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Rebecca Katz: Good evening and welcome to this live Vanguard webcast. I’m Rebecca Katz, and tonight we’ll be talking about Vanguard’s economic and market outlook for 2019. We’ll look at some trends and some issues that might impact market performance in the months ahead, and we’ll talk about how these factors could affect your investment portfolio and mine.

Now, before we dive in, if you need any technical help during this broadcast, it’s available by selecting the blue icon on the left. And you can learn more about Vanguard’s services by clicking the green icon that’s on the right of the player. You can also watch old webcast replays or listen to our latest podcast episode.

So at Vanguard we’re always working to keep you, our community of investors, informed and on track, and that’s why I am so excited tonight to be talking to Vanguard’s Global Chief Economist Joe Davis. Joe is also the head of Vanguard Investment Strategy Group, and in that role he helps oversee Vanguard’s asset allocation strategies for institutional and individual investors like you and me.

Every year at this time Joe’s team develops Vanguard’s official economic and market outlook. It’s really comprehensive. It’s a forecast that looks at economic conditions around the globe, and it explains how particular trends and probabilities influence our decisions around strategic asset allocation.

So tonight’s a chance for us to take a deep dive into his research, ask him really hard questions, and hear directly from Joe about what he sees as potential outcomes in the coming year. We’re going to talk about interest rates and what they mean for your investments, political uncertainty—none of that, is there?—and how it may impact financial markets and economies worldwide, and what to do or better yet, what not to do in response to market ups and downs. So, Joe, thanks for being here, as always.

Joe Davis: Thank you, Rebecca. Wonderful to be back.

Rebecca Katz: So as anyone who watches these webcasts regularly knows, this is your webcast. We’ve gotten a lot of questions in advance, but you can continue to send questions our way, and we’ll get to just as many as we can. Especially if you don’t understand something or you want us to dive into something a little bit more deeply, ask away. But, first, we have a question for you. So on your screen you should see our first polling question, and what we’d like to know is, “Will you continue to invest in mutual bond funds if interest rates continue to increase?” “Yes,” “No,” or “I don’t invest in mutual bond funds.” Please respond now, and we’ll have those results in just a moment.

But, Joe, it’s always great to have you in the hot seat.

Joe Davis: Thanks.

Rebecca Katz: The hotter and hotter seat every day with the market volatility.

Joe Davis: It is, it is hot.

Rebecca Katz: So I thought we would just jump right in. We have a lot of questions from people who registered, and the first one is from someone local, Lois in Malvern, Pennsylvania. And Lois says, “Are there any economic indicators that could signal that we’re entering into a bear market?” I thought maybe you could also explain kind of the relationship between economic indicators and market performance because it’s not always one to one.

Joe Davis: Sure, it’s certainly not always one to one. Thank you for the question and the introduction, Rebecca.

Just to define terms, a bear market is typically defined as the equity market—I’ll use the U.S. equity market as an example; it’s down 20% from its peak. That’s generally been associated with economic recession, so a contraction in, say, GDP and jobs and a rise in the unemployment rate. But as you mentioned, they’re not one for one. The stock market has fallen by 20% more often than we’ve had recessions. But, generally, if we have a recession that is forthcoming, the equity market typically 3 to 6 months before would drop significantly, roughly 20%. So, actually, although it’s volatile, a necessary condition of a forthcoming recession is a bear market.

What indicators we would look at to be more pessimistic on the economic environment would be some of the very signals of the financial markets themselves. You mentioned the equity market, a rise in volatility, falling stock prices. The other one is signals from the bond markets, what some refer to as the inverted yield curve. So what that effectively means is, the yield for long-term bonds, say, that mature in 10 or 20 years—that yield is actually lower than near-term bonds, say, for a money market yield. And why that’s important—if that so-called yield inverts, or the price of longer-term bonds is higher than the price of shorter-term bonds, that means investors are not only not worried about inflation—in fact, prices are expected to fall because of a weak economy—hence they’re willing to invest longer-term with their principal. And so what’s called an inverted yield curve—yields longer-term are lower than current yields, say, controlled by the Federal Reserve. That would be an inverted yield curve, and that has generally portended an economic downturn.

Now, there are parts of the bond market that are inverted but not the traditional measures. And although we’ve had a pickup in volatility, we certainly weren’t hoping for it, but we’re not surprised to see it. We, at this stage, are not forecasting a recession nor anticipating a recession, despite the choppiness we’re seeing today.

Rebecca Katz: Well, I want to come back to the poll results really quickly, but I want to talk a little bit more about the yield curve because there’s so many headlines saying, “Oop, yield curve is inverted. That means recession.” So let’s come back to that, but we did ask you whether or not you would continue to invest in bond mutual funds if interest rates continued to rise. And the results are 62.3% of our viewers said, “Yes,” they would continue to invest in bond mutual funds. Only 13.7% said, “No,” and about 24% said, “I don’t have bond mutual funds.” So does that make sense? I mean, that seems pretty optimistic that maybe people are using bond mutual funds for the right reasons?

Joe Davis: Yes, and it’s amazing how quickly sentiment can change because if you and I were sitting here in the summer, the concerns were by some investors—I would say more than market—some anticipating continued very sharp rises in U.S. interest rates, as an example, and some concerned about losses in, say, conservative bond funds.

Here we are today with the sell-off in the equity markets, and it’s actually—the one market that’s benefiting a lot is the fixed income or bond funds, high-quality in particular. And so it’s not only important to keep that in mind, but also the role that fixed income can often play.

Longer term as an investor in a fixed income fund, I actually cheer for or hope for higher interest rates, because it’s a higher income stream for me and/or for my investors. But if that comes in a short order, that’s, obviously, a concern.

But as we talked about in our outlook this year that was just published, a sharp rise in interest rates was not our primary concern. We were even more—and it’s playing out right now—there’s more risk in the equity market, just the inherent volatility, than there is in the fixed income market broadly speaking.

Rebecca Katz: Okay, well, let me ask another poll question. Then I want to talk more about fixed income.

So our second question is, “What’s your prediction for the U.S. economy in 2019?” And then we’ll get to Joe’s prediction a little bit later. We don’t want to spoil the poll here but “It will grow at a rate similar to 2018,” “It will continue to grow but at a slower rate,” and “We’ll experience a downturn in 2019.” So respond now, and I’ll come back with those results.

So, Joe, a little bit more on fixed income. We talked a bit about inverted yield curve. There were a lot of headlines saying that that was foretelling recession. So why, why not?

Joe Davis: Well I think it’s certainly consistent, at least how we look at the indicators, it’s consistent with the slowdown. I think that’s now broadly acknowledged as something we’ve been anticipating actually for some time, given the combination of fiscal and monetary policies, as well as just what we were seeing across the global economy.

Why the inversion? Again, I’m not complacent to the issue. It’s just, technically speaking, the full yield curve is not inverted. So the yield on, say, a 3-month Treasury bill—or I would say more precisely the federal funds rate, which is the short-term interest rate that the Federal Reserve controls, that is in the low 2, like 2.2% plus or minus. But the yield on a 10-year Treasury yield, which determines mortgage rates and others, that’s roughly 2.8% plus or minus. So there’s actually still a positive spread. It’s only when that broad, very short-term instrument and very long-term instrument, because that’s a 10-year difference—when those yields invert, that’s traditionally been a very powerful signal of a forthcoming recession. But we’re not there yet.

In fact, because of that dynamic, it was one of a number of reasons why we thought the Federal Reserve—it’s still viewed to this day that the Federal Reserve is unlikely to raise rates more than 2 times next year. It would still preserve the flatness of the yield curve, so it would not technically invert, and it’s a forecast we still believe.

Rebecca Katz: Okay, well, I want to hear what our viewers’ predictions are. But when we read your latest market and economic outlook, you’re not really calling for a recession.

Joe Davis: No, we’re clearly not. There are odds, there always are odds because something very unforeseen can happen, but we’ve put the probability for the global economy in large part because of the U.S., and just for context, the U.S. has been one of the few economies that has been growing above its long-run potential for 2018 and was one of our ingredients for outlook last year.

We anticipate a softening in both the United States as well as China. China’s slowdown is well underway. U.S., we should see some slowdown over the course of 2019. I think that’s what the equity market potentially may be starting to pick up now. But we can get into more, because I think there’s more that we can talk about there, but we are not calling for an outright recession.

A lot of things would have to go wrong for us to actually experience a recession, and despite the fact that we are now in the 10th year of U.S. economic expansion, which is very long—I mean it was only 2009 that we came out of the recession. Here we are in 2019; believe it or not, not all of the indicators are consistent with us being “very late stage of the cycle,” which means just because the expansion is old does not mean that we’re “due for one.” Age has actually nothing to do with it, despite it’s often commented in the media.

There are some things that are still strong and could see this expansion continue for the next several years. One would be strong consumer demand and balance sheets of households, broadly speaking. The fact that leverages in some parts of the financial system are lower and much lower than they were in 2008, the fact that monetary policy is certainly not overly tight and, if anything, it’s accommodative. And we still have a fiscal tailwind, which will wane over the course of 2019. But for a number of reasons, we don’t think a recession—certainly it’s not imminent. In fact, if I would put an odd on it right now—it would be roughly 20%–25%.

Rebecca Katz: Okay, this is probably the most optimistic I’ve seen you in a few years. In webcasts, you were always like, “Hmm.”

Joe Davis: Well, I think sentiment now is catching up with where I think is a more realistic economic environment. We are going to get growth scares, as we call them, over the course of 2019, so these nagging concerns of recession or so forth. There’s going to be a disappointing jobs market report—I can’t tell what month it will be—if we’re right with the trend, as there’s a greater tightness in the labor market. There’s going to be choppiness in some of the economic data. Some will point to trade, others may point to, “Oh, recession occurring.” So those nagging concerns will be there, and there will be turbulence ahead in 2019. That’s something that I think we have high conviction on. But at the end of the day, there would have to be a lot of things that would have to go wrong, including bad luck, that we would ultimately actually have a recession, something I certainly don’t wish for.

Rebecca Katz: Okay, well let’s see if our viewers share your perspective. So we asked you what your prediction was for the U.S. economy in 2019, and let’s take a look at the results. And I think maybe people have read your economic outlook. Sixty-two percent of our audience said it will continue to grow but at a lower rate, about 32% said we’ll experience a downturn in 2019, and only 5% suggested it would grow in a similar rate to 2018.

Joe Davis: And I think that’s a very telling, smart audience, respectfully. I mean, I think the 5% only can accelerate from here. That’s what the market is starting to—the equity market, fixed income market, is starting to—raise doubts of, if this is the peak in earnings growth for corporate America, if it’s the peak in the sort of robust hiring activity we’ve seen, then I think that the next thing markets start to see is, well, we’re going to have a sharp downturn. And, so, I think that’s one of the reasons why we’re seeing elevated volatility and some pressure on stock prices.

Rebecca Katz: Yes, that’s actually—the next question I was going to ask is from Ilene in Georgia. And she said, “What has most influenced the downturn?” How far are the markets down now in 2018?

Joe Davis: Oh, well, we’re now finally negative. Now, for the record, for 2 years we’ve had a guarded outlook. Now what does guarded mean? Guarded means we’re certainly expecting lower-than-historic returns, which have been 9% or 10%. We thought volatility was too low, and that we were going to see a rise in volatility and choppiness in markets. And we thought 2018 could be a bumpy ride. We think 2019 will be bumpier. Now we don’t forecast the percentage point and the decimal point on this. We can’t do it. No one can. But we’re not surprised, unfortunately, to see this performance. So I think we have a similar sort of expectation for 2019.

So why is all this occurring? I think we have a confluence of 3 forces, which were part of our forecast even last year. But part of this is timing, and we didn’t know when all this would come to fruition.

One was just elevated valuations in the stock market, particularly in the United States, which was the biggest ingredient for why we had a guarded outlook. So lower-than-historical returns, maybe 4% or 5%, not 10%. And in the past 10 years, it’s been north of that. That’s the biggest reason. Valuations—we’ve had very strong performance, much higher than even the earnings fundamentals of the U.S. companies. So we were due for lower returns.

Secondly is monetary policy becoming less stimulative. Part of that is appropriate, and so that is no longer a headwind. Quantitative easing is wearing off.

And then, thirdly, is just we’ve had disappointing—and our leading indicators were picking this up in various parts of the economies.

I think a fourth element, more recently, is the rise in policy uncertainty. I’d say trade, because it’s rising across multiple markets.

Rebecca Katz: We have many questions on trade.

Joe Davis: Well, if you think policy uncertainty is high in the United States, it’s much higher in China. And so I think all that is coming to bear now. I think, if anything, some of it seems a little bit overdone at this present time in the market volatility. But we’re going to have these nagging concerns, but how should I say it to “bottom line” it? This sort of environment was at some point coming because of those factors I was mentioning, and so they won’t disappear overnight. But I’m not getting—let’s put it this way: Given the headlines, I’m not getting more pessimistic in what we’re seeing.

Rebecca Katz: Volatility is what we expect and it’s here to stay.

Well, we do have a question in from Douglas, who was asking about whether the Fed will slow down its increase in interest rates. You said you expect 2 interest rate rises next year. Is that slower than expected? Do you think that they’ll have to take action, depending on what economic indicators are showing?

Joe Davis: So the Federal Reserve has raised rates 3 times this year and anticipated to raise rates next week, so that will be 4. That was our forecast. I think, as we go into 2019, our long-held view for 2 years has been they would have that plan in 2018. There were some doubts whether they would proceed in 2018. I think the labor market emboldened the Federal Reserve to continue to gradually raise rates. And we still are of the mind that they will only raise the rates twice next year.

Now the Federal Reserve believes—at least their last forecast was—they were going to do a repeat of 2018. They were going to raise rates more aggressively than we were anticipating—although still gradual—4 times next year. That would take the federal funds rate, short-term interest rate, say, a money market rate, to roughly 3.5%. We’ve long felt that, for a number of reasons, they would be hard-pressed to take rates above the high 2%, roughly 3% range. And our arithmetic in a lot of the analysis we’ve done, we still maintain that forecast.

Now the recent market volatility, the concerns have switched from is the Fed going to go 4 or more next year to are they going to go at all? We still stand by our analysis. Again, we’ve been wrong in the past. We could be wrong this year. I still think the risks are balanced, despite the volatility we’re seeing, whether or not they deviate from our 2 federal funds rate path.

Rebecca Katz: So the Fed does this in order to try to hit an inflation target. What is our prediction for inflation? We probably take more of a long-term point of view, but our viewer’s asking about our kind of near-term inflation outlook.

Joe Davis: One, I think the inflation outlook will have a lot to do with it. And one of the reasons why for a long time we have not had the Federal Reserve being more aggressive, as aggressive as the Federal Reserve themselves think, is because our inflation forecast differs a little bit from the Fed and from some other asset management companies. We do not believe that we’re going to see core inflation, which is what the central bank targets. It was below 2%. They’re aiming for 2 over the long run, and it was in the low 1% range. We thought it would cyclically rise this year. It generally followed that trajectory, and now they’re close to 2. We don’t think it’ll keep going.

Rebecca Katz: No?

Joe Davis: No. There’s a number of reasons why we think 2% is a reasonable expectation. If anything, it’ll slightly start to—

Rebecca Katz: I’m surprised because it’s a tight labor market, and you would expect that to push up prices, wages.

Joe Davis: It’s tight labor. That’s how some would characterize it. We do not believe, and I think we have evidence, analysis on our side, that just because we have increases in wages, which I hope for, for all employees—

Rebecca Katz: For all of us.

Joe Davis: —that does not necessarily at all mean that we will see a rise in the passage of prices charged companies because the alternative you can have is a slight decline in profit margins.

And I think it’s harder to generate inflation above 2% in the digital world where we still have, generally speaking, global forces at play. History will determine. If we are wrong this year and the Federal Reserve does follow through on their path to 4%, it’s because inflation went above the 2% target. But I don’t think—if anything, what we’re seeing in the market right now with the decline in oil prices, the strength of the U.S. dollar, if anything, they are modestly deflationary because they will keep down energy prices and import prices at the margin.

Now we have tariffs as an offset, but all of that washes empirically. And so wages—higher, yes, I would hope so. And I think there’s a reasonable expectation for continued modest wage growth. But that does not necessarily mean that we pay higher prices for the consumer goods that we purchase.

Rebecca Katz: Okay, thank you, Michael, in Minnesota, for that question.

Joe Davis: It’s a very good question and it is a risk to our forecast.

Rebecca Katz: Well, you used the T word, so why don’t we jump to talking a little bit about tariffs. And for those of you who are interested in world economic outlook, we will be getting to a lot of those questions as well because, obviously, it’s an interconnected global economy.

But Bob in Quincy, Illinois, says, “How do you think the tariffs will affect the economy next year?” And you talked a little bit about U.S. but also China, so maybe shed perspective on that as well.

Joe Davis: Well I mean it is and, again, everything I will say, I think this bears repeating. This is our economic assessment of what has already been enacted as well as what we anticipate is likely to be enacted from a tariff policy, both the United States as well as China. I’ll focus on those 2. This is not a judgment of the political nature of these initiatives. I’m asking, what is the economic assessment in my job?

And so we have a number of models, including the Federal Reserve’s own model to estimate what the impact of higher tariff rates do to the U.S. economy, to other economies around the world. There’s a lot of math and computers involved, but the long story short is the current tariffs that are enacted will not have a material impact, negative impact, on the U.S. economy. They will have more of a detriment to China’s economy. I think that’s one of the reasons why we’ve seen a softening in their economy. When you put all the math aside, it’s very simple. Although trade is a very important component of U.S. economy, relative to most other economies, we do not rely as much on exports and imports.

Rebecca Katz: Okay.

Joe Davis: And so the current estimates are that current tariff rates will roughly shave only 10 to 20 basis points, so 0.2% or 0.1% off a 3% growth rate on the U.S. economy. So can it offset growth? Yes. But is it recessionary? No.

Now we are assuming that some of the recent truths so to speak from President Xi and President Trump in terms of the 250 additional consumer goods that could go from 10% tariff to 25%, we actually assume, at least in our baseline for planning and our forecast, that those tariffs actually do, are enacted and go to 25%. So we’re being a little bit more, I would say—

Rebecca Katz: Conservative.

Joe Davis: —conservative in terms of our estimates.

Now one of the risks we talk about in the outlook, and actually the biggest one that keeps me up at night, is that we go beyond that and that we have another round of tariffs that are pursued on both sides, and so we have an escalation.

Now, again, buyer simulations, all else equal, just that on the economy would be a drag on both major economies and hence other economies. Now within that, there’s winners and losers. There’s some companies and sectors in the U.S. that would benefit from that and some that would, well, if I’m talking about in aggregate, it’s a modest headwind. However, the wildcard is, how do the financial markets and how does that uncertainty “transpond” to the world? So if there is any at all, with the collateral damage, that’s what we tried to assume. We assume there’s certain market volatility associated just with tensions between the two largest economic and military powers in the world. But that’s why it’s the biggest risk to our forecast.

But we’re a little bit more pessimistic going into 2019 that we’re trying to assume, and that in and of itself is not enough to derail the economy. Could it be unnerving to markets? Certainly. But it’s not enough, in and of itself, to derail the economy.

Rebecca Katz: Okay, great. And, again, if you’re interested in taking a look at Joe’s report, you can click the green and white icon on the player and pull it up and see exactly the forecast that we’re talking about.

So related to tariffs a bit, there’s a question from Dave in Minnesota, who said, “Are then the losses at GM just an anomaly or is that a sign that the labor force gains may increase in 2019?”

Joe Davis: We are expecting the job growth to continue but at a decelerated pace; and it’s not just because of less labor demand. There is what we believe is a labor supply issue, which means even today there are actually more job openings in the United States than there are unemployed Americans.

Rebecca Katz: Wow!

Joe Davis: I mean more than unemployed Americans. And, unfortunately, not all of those job openings match those that are unemployed. And so when I say labor supply constraints, there’s increased reports of having difficulty finding workers, although I think at a certain wage rate, you can find them. So that’s one of the reasons why we expect a slowdown in the labor market.

I would view some of those reports as idiosyncratic at certain companies. But I don’t think we’re going to continue to see the robust job gains that we have seen over the past 2 or 3 years. I mean the unemployment rate is 3.7% and likely headed slightly lower.

Rebecca Katz: Right, wow!

There’s one credit I will give to our global team because we thought—in part because of this labor supply, part of it’s demographics, retirement, slower population growth, as well as continued need for labor, you know, new jobs—we thought that we would not necessarily have an acceleration in GDP growth, yet we would have a continued tightness in the labor market. And that’s the irony we had—is that we have not had accelerating growth for the past 10 years, I mean relative to the 4% or 5% GDP growth. And yet here we are at an employment rate that’s below 4%. I think that if we told that to most of us, myself included, 10 years ago, I would have laughed, but here we are.

Rebecca Katz: Wow. So we did have a question from Robert in Alabama, who did say, “What is your prediction for U.S. GDP growth?” So we talked about it slowing, but what does that look like?

Joe Davis: We have roughly 2.5%, so it’s below the 3%. And as you go throughout 2018, those numbers definitely approach the actual 2%, which is what we estimate trend growth in the U.S. economy to be. So it will weaken. Now what it will actually transpire—there will be some volatility around it. We also expected the sort of job growth we’ve been experiencing—roughly 200,000 jobs per month the first Friday of every month when it’s announced. We will cut those numbers in half by the end of the year. So that’s why we talk about growth scares because we’ll be closer to what some would deem as like zero. And so these nagging concerns, ultimately, I think they will be misplaced, but then we will have concerns of recession scares or growth scares at times because we’re entering a lower trend growth in 2019.

Rebecca Katz: So how does that compare with other places in the world?

Joe Davis: Well, the U.S. is—actually, relative to the trend or what is sustainable for an economy, the U.S. economy has been and we still expect to be actually one of the brightest spots in the global economy. China is growing, as best we can estimate, roughly 5%. It’s reported at 6; they’re growing at 5.

Rebecca Katz: Wow, it was 10 a few years ago.

Joe Davis: Oh, yes, our leading indicator. For the economics community, it was expected to grow roughly 6% to 6.5% this year. It’s part of the plan to slow down and get less on state-owned enterprises, more into the private sector. But they’ve seen a material slowdown in the consumer demand. I think some of that is related to the trade tensions, but some of that is, I think, just China also trying to get more aggressive and tighten certain policy to shrink some imbalances they’ve had in credit provisioning. So some of that is a positive initiative, but they’re seeing growth weaker than expected.

Europe has been a mixed bag. Britain has been weak, and they will weaken further because of concerns around Brexit. Europe is mixed. Japan is modest. Emerging markets is also a mixed bag. There are areas that are under significant duress like Turkey and for part of this year Brazil and Russia, but there are other areas, such as India, which have had some decent performance, so country by country. But when you hear all that, the U.S. has been one of the shining stars.

I think it’s a testament to the resiliency of the U.S. economy, also the rapidity of the response of the Federal Reserve and a number of other factors. But a lot of it is a testament to the private sector.

Rebecca Katz: Now the one thing we often talk about is the relationship between global economics and global market performance. And your team has done a lot of research to show that just because a country—India, for example—is growing faster than other areas in the world, it doesn’t necessarily mean their stock market is going to outperform others.

And we do have a question in from Robert, who says, “Looking toward 2019” —based on everything you’ve said—“should we tend to invest more in U.S. companies and less in international companies, especially in light of economics and the trade policy?” But, again, it’s not always one or the other, right?

Joe Davis: No, not at all, because what matters is the economic performance. What also matters is what the market is discounting in the future and, effectively, what I call what price has been already paid in the stock market for that growth.

So a great example is, in the past 10 years China has had much stronger economic growth rate than the United States. Guess what stock market’s done handsomely better?

Rebecca Katz: The U.S., I would guess.

Joe Davis: U.S. It’s because of valuation going in and the price paid by investors. So, in fact, we are projecting over the next 5 years for the international—non-U.S. markets—equity markets to outperform the U.S. markets. And a lot of that is because of the valuations.

Now what happens quarter to quarter in year to year, we’re certainly not good enough, smart enough; the signals aren’t good enough. I don’t think we will ever have in this world, to tell you what year that will happen, but you give us 5 or 10 years, I have high confidence that projection will be right because the further out we look, the better so-called predictability or accuracy we have. And so, personally, that’s why I continue to rebalance portfolios and have been doing it over the past 2 years outside of the United States. It’s not because I don’t have a high opinion of U.S. companies. I do. It’s because performance has been so strong and the valuations have been expecting even further great conditions that—and conversely outside the U.S., emerging markets in particular, which have underperformed handsomely—that I think disciplined investors, if they can execute, which is what we do in some of our funds, is we rebalance them periodically.

And so, yes, we are expecting so much stronger returns outside the U.S. than we are inside the U.S. It’s primarily due to valuations. It has nothing to do with the absolute expected growth rates of India or U.S. or China. We look beyond that and look at the valuations or the price paid in those stock markets.

Rebecca Katz: For those companies. Great! Another testament to the power of diversification.

Our next question is from Charles, and he’s reflecting, he’s in Missouri reflecting I think what a lot of us feel. “We continue to hear the economy’s doing great. However, my stock portfolios have lost more than all of the year’s gains in the last two months. So where is the disconnect?” We’ve talked about that a little bit, but is there any solace for investors who are experiencing this market volatility?

Joe Davis: Yes, I’m feeling it as well. I was on my account today.

Rebecca Katz: Don’t look.

Joe Davis: I know, but you have to look once a year at least. So, what am I going to say?

This sort of environment was coming. I won’t say this is typical, but when you look over the course of 2018, this is, unfortunately, some of the payback for the very low volatility we had throughout part of the summer and certainly for parts of 2017, 2016. If anything, the anomaly’s been why has volatility been so low given some of the uncertainty in the financial markets and policy globally?

And so why it seems like a disconnect? Part of it is timing. So in the short run, economic surprises can move markets positively. So, for example, if a jobs market report comes out—“stronger-than-expected jobs market”—generally speaking, the stock market will rise that day, although not always because the stock market may say, “Well, the Federal Reserve has to be much more aggressive in raising rates.”

Longer term on the stock market tends to then lead the economy. Again, not perfectly, because the stock market can overreact because there’s a deal of sentiment and emotion to it.

So I’m trying to answer the question. It is complicated. There is both a response from the economy to the stock market, and there’s also a leading, longer-term signal of the stock market, because it’s trying to discount future economic performance of companies and what actually transpires in the economy. And because you have that short-term surprise and this longer-term expectation, those 2 signals can feel that they’re crossed. And I think that’s precisely where we sit today—of both strong corporate fundamentals but perhaps weakening a bit. And then you have concerns, “Whoa, that weakening, does it go like that?” And that market is trying to, in real time, trying to say, “Was this a fair price?” And some days it’s gone up and some days it’s gone down, trying to estimate it as best as it can.

And just because the stock market is efficient, which it is, it does not mean it’s accurate. And so, now, I’m not saying I have a better forecast, per se, than the stock market. It’s just saying that when you go through bouts of volatility, you can get overreaction—under- and overreaction—as the market is trying to discount what is the future for the economy. So I think we’re going to have periods of this in 2019 if our forecast is right.

Rebecca Katz: As long as uncertainty exists, we’ll have volatility.

Joe Davis: Well, we always do, but it’s the rapid change of it at times.

Rebecca Katz: All right, well we have quite a number of questions also coming in. We did have a question, and someone submitted this in advance as well: “How accurate were your forecasts for 2018?” So when we look at making forecasts, traditionally, your group makes long-term forecasts with a degree, a band, of possible results. So how do you measure whether or not your forecasts are accurate?

Joe Davis: So we have a good discipline of forecasting. I’m proud of our framework, so we do not—we certainly don’t provide a 1-year-ahead stock market forecast, like a number with a decimal point. I mean, I think that shows no humility at all.

Our job is to portray the distribution of risk and to be very clear what we think the most likely outcome is. But we’re also trying to convey the risk, and for the financial markets, we will at least look out 5 years and beyond.

Now, we have 1-year-ahead forecasts. We just have a wide band around them. There’s just not that much predictability to them. But we spend a lot of time looking for the best-in-class, the state of the art in terms of economic forecasting, academic studies. We had a whole team looking at this.

I can tell you based upon all that and our framework—in part because our return forecast, we look out a little bit beyond just the next day and the next quarter—that, I think, we’ve calibrated our forecast horizon to where I think we have something to say, and that’s generally been a positive for those that have read the outlook.

So do we have a perfect track record? No, far from it. We’ve generally been, though—I think we’ve got pretty good marks in terms of our forecasts for the financial markets over the past 5 or 10 years, because this time 10 years ago we were one of the very few firms saying our economic outlook is pretty somber. It’s going to be a very slow recovery, and there’s a lot of pain in the labor market globally. But our economic forecast was like this, but our investment forecast, if anything, was for above average. And some investors respectfully pushed back on that, but it was the valuations there were discounting even worse economic environment.

I say that for context. Every year since then, in the past 2 years, we’ve had a more guarded outlook. Now we were too conservative last year, but we’re looking at longer term. Now I think we’re seeing some of that underperformance play out. So I’d say our forecasts, our track record for the financial markets, stocks and bonds, have been pretty good. Our forecast track record for inflation has been pretty good. We have said that inflation was going to be hard-pressed to go beyond this 2% range.

Now what have we done less well? I think we’ve had, at best, an average forecast assessment in near-term, economic-like growth. I think we’ve said, “Listen, China’s not going to have a hard landing. The U.S., the past several years, we’ve had growth scares. Well we’re not going to have a recession.” But did we get the GDP forecast exactly right? No. I mean sometimes we go in the year saying, “It’s going to be closer to 3%.” It was at best 2%. So we’ve had to downgrade some of our growth forecasts for Europe and the U.S. and at times for China. But I think we’ve gotten the big-picture things right, but we have not got what we call the wiggles in the data. And we won’t get them going forward, but I think we’ve framed the argument and the context right, and we’ve gotten the big picture, generally speaking, pretty good.

Rebecca Katz: Well, you know, this means now I have to put you on the spot with the next question, which is from Joseph in Connecticut, who says, “So what is a realistic rate of return for the financial markets over the next decade?” Say for a balanced portfolio, for example.

Joe Davis: Balanced portfolio. So let’s just say, just for sake of argument, you had a 60% stocks diversified portfolio and 40% fixed income. So if you’re taxable, it could be munis or if you’re in a retirement plan, it could be more of a corporate total bond market index. Our expectations there for the next 5 years are roughly 4% to 4.5% for that portfolio. That’s the average. Who knows what the pattern will be along that. It’s below historical averages for bonds, but our forecast is close to what’s your current yield to maturity. If you go into, that’s not always the case, but it was the case this past year and it is the case going forward that the state of maturity, the yield to mature in that portfolio is, loosely speaking, for conservative funds, our expected return. That’s not what we do and how we model it, but that’s how the math works out.

On the equity side, it’s below historical averages. It’s below what the trailing 5-year returns are generally speaking for most, certainly for U.S. investments.

For overseas, emerging markets, certainly for Europe and Asia, we’re projecting higher returns than what have been for the past 3 or 4 years. When you net that all together, you get a modest return that’s above inflation, roughly 4% or 4.5%.

If you ask me what am I assuming personally, Joe Davis from Malvern, Pennsylvania? That is the numbers. That’s the central tendency. And then planning around that. So that’s what all that says.

Rebecca Katz: It’s interesting, though, because if cash is yielding 2.5% or 3% if interest rates rise and then you have a 4% balanced portfolio, cash is not a bad return.

Joe Davis: That is. It’s a lower expected return environment. Ironically, the only thing that will lead us to markedly higher expected returns is actually a bear market because the market will sell off, but it will start to discount a future rate now.

So do I wish for a bear market?

Rebecca Katz: No.

Joe Davis: Certainly not, but I’m just telling you what will have to transpire.

Rebecca Katz: We’ll take slower growth.

Joe Davis: So my parents may be watching tonight, and they may be trying to generate 5% from their portfolio over time. Mom and Dad, I mean, there’s no Magic 8 Ball. You either can take more risk, if one is willing to do it, to eke out a higher return. It’s more equity volatility, unfortunately. Or it is spend less, or save more. I mean they’re the 3 variables that one can choose to pull in some combination. I wish I had better news, but we talked about this time last year, Rebecca, it was going to be more of a patient environment and one that was going to be a little bit frustrating because we’re not going to have the returns that we have had over the past several years.

Rebecca Katz: Right, so control the things in your control.

Joe Davis: It’s getting a little bit better for fixed income. So I’m not here to spin. If we want one solace of positive news, for the first time in 10 years since we’ve been doing this outlook—the first time—our 10-year projected returns did not become lower. Actually, they tweaked up modestly positive, previous year.

Rebecca Katz: For fixed—

Joe Davis: No, for the whole portfolio.

Rebecca Katz: Oh, okay.

Joe Davis: Because we’ve been consistently downgrading our forecast because valuations and the performance in the market’s been strong, and they’ve been ahead of the fundamentals slightly over the past 4 or 5 years, that’s why we got more guarded and more guarded but not bearish. The first time this year we did not downgrade—our computer models did not downgrade the forecast for the next 10 years. So although we see unpredictability ahead and volatility picking up, we are not getting more alarmist or more bearish in our longer-term forecast.

Rebecca Katz: That’s, again, the most optimistic I can get from you sometimes, Joe. That’s great.

We have so many questions. Here is a big one, and we’ve had quite a number of questions on this. This one’s from Charles. He says, “How does the national debt figure into all of this? Is this the big elephant in the room?” So let’s talk deficits.

Joe Davis: Well, it’s a big issue. I may have said before to some of the listeners, longer term it’s one of the seminal economic, social investment, political issues the United States will have to deal with. At the same time, and this year is what it has been the past 8 years, it is not in the top 3 lists of the near-term risks or concerns I have. That does not in any way say I’m complacent on the issue. I’m just saying, does debt matter for the interest rates we pay on our debt and is it something we’ll have to take control over very long term? Yes. But it is not something that is necessarily going to lead to a market rise in yields or interest rates, because there’s a number of other factors that can influence interest rates.

And so we went into this year saying long-term interest rates, roughly 3%, was fair value. We’re here to this day saying 3% is fair value, plus or minus, and despite the increase in long-term debt because there’s other forces that influence bond prices. And so I’m talking about the bond market. There’s a longer-term issue with respect to financial sustainability.

Why I’m less concerned about the financial markets punishing the fact that we have high debt levels is because there’s not a true alternative viable reserve currency in the world. That means that we have to pay a higher price, higher yield for the high levels of debt because debt in and of itself does not necessarily mean that you have to pay much higher interest rates. Japan is a great example. They have the highest debt levels in the world, and they have interest rates close to zero.

So I hope I’m not characterized as being complacent on our debt. It’s just I don’t think the financial markets, at least in the next year or 2, will demand a higher interest because of our high federal debt levels.

Rebecca Katz: Well, you’ve always said that when countries or investors around the world look to buy bonds, they look both at the country’s debt levels but also at their willingness to repay that debt.

Joe Davis: Yes. And safety and liquidity in the market.

Rebecca Katz: And we are seen as very willing to repay the debt.

Joe Davis: We’re still the best in the deepest financial market. And even today with the underperformance of the equity market, there was U.S. Treasuries rising in price and yields falling, a testament to global safety and store value. So should we have in some future point a euro bond? And if Europe would get more fiscal unity or if China’s capital markets open up like they say they will more so in the future, and China’s bond market, which is the third largest in the world, but would be accessible to all investors around the world, maybe someday you have investors saying, “You know what? I need to have a higher interest rate to invest in U.S. Treasury bonds because of the high debt levels.”

But until we have those conditions—

Rebecca Katz: A substitution, yes.

Joe Davis: Or we have runaway inflation, but, again, that’s the same issue. If we’re going to have runaway inflation, that means the value of the U.S. dollar has fallen dramatically. So usually fiscal crisis go hand in hand with currency crisis. Argentina experienced that this year. So emerging markets tend to get into it.

A developed market can face this. I mean, there was a whiff of this in 2011 with Europe. And I hope that we’re preemptive as a nation and get ahead of those dynamics, but if we’re waiting for that to have a large imprint on the financial markets, I just think in 2019 it would be premature to expect that.

Rebecca Katz: Well, you brought up Europe, and certainly, I think everyone was expecting originally tomorrow a vote in the U.K. on Brexit, which has now been postponed. But we do have a question in from Diana. And she says, “How much is Brexit influencing the market’s volatility? And if it does go through, how will it affect U.S. economy?” And I would say, “How would it affect world economies?”

Joe Davis: Well, primarily, so Brexit and what’s in store for Britain and how they leave the European Union, if they leave. Our assessment has been what we will call the more dramatic risk.

So the general consensus was there’s going to be what’s called a soft Brexit. So Brexit, Britain will retain part of the customs union, part of the financial integration with Europe, but they will leave on other fronts. We have been of the mind as a global team that other more drastic outcomes were more possible than the financial markets were anticipating. What’s called either, which came out today and I think is of greater risk was what’s called a hard Brexit. So Britain just leaves without that sort of transition period. That could be disruptive for, I think, Britain as well as Europe’s financial markets. If it hurts the U.S. economy, the primary channel will be through market volatility, which means underperformance in the equity market and tightening the financial conditions.

We’ve worried about that. We’ve had a 25% to 30% risk assessment there. We also think there’s also a risk that Brexit never happens, that there may be a second referendum. To be honest, we read as much as everyone else because we do not have a unique insight on some of the geopolitical, some of the political realm, but we have risk in terms of our assessment. We always look at scenarios. And in our judgment, what we call the tail risk, hard Brexit or no Brexit at all, have been more significant potential outcomes than the sort of less chaotic outcome of the soft Brexit. So I still think that’s what ultimately will transpire as the most likely outcome, but we thought that the deadline would go potentially past through March.

Rebecca Katz: March, right?

Joe Davis: Yes. So we’re not through it yet.

Rebecca Katz: Yes. You might just spend a second. I don’t know how many of our viewers actually know that we have people on your team, both investment strategists and economists, across the globe.

Joe Davis: Yes, in the Investment Management Group, which we’re just one part of, a whole team in London. It’s a really deep team. And I think we’ve benefited at Vanguard—the global depth of the team, different perspective. I think it has made me, I like to think, a better economist. We have economics teams in Asia, in Europe, and in North America, so we benefit, I think, from that global depth and perspectives. And, in fact, it’s been Peter Westaway and his team in London who’ve actually been stressing that these sort of tail outcomes are greater than the financial markets were anticipating. And that’s something that we reflect internally even in our active fixed income strategies in the same way that Qian, who’s in California but is our chief Asia economist, has a deep insight on China’s economy. And that has aided, I think, even our U.S. investors in terms of the insights; we’re able to glean an assessment of risk for the U.S. and global financial markets. So we benefit from that global perspective.

Rebecca Katz: That’s great. Well, more questions. Speaking of Peter, who did come out of a European central bank, Michael in San Rafael, California, says, “How will international markets be impacted if European central banks pull back on their quantitative easing programs in 2019?” So you talked a little bit about what was going on in the U.S. and sort of coming out of quantitative easing, but not so much in Europe?

Joe Davis: Well, we think that there will be—in fact, it’ll start this month—there’ll be a retracement of some of the quantitative tightening as it’s called, which means the size of the absolute balance sheet of the ECB that’ll start to winnow and bend. And we think that’ll occur in a gradual fashion in the same way it’s occurred in the U.S.

Rebecca Katz: And these were measures they put in place after the global financial crisis.

Joe Davis: Yes, the financial crisis. Yes. Now I think within that we may see a more willingness to take greater exposure to certain issues of debt within the periphery but remains to be seen. But the ECB will be more guarded in terms of them raising rates.

Right now we have it—estimate that their first interest rate hike won’t be until this time next year. So the U.S.—we’ve long thought, loosely speaking, that Europe was roughly 3 years behind the U.S. economic cycle. And so if you think of the timeline of the United States where we start to raise rates, particularly in late 2015, early 2016, and the tightening of the balance sheet, that’s where we get the 2018/2019. It was more complicated than that, but loosely speaking, that’s generally—we still are of that view.

Rebecca Katz: Great. Let’s take a more practical question. Michael in Villa Park, California, says, “Should changes in the markets prompt me to change my asset allocation in bonds and stocks or international versus domestic?” So you’ve just given us kind of a broad brush of what we might expect. Should we be doing anything different as investors?

Joe Davis: Well, I’ll tell you what I do, because we don’t want to provide advice with counseling.

Rebecca Katz: Yes. But, Joe, you—

Joe Davis: I know. No, no. I’ll tell you what I do, and I always follow 3 steps. So I’m willing to take on risk in my portfolio. But what I do if, say, in days of market volatility, I’ll always ask 3 questions. One is, What is a reasonable range of expected returns on this investment? Right? And align that to my goal. That’s where our outlook can be perhaps of most value, because we provide those long-run return expectations that anyone can see; and then it’s their discretion to use them, and we use them at Vanguard as the ingredients for our teams across the company.

Secondly, the second question is, What is my view of the risk in the marketplace? So I’ll pick on something, let’s call it the U.S. Fed. So I have my view; I articulate it. The Fed has their view, the bond market has their view, I have my view.

Now here’s the most important and the third question. The most important and third question is, What has the market already priced in? Because for years some would say, “Well the Federal Reserve is raising rates. Should I be out of fixed income?” I say, “Well, just respectfully, the bond market is already expecting the Federal Reserve to raise rates. Do you expect them to be more aggressive or less aggressive than is already anticipated?” And I think with that third question, what I try to do, is to assess the response to my second question versus my third question because is my ability and my assessment of risk. Do I believe that’s more in line or more realistic than the financial markets’ assessment of risk?

If I answer yes to all 3 questions, then at times I have made changes to the portfolio. There are a handful of times I’ve answered yes in the affirmative to all 3 questions, but that’s generally the calculus I work through. That’s generally what I urge family and friends and Vanguard investors to do.

Generally, I do not find a large deviation between the response to the second question than the third, but at times I do, and that’s when I may rebalance my portfolio more actively to align my portfolio to that risk assessment.

Rebecca Katz: Great.

Joe Davis: I don’t know if that’s helpful to the viewers, but that’s generally the framework.

Rebecca Katz: That’s definitely an approach.

Joe Davis: I see 1 talked about a lot in the financial press. I see 2 talked a lot about in the press, but rarely is there a syncing up of, say, a reporter’s view or an economist’s view with what the market is pricing in. And that’s where we’re trying to do a better job of in our outlook publication. The readers will determine if we get that really right, but we’re trying to bring out our risk assessment with the financial market assessment.

Rebecca Katz: And importantly, so for many of us that might sound a little daunting because we’re not economists, we’re not professional investors or maybe not even all that tuned in. But importantly, the research that your team does, and these outlooks are used in our Personal Advisor Services by all of our CFP [professionals] that support Vanguard advice. And so for those of us who would actually rather have someone else manage our money and do the rebalancing and think through these things, the work that your team does, does feed into what we use both in our investment portfolios and our advice portfolios.

Joe Davis: Yes.

Rebecca Katz: We have just a couple minutes left. We have a question in on Facebook where we are broadcasting live. So if you’re on Facebook, if you could send us some hearts, that would be appreciated. The question from Facebook, “What are your thoughts on the housing market for 2019?” So let’s go back to the U.S. and focus on U.S. housing market. And just 15 seconds.

Joe Davis: Strong but not stellar. I think actually the housing market is a good characterization of the U.S. economy right now. There’s some supply constraints that is leading to somewhat weaker growth, but much like the equity market, the performance of the housing market has been on a tear for the past 6 or 7 years. And the same way we talked about, until recently, elevated U.S. equity valuations, housing affordability has fallen because of the rapid rise in housing prices.

Rebecca Katz: Prices.

Joe Davis: But I would not see a material downturn in the U.S. housing market. For that to occur, that means we’re talking about a recession, which is not our forecast.

Rebecca Katz: Okay. Great. Well, Joe, unfortunately, this hour just flew by, but we’re out of time. I do want to give you an opportunity to leave our viewers with one last thought, kind of key takeaway from tonight.

Joe Davis: Well, I think it’s had a somber tone to it.

Rebecca Katz: But you’re an economist!

Joe Davis: I know, dismal signs. It’s not all that somber. I think we’re doing a fair job of characterizing what are reasonable expectations for the next several years. We remain guarded on the markets, but we are not being alarmist here.

I think the market recently is now only waking up to, I think, more realistic assessment. So I do not anticipate that some of the deterioration we’ve seen in the past 6 weeks in the stock market and in the volatility in, say, the high-yield market and so forth, that they continue at the same pace. So I think what I’m doing, me personally, is sticking to my plan, because our longer-run assessment of the global economy of the financial markets has not changed. I think just now that that forecast is now coming into the horizon.

And so I think sticking to the plan and also being realistic that I think we’re going to have these bumps. The volatility in 2019 will be of the same level as we had in the second half of 2018. But that can also create opportunities too. But for those investors that this is too much, I think that’s just maybe telling something that just would be, I think, more conservative regardless of the environment.

For me, when we have environments like this at the margin, me, my personal risk appetite is to actually take on a little bit more risk. But right now we’re sticking to the plan.

Rebecca Katz: Okay, sounds good. As you say in your economic outlook, “Down but not out.”

Joe Davis: Down but not out.

Rebecca Katz: So I don’t think that that’s too somber. Joe, thank you so much for spending the hour with us.

Joe Davis: Thanks, Rebecca.

Rebecca Katz: We always really appreciate your insights.

And thanks to you, members of the Vanguard community, for joining us tonight. If we could have just a few more seconds of your time, you should see a red survey widget on your screen. You can tell us what you liked, what you didn’t like, what else we should be broadcasting in future webcasts.

And in a few weeks, as always, we will send you an email with a replay of this broadcast and a transcript for your easy reading.

And be sure to check out our new podcast series. Remember that green widget, that green icon that you can click, The Planner and the Geek. It’s featuring Vanguard’s own Maria Bruno and Joel Dickson. It’s hilarious, actually. You wouldn’t think finance could be funny, but Joel and Maria are characters. So please check out The Planner and the Geek. To listen to the most recent episode, click that green button.

So continue the conversation with us on Facebook. I mentioned we’re on Facebook. You could watch this live, but you can also send us some comments, or on Twitter by going to @vanguard_group.

So on behalf of Joe and all of us here at Vanguard, in Malvern, we really appreciate you spending a piece of your evening with us, and we hope to see you next time. Thanks.


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