The end of 2016 was a challenging time to make projections. Vanguard economists saw stabilization as the more likely outcome, rather than the extreme scenarios others expected. Has your view on that changed?
I would say the framework that we use to make our projections, which includes quantitative and qualitative assessments of conditions, worked well on the whole. Downgraded global growth forecasts and disinflationary forces last summer led to a consensus view that we thought was too pessimistic, followed by a surge in optimism after the U.S. presidential election that didn’t seem fully warranted, either.
We expect growth of about 2.5% in the United States for 2017. Heading into this year, that would have been closer to the lower end of the expected range of outcomes. In recent months, however, uncertainty about the impact of various fiscal policy proposals has increased significantly, and some of that optimism has faded.
One thing that caught us—and the Federal Reserve—off guard is the weak pattern we’ve seen for U.S. core inflation since March. Although we still expect core inflation to continue rising gradually toward the Fed’s target of 2%, that may not happen until as late as mid-2018. Digital technology will remain a persistent headwind to higher prices, as will globalization and demographics, but we were expecting more short-term support for inflation from wage gains.
Looking outside the United States, we underestimated euro zone growth momentum, which was supported by reduced political risk following elections in the Netherlands and France, along with relatively limited contagion so far from the United Kingdom’s Brexit vote last summer. The region should hit growth of about 1.7% in 2017.
And despite some persistent underlying structural issues, Japan also grew a little faster than expected and should reach about 1% growth for this year. Many emerging markets countries have continued to improve as well, so they’re in better standing as a whole.
Overall, it’s a relatively bright picture. The global economy looks a little less fragile, with growth becoming more synchronized across all markets.
So the prospects for the global economy are more balanced than you were anticipating at the beginning of the year?
Yes, I think that probably sums up the main adjustment to our outlook.
You mentioned the new U.S. administration’s pro-growth agenda. Can you tell us more about what impact you think it might have on the U.S. and global economies?
The short answer is that it’s too soon to say. The fiscal stimulus measures floated during the campaign and afterward, such as corporate and personal tax cuts and infrastructure-spending, fueled some of the optimism in the markets I mentioned earlier. But we don’t know yet exactly what those measures will look like or when they’ll be implemented, so we can’t really assess their costs and benefits. It’s a little like waiting to see what’s behind the doors on The Price Is Right at this point.
Keep in mind, though, that it’s not a race, and changes to things such as tax policy and infrastructure-spending take time. It’s better that they are carefully considered, thoroughly vetted, and well-executed since they have the potential to impact the economy for years or even decades to come.
The U.S. economic recovery is entering its ninth year, making it one of the longest in history. What are some things you’re looking at that could set off the next downturn?
Forecasting is humbling, and forecasting recessions is very, very humbling. Just because this recovery is long doesn’t mean that it has to come to an abrupt end soon—expansions don’t die of old age.
There are, nevertheless, a number of risks on our radar. Geopolitical risks have been creeping into our discussions more and more. The Chinese economy is another area of concern. China should manage to gradually slow its economy and transition to a developed market model that is more dependent on the consumer. That said, this is the first time an economy of its size has tried to do that, so there could be bumps along the way. For monetary policy, missteps at home or abroad can’t be ruled out. The Fed could try to normalize monetary policy too quickly, for example, or have to raise rates sharply if inflation flares up.
The recovery has been long but weaker than many past recoveries. Why do you think that is?
That’s true. You haven’t seen the 3%–5% growth people may have become accustomed to in postrecession periods, so this time there’s a difference. The underlying fundamentals, from capital accumulation to labor force participation, don’t really point to growth much beyond 2% going forward, absent any sort of structural change or big policy shift. We’re comfortable with that level because, so far at least, it’s not being fueled by the kind of debt-financed consumer spending that led up to the last recession.
I’d just add that we may not be capturing growth as accurately as in the past. The standard measures for decades have worked well when you were essentially tallying output (coal cars coming out of mines or widgets produced by an assembly line). But it doesn’t work as well in capturing the value of less-tangible output such as social networks and ride-sharing.
The Fed raised policy rates last December and twice so far this year. What do you see as its next moves?
The Fed will likely remain slow and steady through normalization and will probably use only one “tool” at a time in the near term—either rate hikes or balance-sheet reductions. There’s broad acknowledgement that its bond purchases to bolster economic conditions were unprecedented, so it would be prudent for the Fed to unwind gradually while putting rate hikes on the back burner to evaluate the real-world impact.
We expect the Fed to begin allowing the balance sheet to roll off later this year and the next rate hike to come in the second half of 2018.
If all that goes according to plan, we don’t see significant negative implications for financial markets.
Let’s turn to the markets. U.S. stocks have made strong gains so far this year, and international stocks have done even better. Do you think stocks have become overvalued?
We noted in our outlook for 2017 that equity valuations were fairly high, and they have moved up since then. But I don’t think that we would necessarily qualify equity markets even now as overvalued; maybe they’re on the high end of fair value.
We try to take economic and market conditions into account when we assess equity valuations, rather than look at long-term averages. So if you consider the currently low levels of interest rates and inflation, and that neither of them are expected to climb to prerecession levels, we would say that equity valuations are high but by no means alarming.
Has what’s transpired over the past 6 months made you rethink your “muted but positive” outlook on returns from stocks and bonds?
If anything, the rally in stock prices since the beginning of the year has made us even a bit more cautious about the short term. However, we tend to look out over 10 years on an annualized basis, and that hasn’t really changed. Given where valuations are, equity returns somewhere in the 6%–8% range still feel about right. That’s not far below historical precedent but may be less than the 9%, 10%, or 11% some investors may have come to expect.
On the fixed income side, yields have tended to do a very good job of providing investors with an understanding of what returns could look like going forward. So returns in the 1%–3% range on an annualized basis seem reasonable.
If there’s one segment of the bond market where I’d say investors may not be getting adequate compensation for the risk they’re taking, it would be high-yield bonds. Their spreads relative to Treasuries have compressed a lot, likely a by-product of investors reaching for yield, so the risk-reward trade-off there isn’t looking very attractive.
Some of the market specifics look a little different today than they did 6 months ago. But our longer-term outlook still remains guarded, without being bearish.
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