An episode from Vanguard’s Investment Commentary podcast series
Andrew Patterson: My pleasure, David.
David Eldreth: So, recently, Vanguard released its 2017 economic and market outlook paper. Can you discuss some of the key themes from the paper?
Andrew Patterson: Certainly. So early on in 2016, we saw quite a bit of pessimism being expressed in financial markets. And then, heading into the end of the year, maybe a bit more of an overly optimistic outlook. We don’t feel that either of those views hold much weight in our own outlook for 2017. Rather, we believe, going forward, in all likelihood, growth is likely to somewhat stabilize at a lower trend. We’ve been calling for a 2% trend growth for some time now. We could see some short-term bumps, maybe call it 2.5% in 2017, based on what types of policies are delivered by the new administration. But again, we have to wait and see how those play out. That said, we think that more important rather than short-term bumps of higher/lower growth, really, are the longer-term drivers of growth, the longer-term drivers of economic and financial market fundamentals. In any given period, we like to say that our environment is determined by three factors: the economy, financial markets, and policy. Those all interrelate and work together to sort of shape the environment that we’re living in, in a given point in time as investors. And in addition to that, there are three structural drivers that tend to have longer-term implications for those; those being technology, demographics, and globalization. The last couple of years you’ve heard a lot more discussion around the drag that a retiring cohort of baby boomers could have on financial markets and economic growth. So that’s something to keep in mind. That’s something that’s been going on for quite some time though, it’s not necessarily a new phenomenon. Technology—we’ve seen a lot of advances in technology recently. Some of those you would expect to be pro-growth, but maybe we haven’t seen the adoption rates that we might have expected. So, more on that to come. And then globalization. We saw a big buildup in globalization through the ’80s, ’90s, and early 2000s. Now—a lot of rhetoric out there around protectionist policies, so maybe a pullback on the globalization front. So as those factors ebb and flow and drive our views, that’s really going to shape the environment that we live in.
David Eldreth: Interesting, okay. So Vanguard’s overall economic outlook is classified as guarded but not bearish. Could you explain some of that a little bit for the layman, and what concerns you most that makes it guarded?
Andrew Patterson: So from about 2008 and on, we’ve had quite a good run, with the global financial crisis notwithstanding. We had that factored in there as well. But if you look going back to around 2008, 2009, we’ve seen equity returns north of 10% on an annualized basis. We’ve seen fixed income returns north of 4% on an annualized basis. We don’t necessarily expect those to hold up to that same degree. In all likelihood, we would see equity returns somewhere in the 5% to 8% range on a nominal basis, fixed income, 1.5% to 2.5%, maybe 3% at the high end—just based on some of those fundamentals we talked about, wherein we don’t see us returning, as an economy, to growth rates of 3%, 3.5%. Again, there may be some short-term fluctuation, some short-term bumps. But in all likelihood, we’re going to stabilize at a much lower longer-term trend growth rate because of those fundamental structural drivers—technology, demographics, and globalization (or, in this case, antiglobalization)—going forward.
David Eldreth: Okay. So one thing you mentioned about the lower growth expectations overall: Europe has been kind of limping along with their growth, and this year we expect the Brexit—Britain to leave the E.U.—to take effect. What do you foresee for Europe overall?
Andrew Patterson: So in Europe, Theresa May is going to implement what’s called Article 50. She said she was going to do so by March of this year. I don’t know that those plans have changed. What that is, is that’s just an announcement to the broader E.U. that the U.K. plans on leaving. That kicks off a two-year negotiation process, where they try to figure out what the U.K.’s role is going to be with broader Europe going forward. So that’s going to be a period of increasing levels of clarity. You’re going to have very, very little clarity early on. But then as the negotiations play out, there’s going to be more shape taken by just how things will look in 2019 and beyond. So as that plays out, we think that will be a positive, at least from a sentiment standpoint, because when you have so much uncertainty around a particular piece of legislation or relationship, in this case, to a broader continent, that’s quite a bit of uncertainty for investors to deal with. So we think any sort of positioning where you have a better understanding of just what the future might look like, that’s going to provide some support to financial markets. Maybe not, again, returning to the types of returns we’d experienced in the past, but maybe cutting down on the volatility to some extent.
David Eldreth: Sure. So there’s been a lot of talk about the incoming administration and what impact investors believe that President-elect Trump’s administration will have on the markets and the economy. Can you talk through some of that a little bit and what Vanguard expects the administration will have?
Andrew Patterson: Certainly. So President-elect Trump gets sworn in, today’s the 17th, in three days, and there’s been quite a bit of discussion around potential policy implementation. The fact remains that nothing has been implemented yet. Much has been discussed, not much implemented. So we do have to see which of those campaign promises were campaign promises, and which of those are actually going to be implemented. And we’ll get more clarity around that in coming weeks. There could be some pro-growth policies mixed in there but also some that may be a little bit less advantageous from an investor perspective. We talk about globalization and protectionism. Globalization tends to benefit economies in aggregate. So the whole world economy benefits from globalization. But there are certainly winners and losers mixed in there, and we’ve seen a pushback on globalization because of the negative implications it can have for sectors such as manufacturing. You’ve seen that play out here in the U.S. We’ve seen that play out in Britain. So, [there’s] a lot of pushback on the globalization move over the last several decades. That could actually be a negative for growth in the short term. Again, I know it’s difficult to talk to people who might have lost jobs because of globalization, but in aggregate that may not be a benefit to the economy as a whole. But again, we have to wait and see. Very targeted, focused policies, whether it’s around infrastructure, immigration, globalization, you’re really setting the rules of the game by implementing these policies. We don’t know what the rules are yet, and as more clarity around that is provided, we’ll be able to have a better assessment of things to come. David Eldreth: Aside from the policies of the incoming administration, President-elect Trump has been very outspoken on some issues. Do you expect the market will react when he puts out a tweet or something like that?
Andrew Patterson: You hope not, but the fact remains, if he is making these comments about very specific companies, that certainly could impact those specific companies. It could impact sectors, when he makes statements about the auto industry, or about the banking sector. That could have very real implications for those sectors or companies, particularly in the short term. Longer term, again, it’s going to depend more on the policy that’s actually implemented. So, again, I go back to this point, in that as more clarity is provided around those policies—even if it’s for Congress to propose something, negotiations to begin—that tends to be stabilizing for the economy and financial markets.
David Eldreth: Okay. So right now we have a pretty tight labor market, right around 4% unemployment rate. Many economists believe we’re at full employment or near full employment. What impact do you see the Fed policies having on inflation or interest rates in the coming year?
Andrew Patterson: Sure. So in terms of the labor market, it is tightening. I don’t know that I’d necessarily qualify it as outright tight right now. It’s very, very close to full employment. We’re at 4.6% unemployment rate. If we continue pushing closer and closer to 4%—which we’re likely to do but probably not reach it—you’re going to start to see some inflationary pressures pick up. And because we have seen such strengthening in the labor market recently, or at least rather over the last two years, that’s one of the big reasons why the Fed was comfortable raising rates in December as they did and forecasting three rather than two hikes in 2017. The Fed, in their commentary, has expressed a “comfortability” with letting the economy “run hot” which means maybe inflation running a little bit above 2%. I don’t know that they’ll necessarily get there for an extended period, because some of those structural factors we talked about could be restraining inflation and price growth. But the fact remains that they might be comfortable letting things move a little bit faster in terms of price growth, in terms of growth—stay under full employment, or rather have a lower unemployment rate for some time—because the fact remains that they do have the tools to address high inflation, much more so at this stage than they would to address low inflation or disinflation. Again, also given the incoming contingent of voters on the Federal Market Committee, we could see more of a dovish tone take shape later in the year, so we could see two rather than three hikes. But the fact remains, we’re talking about 25 basis points at the end of the day.
David Eldreth: Right—still the steady, slow, long climb that we have seen and predicted for the last year or so.
Andrew Patterson: Exactly. We hesitate in calling this “monetary tightening.” It’s rather a removal of the extraordinarily easy policies that were implemented over the last several years to address the global financial crisis. Again, they raised rates in December [and are]; likely to raise them two, maybe three times in 2017. They also have their balance sheet they need to start thinking about. Once they get to, in their mind, an appropriate level of interest rates, they’re going to start considering allowing that balance sheet to taper, allowing some of those assets to roll off. I don’t believe asset sales are really on the table in the near term. More so, you’re likely to see a stopping of the reinvestment—so allowing the balance sheet to shrink that way just by not maintaining at the same level. That will probably be the first step.
David Eldreth: And the Fed’s desire to return to more of a normalization for rates, and that in the event that we do have inflation, they want to have the flexibility to lower rates again if that’s possible, right? Isn’t that some of the thinking behind wanting to bring the rates back up to more of a traditional or historically normal level?
Andrew Patterson: Yeah, it’s not the entire reason. They’re not raising rates for the sake of having higher rates, but there is a level of comfortability, absolutely, in their ability to address—if there were to be a recession, we don’t necessarily see the odds as significantly higher than they’ve been in the past, maybe a bit at the margin. But they would be more comfortable with rates of say, 1.5% at the end of 2017. We think they’re going to struggle to get to a policy rate of 2%, even through 2018. So in all likelihood you’re going to see zero or even negative real rates with us for at least the next year or two.
David Eldreth: Okay. Turning to the stock market for a minute, right now, the Dow Jones is around 20,000, just under that threshold. It’s been flirting with it a little bit. Are stocks currently overvalued, and what’s the likelihood of a correction in the near or distant future?
Andrew Patterson: So stocks certainly are at the high end of our fair-value estimates. That said, they’re just estimates. There’s a lot of assumptions that go into these. Any type of model where you see valuations being compared with, whether it’s history, or the way we do it comparing it to the overall environment, factoring in interest rates and inflation currently and expectations thereof, but they do remain somewhat high. That said, they can remain somewhat high for some time. There doesn’t have to be an imminent correction. If you would have pulled stocks out in the mid-1990s just because valuations were stretched, you could have missed out on five, ten years of additional gains. Now you may have avoided that crash in the early 2000s, but you would have missed out on all those gains thereon, so missed out on that compounding effect.
David Eldreth: Okay, finally, with the investment environment expected to be challenging over the next five to ten years, what are the keys for investors, and what should they be focusing on to give themselves the best chance for investment success?
Andrew Patterson: As it’s always been, their plan. If your plan involved a 60/40 asset allocation before 2017, it’s likely to be prudent to maintain that asset allocation through 2017. Unless your goals or investment horizon have changed significantly—if there’s been a birth in the family, if someone’s going to college, or you’re retired—we don’t necessarily see big reason for changes in asset allocation. So we think it’s very, very important to keep that in mind. I mentioned before some of the short-term bumps we may see in growth, we may see in financial markets. Those shouldn’t be what’s determining your asset allocation. It should be more so your long-term goals, your long-term view, and comfortability with risk. All of those should be factored into what should be considered a strategic asset allocation, so one that doesn’t change very much outside of maybe marginal tweaks to maintain a level of comfortability.
David Eldreth: That’s some good insight. Thanks for joining us today, Andrew.
Andrew Patterson: My pleasure.
David Eldreth: And thank you for joining us today for this Vanguard Investment Commentary Podcast. To learn more about the issues we discussed today, check out our website and take a look at our new paper, Vanguard’s 2017 economic and investment outlook: Stabilization, not stagnation. 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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