the MSCI All Country World Index (in EUR). Global bonds represented by the Bloomberg Global Aggregate Index (in USD). Data from 3 January 2022 to 30 June 2022.
3, 4 Renzi-Ricci. G and Lucas Baynes, "Hedging equity downside risk with bonds in the low-yield environment", Vanguard Research, January 2021.
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. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of 31 March, 2022. Results from the model may 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 US and international equity markets, several maturities of the US 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.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
This document is directed at professional investors and should not be distributed to, or relied upon by retail investors.
The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities 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. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.
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