The Vanguard Group thinks stocks around the world will most likely continue to notch gains. That's the good news, but it comes with a big caveat, the likes of which would make the fund company's founder, Jack Bogle, proud.
Vanguard is telling investors to expect returns in the "medium term" of 4 percent to 6 percent, the most cautious outlook it has had on future stock returns at any time during the post-financial crisis economic recovery.
Vanguard is also projecting that international stocks will achieve higher returns than U.S. stocks.
"The sky is not falling, but our market outlook has dimmed," wrote Vanguard chief economist Joe Davis this week in an outlook provided to investors of the fund company, which manages roughly $4.5 trillion in assets.
"The medium-run outlook for global equities has deteriorated a bit. ... Overall, the risk of a correction for equities and other high-beta assets is projected to be considerably higher than for high-quality fixed-income portfolios."
Vanguard said it sees no compelling signs of financial bubbles, but as market returns have risen and "even exceeded" improving fundamentals, "risk premiums for many asset classes appear slim," Davis wrote.
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"For 2018 and beyond, our investment outlook is modest, at best. Elevated valuations, low volatility and secularly low interest rates are unlikely to be allies for robust financial market returns over the next five years," the fund company cautioned in its report.
In a follow-up interview with CNBC, Davis said, "We are in a lower return orbit."
A fund company like Vanguard tends to play it safe with annual projections, and its outlook doesn't match the more bullish view of some Wall Street firms, like Goldman Sachs. It's worth noting that Vanguard hasn't been uber-bullish in recent years, either. It did first move to what it described as a more "guarded" view in 2015, which proved prescient with 2015 being the worst year for stocks since 2011. But it also was guarded headed into 2017, when markets around the world boomed. Vanguard has said that its views aren't bearish, especially in light of the low rate environment.
"Our outlook is intentionally framed on the future five years," Davis told CNBC. "Just because stocks have had a strong year this year doesn't mean they won't have a good 2018. ... We're never going to be able to accurately forecast what equity markets do on a one-year horizons. ... But the odds are increasing that returns over the next two to three years are lower than they have been historically," he said.
Vanguard annual outlook on stocks
2014: Bottom of 6%–9% range
2015: 5% to 8%
2016: 6% to 8% range
2017: 5% to 8% range
2018: 4% to 6% range
Vanguard's outlook does match the view of company founder Bogle, who this week told CNBC that stocks would generate returns in the range of 4 percent in the future.
Where Vanguard now parts ways with Bogle is over the benefits of overseas investing, an approach Bogle has only ever begrudgingly considered. Bogle continues to believe U.S. stocks are the best long-term bet, but in its outlook, Vanguard says expected returns for the U.S. stock market are lower than those for international markets.
Davis said Vanguard's projections for the international developed markets, such as in the MSCI EAFE Index, are higher than the 4 percent to 6 percent range for U.S. stocks — at least 5 percent to 7 percent. He said emerging markets return projections would be at least as high as EAFE, but with more volatility.
"The level of valuations in the equity markets are not bubbles, but it's tough to argue any of the components of equity markets are undervalued globally, with the best example being the U.S.," Davis told CNBC.
Vanguard's goal in providing expected rates of return is not to scare investors out of the market, but to reiterate why it believes a globally diversified portfolio is the best option for most investors. "If one wanted the empirical case for having a globally diversified portfolio with some fixed income, if they ever wanted one, the outlook in the next five to 10 years will provide it," Davis said.
Here are some of Vanguard's views on the broader global economy and the "rising risks to the status quo" that it sees.
Low volatility shows that investors believe that long-term global economic trends of modest growth and tepid inflation will also define shorter-term cycles. But Vanguard says, "Risks lie in mistaking the trend for the cycle."
The fund company warns that if already tight global labor markets grow tighter, a wage or inflation spike in 2018 could lead markets to anticipate a more aggressive normalization from historically low interest rates, "producing a market-rattling shock."
Economic growth: Unemployment is the key
Vanguard says investors should pay more attention to low unemployment rates than GDP growth at this stage of the cycle for prospects of either higher spending for capital expenditures or wage pressures. "The relationship between lower unemployment rates and higher wages, pronounced dead by some, should begin to reemerge in 2018, beginning in the United States," its economists forecast.
If wages do spike in 2018, amid the end of the Fed's easy money era, it could reverberate in developed markets. "The chance of unexpected shocks to the economy during this tightening phase is high, as is the chance that balance-sheet shrinkage will have an unpredictable impact on asset prices."
This story has been updated to include comments from Vanguard chief economist Joe Davis provided in an interview subsequent to the publication of Vanguard's annual outlook.