Vanguard, the second largest asset manager in the U.S., expects higher risks and lower returns in financial markets next year.

“We anticipate a bit more volatility and an uptick in inflation in the year ahead, accompanied by more muted equity returns,” said Joseph Davis, Vanguard’s chief economist and investment strategy group head, in a statement accompanying the firm’s 2018 market outlook.

In what it termed its “most subdued” market outlook in a decade, Vanguard forecast a 3% to 5% return in U.S. equities — down sharply from the 10% annualized rate over the past 30 years — and a 5.5% to 7.5% gain in foreign equities. Fixed income assets are expected to return 2% to 3%.

Moreover, Vanguard sees more downside risks in equities than in the bonds despite the expectations for higher inflation and greater odds of a market correction in the U.S. rather than overseas.

Take a look at this chart:

U.S. equities are approaching historical highs in valuation but not grossly overvalued, while non-U.S. developed markets are fairly valued and emerging markets are slightly overvalued, according to Vanguard.

“The sky is not falling but our market outlook has dimmed,” notes the outlook.

And the risk of higher-than-expected global inflation has increased, according to Vanguard. It expects the U.S. Federal Reserve will likely raise rates to 2% by the end of 2018 — or three more times after an expected December 2017 hike — while the ECB delays rate hikes for another two years.

Vanguard cautions investors against reaching for a “shiny” new investment strategy such as oveweighting emerging market equities and high-yield corporate bonds. Those strategies will not gain as much as they have in previous decades, according to Vanguard.

The mutual fund giant advises that investors diversify assets globally, maintain disciplined asset allocation with periodic portfolio rebalancing, use low-cost strategies and keep in mind realistic return expectations.

Instant Insights /

Vanguard issues its most subdued outlook in a decade

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