Global stock markets delivered robust gains in 2021, but investors face a number of risks in the year ahead. The withdrawal of pandemic-driven monetary and fiscal support creates a fragile backdrop for markets, as demonstrated by the recent sell-off in equities after the Federal Reserve, the US central bank, signalled it may need to raise interest rates sooner than expected to tame inflation.
While short-term volatility in markets should not be a reason for investors to deviate from their long-term investment plan, the new year does present an opportunity to discuss with clients their portfolio relative to their goals and their appetite for risk.
We therefore look at some of the key trends that we expect to drive markets in 2022 and some of the main risks facing investors.
While the global economy will continue its recovery from the Covid-19 pandemic, the easy gains from the post-lockdown rebound in activity are now behind us. We expect growth in both the US and the euro area to slow down to 4% in 2022, and in the UK we expect growth to be about 5.5%.
These numbers are still healthy, but it is important for investors to be aware of the risks. We think there is still a 30% chance of a ‘downside scenario’ in which new virus mutations could hamper economic activity, or where more persistent disruptions to global supply chains could continue to push inflation higher.
These risks underline the importance of having a globally diversified portfolio that is balanced across assets, regions and sectors to limit exposure to unnecessary risks.
Inflation has continued to trend higher across most developed economies, driven by higher demand as pandemic restrictions have been lifted and lower supply due to labour and supply-chain shortages.
Although we don’t see a return to 1970s-style stagflation, headline inflation may persist around current elevated levels in the first half of 2022, before cooling in the latter part of the year.
Policymakers will have to strike a delicate balance between keeping a lid on inflation and unwinding the extraordinary fiscal and monetary support that was put in place in the wake of the pandemic, without derailing the recovery. This could lead to a challenging backdrop for markets this year, as we have seen in early 2022.
In the UK, the Bank of England has already begun the process of raising interest rates, lifting its benchmark rate to 0.25% from 0.10% in December. With price pressures building and in order to head off a larger and more persistent inflation shock, we expect a second hike in the Bank Rate to 0.50%, probably at the monetary policy committee meeting in February.
Looking to 2022 and beyond, Vanguard’s long-term outlook for global asset returns is guarded. This is especially true for equities, where high valuations and lower economic growth rates mean we anticipate lower returns over the next decade.
Given our views on current market valuations, we expect median returns from UK equities to be around 5.6% over the next 10 years on an annualised basis1. This is lower than last year, mainly because of the continued rally from pandemic lows, meaning there is less to gain in the future.
The outlook for global ex-UK equities is more muted, with an expected median return of around 3.8%1 mainly because of more favourable valuations in the UK relative to other regions.
With different regions offering different opportunities, it is important that investors follow a globally diversified approach to exploit any opportunities and hedge the risk that asset classes do not perform as expected.
Against a backdrop of gradually rising bond yields, our outlook for UK bond returns in the next decade has ticked up from last year’s projections to around 1.3% on an annualised basis2, which is line with our expectations for global ex-UK bonds. Nevertheless, we still think that diversification through exposure to hedged non-UK bonds should help offset some risk specific to the UK fixed income market.
Although projected returns from fixed income remain at historic lows, we still believe bonds play a role in a portfolio to act as a counterweight to equities. Typically, when equities fall in value, bonds tend to rise to partly compensate. There have been times when that correlation has turned positive but, our research has found that, given enough time, the usual inverse relationship tends to be re-established3. This is why there is still a place for bonds in a portfolio.
Looking ahead, when we isolated the scenarios projected by our Vanguard Capital Markets Model (VCMM) to have the most negative equity returns (the worst quartile of global equity returns), we found that high-quality bonds would have the highest median returns and the lowest dispersion of returns in those scenarios, as illustrated in the chart below.
High quality bonds are expected to diversify equity risk in the most volatile scenarios
Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Notes: Each box-whisker is the distribution of median nominal returns of various asset classes in the worst decile of global equity returns. VCMM forecasts as at 30 September 2021 in GBP for the asset classes highlighted here. See Vanguard economic and market outlook 2022 for further details on asset classes.
Source: Vanguard calculations, as at 30 September 2021.
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.
Turning to our expectations for a typical UK multi-asset investor with a portfolio that is 60% equities and 40% bonds, median returns are projected to be around 3.7% a year over the next decade4. That is lower than the historical averages of the past 30 years and we continue to believe that investors will need to reconcile themselves to a lower-return environment in future.
It can be tempting for investors to try to improve their expected returns by investing in higher-volatility assets, but this will of course increase the expected risk. Alternatively, investors can partly offset the impact of a low-return environment by making sure they are implementing their strategies through low-cost products. Also consider whether your clients are taking a sufficiently long-term view, or indeed could save more, to increase their chances of achieving their goals.
We continue to believe that holding a globally diversified portfolio and staying the course will give investors the best chance of investment success in 2022 and beyond.
To read Vanguard’s full economic and market outlook for 2022 or listen to our on-demand webinar, click here.
1 Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Source: Vanguard calculations, as at 30 September 2021. Note: The forecast corresponds to the distribution of 10,000 Vanguard Capital Markets Model simulations for 10-year annualised nominal returns in GBP. Asset class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains. UK equity = MSCI UK. Global ex-UK equity = MSCI AC World ex UK.
2 Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Source: Vanguard calculations, as at 30 September 2021. Note: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualised nominal returns in GBP. Asset class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains.
3 Source: Vanguard calculations based on data from Bloomberg. Data between January 1988 to November 2020. Notes: Analysis found that bonds and shares were positively correlated roughly 29% of the time, but once markets are given enough time to factor in the monetary policy responses, the usual inverse relationship between bonds and shares is re-established. See ‘Hedging equity downside risk with bonds in the low yield environment ’, Renzi-Ricci, Baynes, January 2021. Equity returns are defined from the MSCI AC World Total Return Index and bond returns defined from the Bloomberg Global Aggregate Total Return Index, hedged to GBP.
4 Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Source: Vanguard, as at 30 September 2021. Notes: Forecast corresponds to distribution of 10,000 VCMM simulations for ten-year annualised nominal total returns in GBP for asset classes highlighted here. Portfolio exposures are based on market capitalisation and assume a UK home bias of 25% for equities and 35% for bonds.
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. 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.
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.
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.
This document is directed at professional investors and should not be distributed to, or relied upon by retail investors. This document is designed for use by, and is directed only at persons resident in the UK.
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.
Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.
© 2022 Vanguard Asset Management Limited. All rights reserved.