Do you see risks on the horizon that could take the markets by surprise next year and drive up volatility?

Something we are watching very closely is inflation driven by rising wages. This possibility has been largely written off by the financial markets because the U.S. unemployment rate has fallen well below what many would have considered full employment a few years ago. And yet, upward pressure on wages hasn’t really shown up in the data. Our analysis, however, suggests that the law of supply and demand has not been repealed for wages.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.

When you control for those shifts and consider that the unemployment rate will likely slip below 4% in the next six months, a modest pickup in wages may well materialize in 2018. That would push inflation modestly higher. And even a small uptick would surprise the markets, because that’s certainly not something they are currently anticipating.

Volatility in the financial markets has stayed well below historical levels this year despite uncertainty running high. Investors face lingering questions on a number of fronts, including global interest rates, international trade, the United Kingdom’s pending exit from the European Union, and credit expansion in China. Is low volatility here to stay?

In our Economic and Market Outlook for 2018 and in several past editions, we’ve looked closely at three structural forces­­­—globalization, technology, and demographics. These have shaped our long-term outlook for modest growth, tepid inflation, and low interest rates. Many investors have come to share that view. But 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.

The market is anticipating a very narrow set of outcomes for next year even though history shows us that surprises, either above or below expectations, are the norm.

The Federal Reserve’s policymaking committee is set to meet next week. Do you think it will move forward with what would be a third rate hike for 2017?

Yes, and it doesn’t come as a surprise to us. This time last year, we were anticipating that the Fed would raise rates several times in 2017. We also thought it would bring forward its timetable for shrinking its balance sheet and that long-term interest rates would remain low because of the structural forces that I mentioned earlier.

Those projections were on point, but we also said that the Fed might put rate hikes on hold well into 2018. The unemployment rate, however, has dropped well below our estimates, which were already below the consensus; in fact, much of the world is at or near full employment.

So we could see an inflation scare that might embolden both the Fed and other central banks to be more aggressive in tightening monetary policy. The only thing holding the world back from higher short-term interest rates has been the puzzling lack of inflation. That said, we expect any rise in inflation to be modest and longer-term interest rates in particular to remain below historical returns. The benchmark 10-year U.S. Treasury yield should stay somewhere near 2.5% in 2018.

Stock valuations started the year high and they’ve moved even higher. Where do you see them going from here?

Traditional valuation metrics are unusually high right now. We have argued that comparisons with historical averages may be misleading in the current environment of low interest rates and modest inflation. Nonetheless, U.S. stock valuations would still seem to be approaching overvalued territory.

We therefore expect to see lower returns from U.S. stocks and a higher risk of loss over the next five years. It should be noted that the outlook for non-U.S. stocks is higher as their valuations are not as stretched­­––another argument in favor of international diversification for U.S. investors.

More modest stock returns, low bond yields, and higher volatility––that doesn’t sound very encouraging for investors. What are reasonable expectations for returns?

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.

So, for both stocks and bonds, it’s important to recognize that we are currently in a lower- expected-return environment.

What’s an investor to do about that? Rather than taking on outsized risk in the hope of boosting portfolio performance, investors might be better off trying to work some of the levers that fall under their control. In particular, they might consider saving more, spending less, and minimizing investment costs. The expected benefits from those levers and others such as maintaining a long-term focus, remaining disciplined, and rebalancing from time to time, are likely to be even more crucial than when returns were higher.

As my colleague Fran Kinniry likes to say, investing is a partnership between investors and the markets. Since the end of the global financial crisis, the markets have done most of the work. Now it’s our turn.

For more, read Vanguard’s economic and market outlook for 2018 and As U.S. stock prices rise, the risk-return trade-off gets tricky, part of our Global Macro Matters series.

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Bonds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

Diversification does not ensure a profit or protect against a loss.

Past performance is not a guarantee of future results.