In Vanguard’s midyear economic and market outlook report, the giant investment management firm doesn’t paint a rosy picture regarding the post-Covid economic recovery. It’s not a doom-and-gloom outlook, but it doesn’t provide a lot of warm fuzzies, either.

Vanguard’s report has a chart that defines its baseline economic outlook and its upside and downside scenarios by focusing on health factors. According to Vanguard, health developments are the biggest risk factors for economic recovery. Its upside scenario depends on several elements, including a vaccine becoming widely available in early 2021 and a population that's closer to herd immunity. Vanguard assigns a 15% probability to this scenario occurring.

It puts a 50% probability on its baseline forecast playing out, which entails a gradual, staggered return to work; local virus recurrences that are suppressed by test-track-trace processes; consumers being slow to engage in highly social activities; and an effective vaccine becoming available in late 2021.

The downside scenario comprises a premature rollback of social distancing measures; the re-emergence of both the virus and national shutdowns; Covid-19 mutating into a more virulent form; and delays in vaccine development. Vanguard puts the odds of a downside outcome at 35%.

“Our view of the risks are skewed toward the downside,” Vanguard said in what might be the nut graph of the entire report.

Vanguard noted that the global pandemic created the sharpest and deepest short-term economic contraction in modern history.

“Even as some countries succeed in controlling the outbreak, the case count continues to grow globally,” the company said in its report. “The twin crises of health and economics are far from over.”

Vanguard’s take is that countries that controlled the outbreak early with a combination of swift lockdowns and tracking and tracing features have set themselves up for a potentially quicker recovery. It cited China, South Korea, Australia and New Zealand as examples.

But a virus revival requiring further lockdowns could crimp economic gains in any and all countries that are negatively impacted.

“This debate about health risks versus economic costs emphasizes how the usual uncertainty about the path of recovery for the global economy is amplified by the range of possible health outcomes as defined in our baseline, upside, and downside scenarios,” Vanguard wrote.

Vanguard’s economists and investment strategists who contributed to this report assessed the recovery of the economy’s supply side by delineating sectors into low-, medium- and high-risk categories based on the feasibility to work from home and/or the proximity of workers in the production of the good or service.

Low-risk sectors with a lower shock persistence include agriculture and professional services, the latter boosted by the work-from-home movement. High-risk sectors include transportation and indoor recreational activities.

Vanguard posits that a rebound in aggregate demand will take longer than a recovery in supply due to uncertainty about when people who've been economically impacted by the lockdowns will recover their incomes, along with lingering fears of taking part in face-to-face activities.

“The latter may not fully dissipate until a vaccine or therapeutic treatment is found, or until the virus has been eliminated by suppression or herd immunity,” according to the report. “This will likely extend a full recovery well beyond 2021.”

Vanguard praised policy responses to the virus as being “impressively bold and swift,” and it sees monetary policy staying loose well into next year, with further fiscal support being likely.

“The burden of the resulting increase in public debt should be lessened by current extremely low financing costs. Inflation will likely remain subdued given the prolonged period of excess capacity,” Vanguard said.

But while Vanguard believes that governments have appropriately responded by propping up their respective economies, it offers that productivity could be lower for three reasons:

• Company bankruptcies or the inability to service loans due to impaired cash flows could take many years to recover from.

• People who lost jobs during the pandemic might lose skills or become permanently disconnected from the labor force.

• Airlines, commercial real estate and other industries might never recover their former size, and redistributing those activities to other sectors where demand has been reallocated could take a long time.

Regarding the financial markets, Vanguard appears to be cautiously optimistic. That is, as long as investors remain realistic about the current realities.

“The turmoil caused by the pandemic has triggered a change in fundamental and macroeconomic variables that could affect future market performance, particularly on the equity side,” the report said.

It noted that U.S. equities went from being overvalued before the pandemic to undervalued by the end of March, and that the subsequent stunning rally elevated the U.S. market to fair-value range. And it said the ex-U.S. developed market, while still fairly valued, is closer to the undervalued range and is more attractively priced.

“Given lower current valuations, especially in the international market, and a higher fair-value range because of lower interest rates, our outlook for U.S. and international equity returns has improved compared with our expectations at the end of 2019,” Vanguard said.

Specifically, Vanguard’s investment strategists expect average annual returns of 4% to 6% for U.S. equities over the next 10 years, versus annualized returns of 7% to 9% for international equities during that period.

Vanguard concluded its report by stating that policymakers might be putting too much weight on the prospects of a universally available effective vaccine, while investors run the risk of pricing assets close to perfection by assuming that corporate profitability will soon return or that central banks will keep priming the pump with accommodative monetary policy. 

“Investors will be well-advised, as always, to maintain appropriately diversified portfolios appropriate to their goals,” the report said. “Attempting to time the market during extreme market volatility is tempting but rarely profitable.”