• While global equity market losses in 2022 were significant, our long-term outlook for global equities is now more attractive than it was a year ago.
  • We expect there to be greater opportunities within the euro area and other equity markets relative to the US in the decade ahead.
  • We believe that a broadly diversified portfolio can offer investors the best chance of meeting their goals.

 

By Lukas Brandl-Cheng, investment strategy analyst, Vanguard Europe

While global equity market losses in 2022 were significant, in our Vanguard Economic and Market Outlook for 2023: Beating Back Inflation, we highlight that our long-term outlook for global equities is now more attractive than it was a year ago.

The sell-off in equity markets in 2022 was widespread. However, euro weakness, particularly against the US dollar, meant that euro investors in global equities (denominated in US dollars) will have seen a boost in the relative value of their global equity exposures.

In USD terms, the FTSE All World index declined by 14.5% to the end of November 20221. However, due to the dollar’s strength and the weakness of the euro, this loss decreased to -5.6%2 for euro investors.

As we go into 2023, the charts below show our equity return expectations for euro investors over the next 10 years and our view of valuations across developed and emerging markets. Our valuations and forecasting frameworks are intended to set long-term expectations and should not be seen as a short-term signal.

Equity market 10-year outlook: setting reasonable expectations

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Notes: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualised nominal returns in GBP for the asset classes highlighted here. Median volatility is the 50th percentile of an asset class’s distribution of annualised standard deviation of returns. 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. Indices are unmanaged; therefore, direct investment is not possible. Indices used: Euro area equity – MSCI European Economic and Monetary Union (EMU) Total Return Index; Global ex-euro area equity – MSCI AC World ex EMU Total Return Index Euro; EM equity (unhedged) – MSCI Emerging Markets Total Return Index Euro.

Source: Vanguard calculations in EUR, as at 30 September 2022.
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 are as at 30 September 2022. Results from the model may vary with each use and over time.

Valuations are more attractive than a year ago

Past performance is not a reliable indicator of future results.
Notes: This chart shows current valuation percentiles relative to fair value, compared to last year’s values (in parentheses). Euro area and UK equity valuation measures are the current CAPE3 percentile relative to the fair-value CAPE for the MSCI Germany and MSCI UK total return indices from 31 January 1970 to 30 September 2021. The US valuation measure is the current CAPE percentile relative to fair-value CAPE for the S&P 500 Index from 31 January 1940 to 30 September 2022. The emerging markets, US growth, US value and US small-cap valuation measures are the percentile relative to fair value. The US growth valuations are composite valuation measures of the style factor to US relative valuations and the current US CAPE percentile relative to its fair-value CAPE. The relative valuation measure is the current ratio of that style factor to US price/book metrics relative to its historical average from 31 January 1979 through 30 September 2022. Indices used: Euro area equity - MSCI European Economic and Monetary Union (EMU) Total Return Index; UK equity - MSCI UK Total Return Index Euro; US equity - MSCI USA Total Return Index Euro; Emerging markets equity - MSCI Emerging Markets Total Return Index Euro; Small-cap (US) - equities with a market cap in the lowest two-thirds of the Russell 1000 Index; Large (US) - equities with a market cap in the highest one-third of the Russell 1000 Index; Value (US) - equities with a price/book ratio in the lowest one-third of the Russell 1000 Index; Growth (US) - equities with a price/book ratio in the highest one-third of the Russell 1000 Index.

Source: Vanguard calculations in EUR, as at 30 September 2022.
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 are as at 30 September 2022. Results from the model may vary with each use and over time.

US equity valuations still look stretched

Following the recovery from the pandemic-driven sell-off in 2020, the cyclically adjusted price-to-earnings ratio (CAPE)3 of many markets had been rising strongly, before reaching a peak at the end of 2021. This was especially true in the US, where overvaluation relative to our fair-value estimate reached a level not seen since the dot-com bubble.

While equity valuations have improved recently, high inflation and rising real interest rates have simultaneously caused our estimate of fair value to decline and parts of the US equity market remain overvalued.

In the euro area, on the other hand, the surge in valuations in 2021 was less pronounced. The German CAPE ratio stopped below the mid-point of our fair value range, and both the fair value range and the German CAPE ratio have since been moving downwards, with valuations falling faster and moving below the range again.

Greater opportunities within the euro area and other equity markets relative to the US

Though US equities have outperformed their global peers by a very wide margin over the past decade4 and many reasons have been cited for this outperformance5, we believe that stretched valuations in parts of the US equity market are sowing the seeds for lower returns in the decade ahead.

Our outlook is positive for global ex-US equities despite our view that the US will have higher earnings growth, though we may need to see a weakening of the US dollar for the outperformance of global ex-US equities to be sustained.

More favourable valuations outside the US, however, are not a new story. Nevertheless, the euro area and other equity markets have been unable to generate any significant outperformance relative to the US. This has been, in part, due to the strength of the US dollar and the weakness of the euro.

Currency returns are notoriously difficult to forecast over short time horizons and many factors can cause them to deviate from their fundamentals. However, over a sufficiently long horizon we expect global inflation and policy convergence to lead to exchange rate normalisation.

Given the long-term nature of our valuations and forecasting frameworks, over- or undervaluation should not, in itself, suggest a short-term action on the part of investors. This underscores the challenges facing investors who tilt their portfolios heavily in one direction. We believe that a rigorous investment approach, combined with the principles of broad diversification aligned with the investor’s goals and constraints, offers the best chance of success.

 

1 Source: Refinitiv, FTSE All World Total Return Index USD, as at 30 November 2022.

2 Source: Refinitiv, FTSE All World Total Return Index Euro, as at 30 November 2022.

3 The ratio is used to gauge whether a stock or market is undervalued or overvalued by comparing its current market price to its inflation-adjusted historical earnings record.

4 On a cumulative return basis, a portfolio of US equities bought in 2012 is worth twice as much as a portfolio of international equities bought in the same period.

5 Stronger US growth, a less uncertain economic environment and the sector composition of the US equity market.

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.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

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. 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.

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, U.S. 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.

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