Dave Eldreth: What does the future hold for the economy and the markets? Will inflation remain in check? And what should investors’ expectations for returns be over the next five to ten years? I’m Dave Eldreth, and welcome to Vanguard’s Investment Commentary Podcast series. In this month’s episode, which we’re taping on January 16, 2018, we’ll discuss Vanguard’s 2018 economic and market outlook. With us is Josh Hirt, an investment analyst with Vanguard Investment Strategy Group. Josh, thanks for joining us today.

Josh Hirt: Great to be here, thank you.

Dave Eldreth: Vanguard recently released its annual market outlook paper. Can you start by broadly hitting on some of the key themes from the paper?

Josh Hirt: Sure. Well, one of the key themes of the paper—we’ve titled it “Rising risks to the status quo”—and we’ve spent a number of years really hitting on and anticipating some of these longer-term structural elements of the economy, such as the impact of technology, globalization, demographics, how that impacts the economy, and we’ve anticipated a lower-growth, lower-inflation world really for a number of years now. What we’ve seen is that the market has come more in line with that. And at this point in the cycle, what we would see as a more underappreciated aspect is a cyclical uptick. So we do feel that, you know, as we do have much more sound economic growth currently, we do feel that the risk of an uptick is less appreciated currently right now. So one of the key ones, certainly.

Dave Eldreth: So a lot of financial services companies release papers like this. What does Vanguard do differently than maybe some of our competitors?

Josh Hirt: Absolutely. Well, I would say one of the key things that has a global effect on how we really go through our research, just goes back to the firm’s mission: to treat investors fairly, give them the best chance of investment success. I think the way that that comes out in the research is that it allows us to really ask what matters to investors, whether that is something that is short term or is something that, and often this tends to be the case, where it’s a bit more long term in nature in terms of trends. It allows us to not become overly dedicated to describing events as they’re occurring in the marketplace right now.

We certainly put a lot of time and analytical rigor looking at markets day-to-day, but we also find that often what matters most for investors are some of these longer-term aspects, and I think that our viewpoint as a firm allows us to really step back and take that approach.

The other aspect that I would really point to is just the analytical firepower that we put behind the outlook itself. We focus on a quantitative lens, really looking at things both from the theory side of things but also being able to prove it out. I think a really key one, just as an example, would be some of the work we’ve done around inflation as a really key topic and the impact that technology has on inflation. So this has been something that’s been a viewpoint in the markets. Is the adaption of technology really weighing on inflation, things like Amazon, e-commerce, are these impacting inflation? What we did is, we actually went in, we quantified it: How big of an impact is inflation taking from technology? So I think a really good example of just that quantitative lens to everything.

Dave Eldreth: Sure, now talking about that long-term versus short-term perspective for a second, it’s really difficult for anybody to predict the short term in any kind of accuracy, correct?

Josh Hirt: Well, without question. I mean, there’s always going to be a significant amount of noise that’s involved in very short-term prognostications or just what can happen in the markets day-to-day. It’s very important to be involved in that, and we are, currently, on a day-to-day basis, taking a look at markets with our work that we do with our Fixed Income Group. It’s very important to be very actively involved in everything that’s happening short and long term.

I think just when we take a step back and say, “What really matters for the broad part of our investors?” It tends to be some of the longer-term trends that we see. And so I think there is a healthy mix between being able to accurately describe, analyze what’s happening in the moment—it’s certainly something we put a tremendous amount of effort into—but also at times when you can step back and say, “How does this affect investors, how can they use it, what really matters?” There’s always a healthy mix there, but I think that’s something that we definitely put an emphasis on getting right.

Dave Eldreth: Okay. Now turning specifically to economic growth, what are some of our expectations globally?

Josh Hirt: Sure, well, I think even the last year, perhaps even a little bit longer, we’ve really seen a very unprecedented, at least since the financial crisis, synchronization of growth globally. So, especially if you’re looking at developed markets, really excellent performance from an economic-growth standpoint—not by historical standards to the same levels, but in terms of where we are coming from, the underlying broad-based growth, very positive across most of the world, in terms of developed markets.

If we think about the U.S. or if you think about Europe, really, two pretty bright spots last year in terms of economic growth. I’m really surprised on the upside from Europe, and the U.S. economy has continued to strengthen, both from an actual level of growth as well as the broad-based nature of it. So, really, two components of that, and we would expect that to continue. So part of, going back to some of the risks that we potentially see, we do think that this growth momentum has some legs in terms of, certainly, 2018, perhaps a bit beyond. But we do see, if we look out at the global economy, we do see underlying strength in terms of growth.

Dave Eldreth: Sure. What are some of the risks that Vanguard sees out there on the horizon that could derail some of the growth that we’re seeing right now?

Josh Hirt: Well, I think there’s a number of things that are less certain than they were previously; hence this comes back to our view of the rising risks. Economically, if you look at some of the different regions, the underlying strength is actually very good, so I think if we would look at areas of weakness, it probably would not be from an economic standpoint or a fundamental standpoint. But we do turn to things such as central bank activity, and we are entering some unchartered territory in terms of normalization of central banks. The Federal Reserve has really kicked off that process, but really, globally, eventually we see this as really the beginning of the trend of normalization. And this is really unprecedented territory in terms of now both normalizing policy but also balance sheets, and so the path is sort of unmarked as we go forward.

It’s certainly something that adds potential risk to the equation. The other thing to point out, and we’ll probably get into this as well with the financial markets, is, we have continued to see, especially in the United States, really healthy—in fact, beyond that, robust—returns for a number of years. This has seen elevated valuations just continue to get stretched further, so I think these are things that definitely bring some concern for us.

Dave Eldreth: Now one of the changes this year is that the Fed has a new chairman; Jerome Powell is taking over for Janet Yellen. Do we expect any significant monetary changes based on that transition?

Josh Hirt: I think both our expectations, as well as the markets’, generally, viewed Chairman Powell as being relatively consistent with the prior regime in terms of policy take. So I think we shouldn’t be expected to see any sort of major deviation in monetary policy.

One of the things that the Federal Reserve really has spent a lot of time and effort in has been their forward guidance, in really clearly allowing the market to have an understanding about what they’re doing and why they’re doing it. They really forecasted changes with a great degree of effort over the last number of years. I think it would be a surprise to see any strong deviation from that at this point, where the market really does have, in our view, have a very good understanding about what the anticipated monetary policy will be—both what’s driving it from an interest rate standpoint as well as balance sheet roll-off. I think the market has a clear view about what the Federal Reserve is looking at, what they intend to do, and we think that’s a positive thing. At least at this point, we’d be surprised to see major deviations from that.

Dave Eldreth: Okay, so in terms of the U.S., we’ve seen a very tight labor market; it’s hovering around 4%. Can that market get even tighter, and what do we expect abroad in some of the other markets? Is it comparable to what we’re seeing in the U.S.?

Josh Hirt: Well, the short answer is, it can get tighter. Just looking at the rate at which we are creating jobs in the economy, it’s actually continued to be quite strong—probably stronger than our expectations. We would have thought that we would be seeing less robust job growth on a monthly basis than we currently have. 2017 averaged about 170,000 jobs [per month], and really, that, by its nature—where we have about 80 to 100 thousand new entrants entering the labor force [each month]—that, just looking at the differential there, is going to continue to drive down the unemployment rate. So we would not be surprised to look out at the end of 2018 and see an unemployment rate somewhere in the 3.5% to 3.7% range. Just looking at the numbers, that would not be something that surprises us.

And if we look globally, it’s actually a story that—not at the exact same levels as the United States—but its a theme, in general, is also very consistent if we look out globally. But roughly 80% of the global economy, major developed economies, are at full employment. There are some differences if we look at other regions, such as Europe. They definitely have decreased their unemployment rate. However, you are seeing some structural issues, such as underemployment, being an issue that Europe has to a greater extent than the United States. But, in general, full employment is a global theme.

Dave Eldreth: Now normally when we see labor markets this tight, wage pressures start to come into play, and we typically start looking more at inflation; and we haven’t really seen that to this point. Do we expect that to remain in check, or is it possible that we could see a little bit of an uptick in inflation?

Josh Hirt: Well, that’s right. I mean, probably one of the biggest surprises of 2017 was softer inflation than expected. And there have been some both transitory reasons for that last year as well as some of those that we think are structural. You know, going back to the analysis on technology and how that impacts it, there are really different forces that are affecting inflation. But I would say the short answer to that is that, yes, we do expect this relationship between having ever-tightening labor markets and having some inflation pressures to emerge into 2018.

Dave Eldreth: Okay, now switching gears for a second from our economic outlook to our investment market outlook: Our expectations internationally are more bullish compared to the U.S. And that’s flipped from years past, correct? What’s driving those expectations?

Josh Hirt: Sure. As we look through the Capital Markets Model and we run our simulations in terms of the forward-looking expectations of the markets, we see that the U.S. equity market’s somewhere in the 3% to 5% range; you know, we would expect to see international markets slightly more robust, in the 5.5% to 7.5% range over the medium to long term. And a really key thing: That’s one of the bigger differentials that we’ve seen in quite some time.

The key things that really are driving those expectations for international markets would really be two things. One would be the level of valuations. So if we look currently where the U.S. market is valued, we do see that they are stretched compared to international markets. That’s something that’s playing into that outlook—as well as currency. So we would have an expectation of a weakening dollar over the longer term, which should also be something that’s going to play a role in that equation for growth expectations.

Dave Eldreth: Sure. One of the key principles that Vanguard’s been hitting hard for the past few years is international diversification. And that would seem like it would become more and more important going into this market environment, right?

Josh Hirt: Yes, we would continue to highlight the benefit and the power of a globally diversified portfolio. And I think this market environment really just underscores some of that benefit that you see there, as when you do have differentiated markets, that diversification can really show itself. So that would be a key element that we would continue to stress.

Dave Eldreth: So if we’re correct in our medium-run outlook and the view investors should expect returns in the 4% to 6% range, what should advisors be focusing on to give their clients the best chance for success? We talked about international diversification being one thing, but what are some other factors?

Josh Hirt: Right, absolutely. I mean, diversification; continue to stress that, of course. But we’d also see—one of the typical responses to a lower-return environment is to increase risk in the portfolio. And so that’s something that some may be turning to at this point, and it may be appropriate; [but] one of the things that we looked at in the paper, in the analysis, was we tried to analyze whether these traditional tilts would perhaps get us back to some of the historic levels of returns that investors may have been used to and may be still trying to reach. Our analysis shows that adding additional risk to the portfolio is not going to bring you back to the same level of returns that you may have been comfortable with, so we would just raise some caution and set expectations there about what adding risk to the portfolio can actually do for you.

You know, the other thing that I would say is, and this is Joe Davis, our chief economist, this is really his words, but “eating your vegetables.” I should probably think of a better term, but I really think that aptly describes what the process is. Things that investors can do to enhance portfolio returns: lowering costs, saving more, cutting back in areas of spending to meet these expectations rather than adding risk to the portfolio.

Dave Eldreth: Sure. That’s interesting analysis about taking on more risk or accepting more volatility and not getting the payoff for it.

Josh Hirt: Right. And just to clarify, we’re not saying that adding risk to the portfolio is not going to increase expected returns. It’s just that if we’re comparing that to levels that investors may have been comfortable—whether it’s 6% to 7% for a balanced portfolio or 8% to 9% for an equity portfolio—really looking at, Are these tilts going to be the type of things that will get an investor back to those sort of levels? And our analysis finds that that’s not the case.

Dave Eldreth: Great. Well, we appreciate you sharing your insights with us today, Josh.

Josh Hirt: Thank you for having me.

Dave Eldreth: Thanks for joining us for this Vanguard Investment Commentary Podcast. To learn more about Vanguard’s thoughts on various financial planning topics, check out our website, and be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on LinkedIn and Twitter. Thanks for listening.


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