Vanguard Chief Economist Monitoring Inflation in 2018

Inflation may have been written off by investors and the financial markets for 2018, but Vanguard is keeping an eye on a possible increase in inflation driven by rising wages this year.

In a recent interview, Vanguard Chief Economist Joseph Davis said that the markets have been shrugging off the likelihood of increasing inflation given the U.S. unemployment rate dipped below what many consider full employment a few years back. At the same time, wages have not increased, setting up a situation in which wage increases are likely to occur in 2018. "Our analysis, however, suggests that the law of supply and demand has not been repealed for wages. It still applies, although the unemployment threshold at which pressure begins to build on wages appears to have fallen, in part because of automation and global competition," Davis said. He said that a modest pickup in wages is likely to happen this year, which could push up inflation. Even a small increase would surprise the markets and create volatility simply because it is not anticipated, he said.

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Meanwhile, Davis said that volatility, which has stayed low in 2017 despite geopolitical concerns, monetary policy actions and the potential for a slowing Chinese economy, could increase in the short term. "The low volatility we've seen makes me worry that the long-term outlook is what they are counting on seeing over the short term as well. The short- and long-term sometimes diverge," he said.

In late November, Vanguard offered up its view of the markets in 2018, warning that the year will be marked by higher risks and lower returns, pressuring investments for equity and bond investors, largely those in the U.S. Vanguard, which manages $4.8 trillion in assets, said in its annual outlook report that the biggest risks to the status quo's strong market returns and low volatility are in the U.S., where a tight labor market will only become tighter. Vanguard expects unemployment to dip well below 4% and for wages to increase, along with increased inflation. As a result, the Federal Reserve will likely raise interest rates to at least 2% by the end of next year, injecting more volatility into the markets.

"The secular forces of globalization, demographics and technology have for years served as the foundation for Vanguard's long-term outlook of modest growth and tepid inflation. As we head into 2018, investors should not mistake these secular trends for short-term cycles," said Davis at the time in a press release highlighting the outlook. "Instead, we anticipate a bit more volatility and an uptick in inflation in the year ahead, accompanied by more muted equity returns."

As for stocks, which seemingly set new highs every month in 2017, Davis said that traditional valuation metrics are "unusually high right now" and that comparisons with historical averages may be misleading in the current environment marked by low interest rates and modest inflation. The valuations of U.S. stocks seem to be nearing "overvalued territory," according to Davis. "We are expecting U.S. equity market returns in the mid-single digits over the next five years. Historically, and especially in the past nine years, returns have been well ahead of that. U.S. bond yields have been grinding lower for decades, which, of course, boosts prices but also can be expected to limit future returns," said Davis.