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Although their outlook was not bearish, the authors cautioned that global growth would likely remain "frustratingly fragile" and that investors should expect continued volatility. We sat down with Roger recently for an update.

A lot has happened since the beginning of the year. We've seen wild stock market swings, discouraging data from China, shifting signals from the data-dependent Federal Reserve about further policy rate hikes, and the United Kingdom's recent vote to leave the European Union. Has any of this resulted in material changes to Vanguard's outlook?

Things will catch us off guard, like Brexit or China's currency volatility earlier in the year. But to give credit where credit is due, more of our team's outlook has proved to have been on-point than off-base. That said, we're far from complacent; we know that we have to continue to evaluate market forces in this uncertain environment and adjust our forecasts accordingly.

One of our key expectations has been that the United States economy would remain resilient despite global economic fragility. We didn't expect it to grow at 4% as it did in the "good old days" when expansion was being fueled in part by debt-financed consumer spending. We have been projecting 2%, which is a more sustainable, balanced growth rate, and full employment in the United States, which would result in a slowing of job growth. We are pleased to see both outcomes playing out in the data, as these are signs that the US economy is remaining resilient.

Unlike many in the industry, we didn't believe that emerging markets would see a cyclical rebound this year, because there's a structural need for debt deleveraging. The Federal Reserve not raising the federal funds rate has probably been supportive, as have more stable commodity prices. We still think, however, that these economies need to recalibrate to a new business model and that this will likely be a long and difficult process.

The sharp drop in commodity prices, including oil, at the beginning of the year certainly surprised us, as we had believed that the global deflationary bias would ease. As we expected, however, core inflation in developed markets, while still low by historical standards, has stopped falling - and in the United States, it's slowly moving in the right direction.

We were one of the few in the industry to underscore the importance of holding high-quality fixed income for diversification purposes, even in times of low interest rates. Yes, returns from bonds are low, and are expected to stay low going forward. But investors should appreciate that bonds will continue to act as ballast for portfolios in times of stock market stress. That was clear in the market reaction to Brexit - an outcome, by the way, that we were not expecting.

There's been a lot of talk in the financial press about divergence in monetary policy around the world. Where did you stand on that late last year, and has your outlook shifted since then?

We were expecting to see a very gradual, or "dovish", tightening by the Federal Reserve, with an extended pause in short-term interest rates at around 1%. With Brexit, it now looks like it will take the Fed longer to get there - we're now thinking we might see one policy rate hike towards the end of this year. The timing of further hikes is less important than the terminal policy rate - the level at which the Fed stops tightening. In contrast, the European Central Bank and the Bank of Japan have policy rates in negative territory, and they may further expand their extraordinarily easy monetary policies.

That might sound like divergence, but the bigger picture is that they are all very near zero. If you take a step back and look at the historical differences in US policy rates compared with those of Europe and Japan, they've usually been 300 basis points or more. So the current differences in policy rates are trivial. In fact, I'd actually categorise what we're experiencing right now as a rare period of convergence in central bank policy, one that reflects global structural forces of lower trend growth, demographics and debt deleveraging.

Moreover, we believe that the ability of other central banks to continue easing policy, including how much deeper they can go into negative rates, is very limited. I'd argue that we are getting to the limits of what central bank action can do. We haven't seen these unconventional monetary policies, whether they involve quantitative easing or negative rates, really do much to stimulate lending and investment. In order for us to see a greater cyclical thrust above trend growth, we'll probably have to first see some coordination between monetary and fiscal policies, particularly with respect to infrastructure spending.

Japan is a great example. Abenomics and its three arrows of fiscal stimulus, monetary easing and structural reforms were announced back in 2012, but that program hasn't been as successful as policymakers had hoped. It got a lot of press coverage and there were some early wins, but clearly there's been an over-reliance on the monetary policy arrow. And we haven't seen much of the promised structural reforms at all in areas where it's needed, such as the labour market.

And just a word or two about negative rates, as I get asked about this a lot and it's not very intuitive: some investors are leery of diversifying their bond holdings to include bonds with negative yields, like those seen in Japan and much of Europe. But buying an international bond with a negative yield doesn't mean you're locking in a loss. Unlike domestic bonds, international bonds come with a currency effect - which happens when the currency is converted to the investor's home-base currency - that should offset the yield differential between domestic and international bonds. For US investors, for example, a 10-year German bund would be expected to yield in US dollars as much as its US Treasury counterpart.

A defining event in the first half of the year was Brexit - the United Kingdom voting to leave the European Union. What are some of the near-term and long-term consequences of that likely to be?

The uncertainty generated by the vote to leave the European Union will likely start to show up in UK data on consumer purchases and home buying, and also in business investment and foreign direct investment.

On the monetary policy side, action by the Bank of England to cut policy rates or provide additional quantitative easing could help mitigate the fallout; on the fiscal side, so could some easing up on austerity measures. [Note: On 4 August 2016, the Bank of England announced economic stimulus measures that included a 0.25% rate cut.] The depreciation of the British pound can also help at the margin, through exports.

But all this probably won't be enough to offset the scale of the downturn in sentiment we're likely to see among consumers and businesses. Looking further out, it's hard to predict how negotiations to access the European Union's single market will go, but we do know that it will be some time until we start gaining some clarity on the type of deal the United Kingdom can strike with the European Union. There is a lot at stake for the United Kingdom in these negotiations - keep in mind that almost 50% of British exports go to the European Union, and an even higher percentage of imports into the United Kingdom come from the European Union.

So a cloud of uncertainty is setting over the UK economy, and we're likely going to see a brief recession this year or early next year. That's a significant change from the beginning of this year, when we were expecting the Bank of England to consider raising policy rates.

We'll see some fallout in the European Union as well. Its economy, which has only been growing at around 1%, is likely to decelerate further. The farther you move away from Europe, the less the impact you're likely to see. That's assuming financial conditions remain robust - which is a big "if", because headline risk is not going to go away overnight.

I have to add that the unexpected outcome of the Brexit vote was a reminder of what we've said many times, that we should "treat the future with the deference it deserves". And this also applies to other issues that the vote brought to the fore: unity within the European Union, public opinion on trade globalisation and the momentum of anti-establishment movements, to name just a few.

Concerns about growth in China sent global markets sharply lower early in the year. Did that catch you off guard?

Well, we mentioned that "growth scares" were to be expected, and China proved a case in point. Global stock markets retrenched on fresh signs of slowing in the world's second-largest economy along with unexpected movements in its currency and sharp stock market losses.

We were not expecting - and still do not expect - to see a hard landing, though. The Chinese government has ample policy tools to cushion an economic slowdown and recent data for Q2 growth seem to confirm this expectation. That said, maintaining a relatively steady pace of growth while rebalancing the economy away from investment and exports will remain challenging. It won't be a linear process, and potential policy missteps can't be ruled out. We've also noted that there's a growing buildup of leverage in the Chinese economy that policymakers need to address, and we don't expect to see how that story plays out before the end of this year.

You said you were "guarded, not bearish" about the outlook for market returns, given not-cheap stock valuations and the limited income on offer from bonds. In an environment like this, what's the right approach for investors to take?

Lower global trend growth and lower fixed-income yields relative to historical norms are likely to translate into a more challenging and volatile investment environment. However, our long-term return expectations are muted but positive. Patient investors with broadly diversified portfolios are likely to be rewarded over the next decade with fair inflation-adjusted returns. So our guarded outlook doesn't warrant some radically new investment strategy. The principles of portfolio construction still hold true, even in such an environment.

Robin Bowerman
Head of Market Strategy and Communications at Vanguard.
29 August 2016