On Monday, Vanguard’s Investment Strategy Group released their monthly economic and market update.
• Vanguard expects 7% GDP growth for the full year 2021
• Inflation is expected to peak this year and decline in 2022
• Interest rates for the 10Y are expected to rise late 2022 reaching 3% in 2024/5

Vanguard’s team noted that unemployment insurance and fiscal stimulus will continue to drive spending in the second half of the year.   Meanwhile, the Euro area is expected to rebound in the second half and deliver 5% GDP growth.

Regarding inflation, Vanguard sees the current inflation situation as transitionary.  They note sharp increases in demand due to reopening as well as supply / demand shocks as the driver for the inflation.  They expect inflation will peak by the end of 2021 at 3% before falling below 2% in 2022.

US jobs recovery is expected to gradually reduce the unemployment rate back to 4% by the end of 2021.

Market Returns Forecast

Previously, we wrote about Vanguard’s 10-year forecasted return published in December 2021 here.  They have updated the ten-year forecasts and I summarize the forecasts below.

From the table, we see Vanguard’s long-term inflation forecast has risen slightly.  They include a sharp rise in expected bond returns for the US aggregate bonds of .7%.

Equity forecasts have come down significantly.  The US stock market is forecasted to return 3.6%, down from their estimate of 4.7% in December.  International equities are expected to outpace the US market with forecasted returns of 6.5%.  In a webcast with advisors on June 30, the Vanguard team noted that “70% of difference in US vs. International stocks is driven by the current valuations”.

It is important to note that the Vanguard model is largely derived by assuming that the market will revert to previous historical returns.  At this point, the Vanguard return assumptions are now at the low-end of the range when we look at other forecasts.  The primary critique on the Vanguard model is that Vanguard assumes that interest rates will return to pre- pandemic levels for the 10-year treasuries (3%) and that the PE ratio for the US would also revert to the mean.  At 3.6% forecasted return for US stocks, the equity risk premium to bonds would be just .6%.  Historically, the premium has been in the 3-4% range.

Using a dividend yield of 1.37% along with assumptions for inflation of 1.5 – 1.8% and real GDP growth of 1.5 – 1.8%, my base assumption would be in the range of 4.37 – 4.97% return.  This is before any PE multiple explanation / contraction or stock buybacks.  I expect that rates will not rise significantly above 2% and that PE compression would be minimal.    That said, with large debt and deficits spending likely to continue it is more then likely that corporate taxes will go up and that will hurt earnings.  As a result, we would not take on additional or excess risk the next 12-18 months.  Let’s see how things settle out.