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Rebecca Katz
Rebecca Katz

Rebecca Katz: Well, good evening and welcome to this live Vanguard webcast. I’m Rebecca Katz, and oh, my goodness, where did the year go? We are here tonight to talk about 2017, and 2016 just went by in a blink of an eye. Well, with continuing uncertainty and transition here in the U.S. and abroad, we thought that now might be a good time to take a pulse check on the global economy.

So, over the next hour we will discuss the prospects for growth, where the Fed may head, and how the financial markets may react. Now, I will say, we asked you for your questions upfront and the majority of them were about President-elect Trump and his possible policy changes in his administration, and while we don’t want to speculate, we will try to answer some of that using some good historical context.

So, luckily, joining me, here in studio, is Vanguard’s very own Global Chief Economist, Joe Davis, who is going to ground us in facts and figures tonight, right?

Joe Davis: Yes, that is the goal. That is the goal. Great to be here Rebecca. 

Rebecca Katz: Thank you for being here. So, as you know, with all of these webcasts it’s really about answering your questions, which you can send on through to us while we’re talking. Many of you sent questions in advance as I mentioned; we’ll take many of those as well. Two quick housekeeping items: On your screen you should see a couple little icons, little widgets, and on the left-hand side there is a yellow one. If you have any technical problems, click on that and someone will be there, standing by, ready to help you. And, if you’d like to read up on any of Vanguard’s thought leadership including the brand-new, hot-off-the-presses, Vanguard Market and Economic Outlook, which Joe’s group produces, you can click on the little resource widget, which is green, and that is on the right side of the player. We hope you’ll check that out and download those resources.

Now, Joe, before we take a pulse check on the global economy, why don’t we take a pulse check of our viewers with a quick poll?

Joe Davis: Sounds fantastic.

Rebecca Katz: So, on your screen you should see our first polling question, and what we’d like to know, and we asked you this last year if you were tuning in, so we’re going to compare notes, is which of the following best describes your outlook for the U.S. economy? Are you optimistic, are you pessimistic, or are you uncertain? So, vote now. We’ll have all those responses in just a second, and we’ll do a little comparison to a year ago today.

So Joe, why don’t we jump right in. We’ve got a list of great questions here sent in by our viewers and why don’t we just tackle the elephant in the room?

Joe Davis: Okay, sure.

Rebecca Katz: So, our first question is from James in California, who says, “What effect will Donald Trump’s presidency have on the equity and the bond markets?”

Joe Davis
Joe Davis

Joe Davis: Well, you know, we clearly have already seen a very strong reaction by the financial markets globally, Rebecca. Just for context, you know the past— The past two weeks we’ve seen stock markets, at least in the U.S., rise very strongly. Interest rates have risen as well and commodity prices globally have rebounded from the recent lows. So, I think the one thing that it is important to note is, interest rates in our mind, long-term interest rates, say a Treasury yield, which is the underlying force for, say, mortgage rates. They were, if anything, somewhat below where we thought they should be given the economic fundamentals globally, and that’s with some headwinds we can talk about tonight.

And so, I think there was almost too much pessimism in the global economy. Since the election, in my view, we’ve seen some of that just unravel. I think we’re now more towards fair value for long-term interest rates. So yes, interest rates have risen roughly half a percentage point over the past month, which is a really strong response, but I think in context, it’s just unraveling some of that overdue— Undue pessimism that was out there.

Rebecca Katz: I was surprised— I don’t know if we’ll get a question about Italy today and the news out of Italy, I really thought waking up this morning the markets would react negatively.

Joe Davis: I did too.

Rebecca Katz: And actually, the markets had another strong day.

Joe Davis: At 4 a.m. and you see the headlines, and I don’t know if part of this is the markets have become a little desensitized to some of the political challenges, and this is— The headlines we’re seeing in Italy, I think, are not the last headlines we will see with respect to some of, you know, what some call the populism moments. But, it’s really these tensions which we can talk about; I know some of your viewers had questions, because I think it’s important to understand we’re not going to talk about politics for politics’ sake. It’s important to place, in our judgment, what is the context and what are some of the economic forces that are driving, some of which we may see in the political sphere. I think that’s important, because diagnose that, one has a greater sense of the potential market implications.

Rebecca Katz: Right, and you and I have talked and you had some really interesting observations to share. So, why don’t we take a look and see how our audience is feeling today. We asked whether or not they were positive, negative, or uncertain about the U.S. economy, and let’s see the results. So, actually a fairly optimistic crowd. We have 38.7% of people responding that they’re optimistic, 10.9% say they’re pessimistic, and 50% say they are uncertain, and that’s actually fairly in line with last year.

Joe Davis: Really?

Rebecca Katz: So, considering we had a year of a lot of volatility, a big political election, people’s minds have not changed much.

Joe Davis: Yes, yes. Well, you know, I think it’s important— I think, actually, you know, if you asked me that question I’d be mixed on it. We’ve been generally formative or somewhat positive on the financial markets, because you know, Rebecca, our viewers could even download past outlooks. We’ve been a little guarded, we’re not bearish on the financial markets, but a little bit guarded just given particularly the overseas headwinds and fragility in some of the global economy. But you can point pictures, in terms of the economy, both optimism and pessimism, depend upon certain metrics you look at, you know.

So, the level of growth is below historical standards, but the labor market is tightening, which is good for all, and that’s globally, that’s just not the United States. But yet, you have things with respect to wage growth, particularly in certain income cohorts which has lagged historical averages. So, that’s on the pessimistic side.

So, I think dependent upon what area of the country you may sit in or what industry you’re in, I think you get different— You get these different feelings, but the financial markets— It’s tough to argue that the financial markets are pessimistic when you look at the past few years.

Rebecca Katz: Well, based in the short run. So, why don’t we ask our viewers another question. You touched on interest rates just a moment ago and again, we asked this last year, we’d like to know which of the following would be your most likely response to an interest rate increase by the Fed? Would it be you’d decrease your bond allocations, you would take action and decrease your bond allocation, increase your bond allocation, or make no changes to your portfolio’s allocations? So, respond now and we’ll be back to share those in a moment too and see if you’ve changed your opinion since a year ago.

So, why don’t we jump back to some more of our viewer questions? You know you said there’s optimism and pessimism in the economy, Eden in New Jersey says, “Well-respected economists are saying that the U.S. is headed for a recession in 2017. What is your view on this?”

Joe Davis: I think those odds are low. I mean, initial conditions matter. I think the U.S. economy is going to enter 2017 on decent footing. The service sector is in fairly strong shape, labor market, you know, the unemployment rate is well below 5%, and we continue to add jobs at a fairly consistent basis, Rebecca. That’s not to say, you know, there isn’t a risk of recession, but it would have to be a very significant shock for the U.S. to fall into a recession at this point.

I think, if anything, I think our central tendency for the U.S. growth next year is somewhat better than what it was for 2016, marginal improvement. Now the tail risk so-called, the dispersion around those estimates have increased on both the upside as well as the downside in part, because you know, some of the question mark with respect to fiscal policy of the United States and overseas. So the so-called, what economists will call tail risks, or the distribution of outcomes has widened, but generally speaking it’s a little bit more positive going into 2017 than at this time last year.

Rebecca Katz: What are some of the things that you would be looking at that could tip us into recession or have stronger growth than expected?

Joe Davis: Well, let’s look at the positive first. I mean, we tend to always focus on the negative. I think on positives— I mean, I think already, just to set benchmarks, the U.S. economy has been growing roughly 2% over the past five or six years. Historically, it was between 3% and 4%, so below historic and that’s not news to many of the viewers. You know, I would have said the U.S. economy had decent odds of going 2.5%, perhaps even closer to 3%, that’s before some of the discussions of more significant fiscal policy, which in our mind, was somewhat lacking over the past several years.

So, I don’t think what we may see on the policy front will change markedly the 2017 outlook, but I think at the margin, whether through corporate tax reform or potentially modest infrastructure spending, you could lift some of those numbers. But again, whether or not the economy remains strong this year, that can be so much for policy. I think it’s gotten actually, a little too much attention. I think, you look at the private sector which is roughly 90% of the economy, it’s performing decently and there’s greater confidence. Consumer confidence, business confidence, it’s actually by some measures as high as the late ’90s and 2003, 2004.

So again, it’s not to say that we don’t have some challenges, but modestly continued to deliver progress over the past seven years, so here’s where we are. So, I think that’s good and that’s on the positive. So, I think for the first time, in 10 years, global growth expectations during the course of 2017 will not be downgraded, because they have consistently come in weaker than expected. I mean, for the first time in a long time, we’re seeing them more balanced, so that in itself is good news.

Now on the negatives, you know, I think some— You know, I think our three biggest areas we focus on is China and the prospects for a hard landing meaning their housing market really deteriorates, capital outflows, and that incites global financial panic. We don’t place very high odds on them in the near term 2017, 2018, that’s one.

Secondly, would be Europe. I think we will continue to have lingering doubts around just the sanctity of the European Union. We still believe the euro will remain intact as a currency in the European Union, but that will continue to be tested because they are not fully out of the woods. We saw the Italian headlines today; we will see occurring election headlines in 2017, whether it’s from France or Germany.

And then finally, in the U.S., the one thing that I think is the biggest wild card in our forecast, and to be fair, I think most economists in the financial markets, at least right now, are looking beyond and that is the uncertainty with respect to trade policy. Which, if it became very protectionistic, would actually I think, be very deleterious for the markets and from a policy perspective that could both reduce growth expectations and raise the threat of higher inflation. That would not be a good mix. That is not our baseline either, but there are the three negative risks that we are most closely monitoring: trade policy, Europe, and then China.

Rebecca Katz: Okay. Well, certainly we’ll keep an eye on all three of those. Why don’t we talk about interest rates in just a second? We have the polling results back in; we asked if the Fed were to raise rates, what would you do with your bond portfolio allocation, and we know it’s a Vanguard webcast because 73% of viewers said they wouldn’t do anything, they would stay the course just like Mr. Bogle instructs. Only about 15% said they would decrease their bond allocation, and an equivalent amount also said they’d increase their bond allocation. Any surprise there?

Joe Davis: No. I mean, I think the other thing too is I’m very proud to be a Vanguard investor and a Vanguard employee and I think all of us, we can share that the one concern we’ve had Rebecca— I remember, you and I talking about this two or three years ago, our biggest concern was an environment where interest rates don’t rise at all because of the environment that would speak to with respect to the threat of falling prices, very weak growth, even weaker than we’ve currently had, and just increased pessimism in the global economy marketplace. So, the fact that we are continuing to talk about the pace with which the Federal Reserve will likely raise rates both in this month, or next week, and then in 2017 again, at the end of the day is one of confidence in the global economy. I think it’s also a benefit to savers who have continued to shoulder some of the burden of near-zero interest rates.

Rebecca Katz: We did have a question from Brian in Palm Springs who asked, “Do you expect many interest rate rises over the coming year?”

Joe Davis: So, we’ll look at it within distribution outcomes, but I’m not— We’re not apologetic to say, and what we said last year was, I think the U.S. economy is of sufficient strength and vigor that it no longer warrants interest rates below 1%, short-term interest rates. So, we’re very likely to see the Federal Reserve raise the target rate next week. That would raise into the 50, 75th basis points, so still below 1%. And I think it’s a higher hurdle for the Federal Reserve to not raise interest rates to at least 1% by the middle of 2017. So, potentially once a quarter.

I think they’ll be hard-pressed to raise rates markedly stronger than that because of overseas conditions and the potential that that could lead to increased appreciation of the U.S. dollar, which at the margin would slow down both growth and inflation in the U.S. I think there’s a limit, but again, the Federal Reserve has a strong case to make to raise rates.

Rebecca Katz: Great. We have a question just in, and this is from Mark. So, shifting gears from bonds to stocks a little bit, Mark says, “PE ratios are very high,” so price earnings ratios, which is a measure of sort of the value of a stock. “How is this going to work out? Are future earnings going to justify these or is the market going to move sideways for the next couple of years?”

Joe Davis: It’s another fair question. You know, I think— Again, so I think going into this year we’ve had the more muted or lower expected, you know, central tendency for stock returns both U.S. as well as overseas, we’ve had since 2006. Now, that sounds alarming because we know what happened 2007, 2008. We’re not alarmed, but I think mid-single digits is where— We’re on the order of 5% or 6% over the next couple of years, which is well below the historical rate of 8% or 9%, and well below what we’ve had the past five years, you know, it’s double digits.

Rebecca Katz: Is this just the math because it’s been so high for such a long time? It’s such an astonishing bull run.

Joe Davis: It’s not, it’s part— Because the gentleman’s question is around the valuation, so just because the equity market has been strong does not necessarily mean you’d have lower expected returns. It depends—price is relative to earnings and the fundamentals of corporations. They’re not as based upon our analysis, and some of that is actually in the outlook that you referred to, Rebecca. It’s not as— The equity market is not as overvalued as some of the metrics which adjust, and in part because you have to adjust for the low-interest-rate environment we have. But, when you do that, you still come to the arithmetic of mid-single digits. So again, it’s a more guarded outlook.

It’s very unlikely however, that we’re going to see the returns that we’ve seen over the past six or seven years. I mean, again, this is one of the strongest equity bull markets in the U.S., in U.S. history, which again, one of our cornerstones from several years ago is we can have a challenging economic environment, but we can have a strong investment one. So, I’m very proud of the analysis that we as a firm did, because— And our listeners for staying the course through that because they’ve been rewarded in their portfolio.

Rebecca Katz: Actually, my very next question I was going to ask you about this, because Paul in Irving, Texas, says, “Do you continue to see minimal correlation between the performance of the economy and the performance of the financial market?”

Joe Davis: Yes. Particularly over longer-term horizons, yes, both across countries and in one country over time. I mean day-to-day, if the jobs report comes in and it’s stronger than expected, you tend to see, you know, the stock market rise a little bit, but even then it’s weak. So, in the short term there can be some modest correlation, but yes, over one year, three, or five years— I mean, just look at China. China has been slowing down, you know, the past decade and yet some of their strongest equity market returns have come in years when their economy has been below expectations.

So, it wouldn’t surprise me at all, we could have an environment where the equity market doesn’t do as well in 2017 as this year and yet the economy did a little bit better than expected.

Rebecca Katz: Okay. Interesting. Let’s talk about volatility for a moment. So, we’ve talked about correlation here, but Greg in Cardiff, California, says, “Do you see potential volatility in the stock market on the rise for 2017 compared with your forecast of a year ago?” So, lower returns but more volatility, or less?

Joe Davis: I think higher. I think we’re at a very— I mean, one of my bigger concerns is— This is not for investors, this is for the investment markets, they’re somewhat complacent so even early this morning with the news out of Italy and the equity markets, stock markets up very strongly. I think— Let’s put it this way, the equity markets is increasingly pricing in a very rosy scenario for growth and for the global economy. Again, we haven’t been as pessimistic as some, which have been proven wrong, those pessimists have been proven wrong, but I’m also a little concerned you have a backdrop of elevated valuations and low volatility. That’s usually not a good recipe.

So, I just think it’s hey, eyes wide open, let’s be a little cautious here. I think we’re going to have, in a Federal Reserve that’s modestly raising rates, political uncertainty overseas, we’re still going to have some— I think it’s just natural to have greater volatility in the marketplace. I think we’re going to have that in 2017. That would be my base case, higher than we had this year.

Rebecca Katz: We need to turn off our TVs and not watch the market reports.

Joe Davis: That tends to help.

Rebecca Katz: Okay. Our next question is from Tom in Gilbert, Arizona, and Tom is asking, “Why is economic growth so slow?” So, you’ve painted a good story about economic growth, albeit slow, but why has it really slowed down? Why haven’t we seen—

Joe Davis: That’s a great— Again, these are all fantastic questions. You know, three reasons. One is, and this is a positive, which I think is lost on many including policy makers and certainly economists in my profession, and that is part of the past growth that we had in the 1980s, 1990s, much which I was familiar with of 3% or 4% growth, GDP growth as an example, that was boosted up or elevated— Boosted up, I would say artificially by ever-increasing rise in consumer debt and housing debt.

That’s part of the reason why the recession in 2008 and 2009 was so deep. If we had lived hypothetically in a world without the rise up in leverage, growth would have been closer to 2.5%. So, if we’ve been growing at 2% or 2.5% the past seven years, it doesn’t look as weak a recovery as many paint. In part, because we have the wrong benchmarks from before.

Now that said, there’s other ones. I mean, clearly over the past 50 years, population growth has been slowing so all else equal, lower population growth, lower absolute growth rates, which in and of itself is not bad. Then the third one, is one where the economists are struggling most, and if anyone can answer that, there’s a big personal prize, a potential Nobel Prize, and that is why productivity growth is so low. So, even when you adjust for the leverage and you throw that away, and you adjust for slower population growth, you still have a fact that output per person has been growing barely above zero, so-called productivity growth, which is how our standards of living go up.

I think part of that is a cyclical phenomenon. It’s tough to square that with the high rates of innovation, technological disruption we see, but that’s still— I think there’s some mismeasurement, but even with that, even myself, we focus largely on research, and even we are scratching our head to some extent. That’s I’d say a third of it is explained population, a third is leverage, and then the third is kind of like question mark, to be determined. I think it will ultimately improve because we have been here at least ten points in long-term history, but that’s the wild card in this.

You know, if we’re right and the productivity growth is as low as some fear, then that would say that it’s, you know, inflation is a little bit greater risk and stagflation a little bit greater risk than some currently place. But I’m not ready to make that argument.

Rebecca Katz: Well, we’re going to come back to the theme of technology in a minute, because you had some really interesting observations around that. Another question just in, Gene Max asks, “In view of the fact that China owns about a third of the Treasury debt, how would that affect the U.S. economy assuming they decide to dump our debt, or would they?” So, you talked about a hard landing, if China, global uncertainty, China needs to do something.

Joe Davis: Sure. I think I’m hard-pressed to see a scenario where that would— It could happen, but where it would happen. I mean, there’s a symbiotic relationship at the end of the day. I mean, at a very high level, China doesn’t have a freely floating currency, and one of the ways that it’s managed is a large purchase of U.S. Treasury securities. I think if— If you would just paint a very pessimistic scenario, well, for whatever reason China sold it en masse, I think there would be— And I think the past five years have shown this, there would be a long list of buyers of U.S. Treasury debt.

That does not mean interest rates cannot rise, but I think if anything, what the past few years have shown is at the end of the day our economic fundamentals combined with the other overseas risk makes U.S. Treasuries a very viable store of value in U.S. currency. So, you know, there could be a blip, if you would even paint that. I mean, the estimates are that they’ve helped reduce interest rates perhaps 50 or even 100 basis points. But, that doesn’t happen in a vacuum. If interest rates magically rose another 50 to 100 basis points, I think there’s a long list of pensions, long-term investors, and other active investors that would be looking at U.S. Treasuries relative to near-zero interest rates in Japan, and Germany, and elsewhere that would say wow, we’ve already seen in the equity market, it’s actually a compelling investment, so at some point. That would clearly be a very volatile environment, it’s something I think China would have actually a difficult time trying to exercise given how they’re trying to manage their currency.

Rebecca Katz: Okay, great. Let’s— Why don’t we pivot a little bit to Europe since we started to touch on overseas. We keep referring to this, the headlines in Italy today, which are basically that the prime minister is set to resign, and we know that there have been elections, or pending elections in France and in Germany; we had Brexit earlier this year. How do all of these affect market dynamics in the rest of the world, and this is a question from Carling.

Joe Davis: Well, I mean, you know, theoretically how it should work is if there’s a greater uncertainty after an election regardless of where you reside, that would say all else equal, that’s a headwind for the markets and for growth. Markets, they don’t like uncertainty. Uncertainty tends to stall business investment or consumer spending for a time until, you and I know, what’s going to happen and if you’re a small business, or any business manager, you may say, “I’m going to hold off.” Historically, that has been at the margin a depressant for growth.

But, you know, I think there’s a broader— I’ll get to some of this now, Rebecca, all those events that you say, there’s a common thread throughout all of them, and I know globalization is taking it on the chin, but let me say two things.

If globalization is the root cause of all of these events, then you would expect, say, manufacturing jobs, I mean, I’m just going to call a spade a spade from an economic analysis, you expect manufacturing jobs to be rising in many countries and falling in the United States. The fact is, they’ve fallen in every developed market in the world.

So, the biggest reason for the job losses, or I would say for the efficiency gains, has been technology. That explains, by academic studies, roughly 85% of the job losses, or I should put it this way, of the lack of job growth in manufacturing globally is due to greater efficiency gains. In fact, manufacturing is probably the most efficient and productive sector of the global economy, which is why output has doubled over the past five years even though job growth has been flat.

So, I wouldn’t expect to see a rapid rise in manufacturing jobs employment in part because of the technology that is at work. And I think in computerized digital technology, we’re going to see some of these—It’s both a tail wind, because that means higher standards of living because of higher productivity growth, but it does mean that, you know, if one is hoping for a very strong rapid rise in employment in the manufacturing sector, I don’t think given the analysis, I don’t think we’re going to see a rapid increase to what we saw, say, 20 or 30 years ago to the level that we’re at.

Rebecca Katz: Right, it’s different types of jobs. The robots come in, and the jobs shift.

Joe Davis: Well, let’s also be fair, some of the jobs that have— Not all, so I’m— I have to be careful here, I’m trying not to— It’s a very politically charged topic. But I can tell you, some of the jobs globally that have been lost, not all, but some of them are actually, you know, they weren’t the most high-paying and most productive. Actually, some of the— I would argue the manufacturing industry in the United States is actually the most productive sector of the U.S. economy. It’s the strongest. That’s why it tends to not add as many jobs as other sectors, because it is so efficient with technology, machinery, and so forth, robotics.

And so, there’s other— The U.S. is still probably the most productive of all the manufacturing countries of the world. China is not nearly as productive or efficient, which is why at the margin they have tended to add jobs, because they’re not as efficient and productive.

Rebecca Katz: Right. They need bodies to actually do that.

Joe Davis: Their wages are lower. Now again, where that equilibrium or that fair point is, how one defines fair, probably every single viewer on this webcast has a different definition of fair, but there is a technological backdrop to the trends that we are seeing, which means, you know, we’ll tend to see more of these headwinds politically over the next few years. But, there’s a lot in this. It’s not globalization as if some country is losing and all these other countries are winning.

Actually, you know, there’s efficiency gains which is good for global economy, but to say that jobs have gone away here and they’ve sprouted everywhere else is actually not in the data. The manufacturing share of the economy has fallen in many industrialized countries.

Rebecca Katz: This is why I said you’re going to keep us rooted in fact and figures.

Joe Davis: Well, Germany, Japan, France, Italy—

Joe Davis: It keeps going down, so.

Rebecca Katz: Alright. We have another question just in, kind of a follow-up to our interest rate discussion and our poll. Mike said, “Since Joe just told us interest rates are likely to go up, it would seem that this is the classic time to decrease your bond allocations,” even though our viewers said they weren’t going to do that. “What’s the reason for not decreasing your bond allocations?” So, you might want to explain the inverse relation between bonds and interest rates in case anybody doesn’t know.

Joe Davis: Well, yes, if all else is equal, you tend to have interest rates rising and bond prices falling, right, and for a time you can have lower negative return. I think two things, one is the standard sort of rule of thumb, shortcut if you will, is if your investment horizon is beyond or extends beyond, or is longer than the duration or average interest rate exposure of your portfolio. So, if someone has an intermediate-term bond fund, generic bond fund, let’s say the duration is five years, so if you have an investment horizon beyond five years you’d say, “Hey, I’m indifferent; in fact I would welcome interest rate increases.”

There’s also a nuance with respect to the Fed tightening. I think we will very likely see in the next— At least through early 2017, the Federal Reserve should, or I would anticipate when they raise rates, it will not necessarily mean a rise in long-term interest rates. So dependent upon what bond fund an individual is in, is important. And, one of the reasons why a central bank raises short-term interest rates is, in fact, to preserve, you know, keep inflation expectations stable, right, and to make sure long-term interest rates don’t rise too much, which is tied to corporate borrowing, mortgage rates, and so forth.

So, we’ve had long-term interest rates rise before short-term rates. So, one of the— What’s called a flattening of the curve, but that’s a technical term. When any central bank raises rates, sometimes you can have it so long-term interest rates don’t rise much at all. It’s just a nuance where you say, “Hey, is it time to get out of bond funds,” or so forth. The market is already anticipating, with 100% probability actually, the Federal Reserve is going to raise interest rates next week. So, you could have an environment where the Federal Reserve is raising short-term interest rates and bond prices for long -term bond securities are actually rising and interest rates falling at the margin. That’s one of the reasons why a central bank will often raise rates, is to preserve long-term interest rates, because that’s a stimulative for growth.

Rebecca Katz: So, basically the advice is don’t try to time the markets?

Joe Davis: Interest rates are challenging. I think for some investors, if they’re really— You know, if they’re concerned about it, I mean again, this is not, you know, again, this is not considered counsel, it’s just food for thought, you know, many of Vanguard’s bond funds are actively managed. The portfolio management team, which I work closely with, I’m not a portfolio manager but I work closely with them, they think about these sort of things every single day, and they’re really sharp. So, that’s another solace and something to think about, right? And the other thing is not to get too cute to time it.

I think if one’s going to even go down that path, Rebecca, one would at least want to know what is the financial market or bond market already anticipating for interest rate rise? They are now starting to anticipate at least one move, not only next week, but then the following in 2017. So, to say that the market— The Fed is going to raise rates, hence I would get out of bonds, well, not so quick, if they don’t go as fast as the bond market is expecting, interest rates would fall and bond prices would rise across the interest rate curve.

Rebecca Katz: So, just stick to our asset allocations. Turning back to kind of U.S. policy and again, this is another one where I don’t want it to get too political, but we have two questions. One is from Chris in Ardmore, Pennsylvania, up the street here, and he asks, or potentially she asks, “What is your assessment of the impact of decreased U.S. participation in global trade deals and higher trade tariffs on U.S. and global economic growth and equities?” And then, a question just in was similar, “How would unraveling NAFTA impact the market short-term?” So, if we put up trade barriers, how does that impact the U.S. markets, global markets potentially?

Joe Davis: Yes, that’s I think clearly one of the big wild cards, so it’s understandable the questions. I think it is— I think it’s fair to say, and there’s widespread economic agreement, that not only if we’ve had an increase in trade amongst various nations of the global economy over the past 50, 60 years, that the margin, that’s generally raised economic growth. And so, if you would have— The question is, is trade as a percentage of the global economy, does that kind of go into decline; I would actually hope not.

I think that if we saw a marked rise in protectionism, so tariffs across the board, you could expect a retaliatory strike by other economies. It could potentially hurt some other economies more so than the U.S.. The U.S., although we’re exposed to a global economy, we’re not nearly as much so as say our trading partners, Canada or Mexico, right. Their trade with the U.S. is much higher than our trade with either of them. But it would be what I would call a debt-weight loss, which means you would have modestly higher inflation domestically.

I mean, trade has probably lowered consumer prices; if you said an average basket throughout the year they spent $1,000 on consumer goods, that would probably be well north of $1,100 or $1,200 if you went back to the trade levels we had 50 years ago. So, it tends to lower prices. That’s not to say everyone makes out equally to that and that’s where I think some of this divide is and tension is.

But, I think, you know, to— For policy makers to look at, you know, the various trade policies, that actually happens with some regularity. So, I— If it’s— If they’re small and they’re targeted, or negotiated bilaterally, I’m not as concerned as if there was a very large increase in tariffs across the board.

The last time we saw that, was in the 1930s, and although that may not have been the primary catalyst or contributor to the Great Depression, that certainly did not help economic growth prospects, with the Smoot-Hawley Tariffs. So, you know, although it would seem like, hey, we would become insular and so we would trade with each other, there would be certain corporations that clearly would have to cut spending plans and investment plans, because many of their partners are overseas.

In fact, roughly 50% of earnings in the S&P 500, so the largest companies in the United States, their revenues are derived overseas. I think also it seems that a loss and a debate though, despite all the discussion with it, I don’t— I think it’s harder said than done if one really wanted to close, you know, some of the economy to trade. Supply chains, whether you manufacture a car, or you trade computer software or make computers, those global supply chains are more integrated than they ever have been in just-in-time inventory delivery. I think it would be very hard to actually do that and so, that’s different than where it would have been 20 or 30 years ago. So, although we may see, you know, industry by industry increased both focus as well as discussions with respect to bilateral trade agreements.

Rebecca Katz: That’s incredible. We’re looking at new cars, and you can see the laundry list of where all the parts came from.

Joe Davis: Oh, hundreds— There’s thousands of parts from hundreds of countries. There’s thousands of parts from hundreds of countries, and many of them have one or two suppliers for each part. So, the other thing that would happen— One of the first things you would see is not only the financial markets potentially sell off, you would also have disruptions in even U.S. activity until you could work that out. We saw a little bit of this, unfortunately, a very unfortunate event, the earthquake in Japan and so you saw certain industries whether it’s from tires to computer chips, you know, production was really disrupted globally because the key components were made by certain Japanese suppliers. So, there’s really this increasingly intertwined that I don’t think is fully appreciated.

Rebecca Katz: Okay, great. Well, turning back to the U.S., we have a question just in from Jerry, and Jerry says, “How could we hope to service the growing federal debt with such a low GDP?” So low growth, growing debt, and concerns about it? We’ve talked about that in the past.

Joe Davis: We have talked about debt in the past and it’s funny, Rebecca, you and I’ve talked, it was probably 2010, 2011 and we said at the time, it was one of the— It still is one of the seminal issues, certainly I’d say of our generation, right, so our age, of all our generation. I mean, the debt, if you were bull enough to look out 50 or 60 years from now it’s concerning. Debt-to-GDP right now is not alarmingly high, you know, it’s roughly 80% to 90% debt-to-GDP depending upon the metric you use, but it will rise, you know, over a longer period of time in large part because of Social Security, Medicare, and Medicaid. That’s just arithmetic.

You can go on the Congressional Budget Office, the CBO, which is a nonpartisan group, which generates all the budget statistics, you know, to look at the data. Again, I think the bond market has given this issue a pass and I think will continue to do so for the next two or three years until there’s an alternative viable currency and bond market that can rival the U.S. dollar and U.S. Treasuries. But, I hope we can use that time to at least— If we’re— I’ve long hoped for an environment where you could do short-term fiscal stimulus, but you would pair that with making sure that that doesn’t rise. It’s called revenue neutral, but longer-term, very longer -term, doesn’t, you know, contribute significantly to long-term debt prospect.

We’ll see, because that could very well occur. I think it may not be getting a lot of discussion right now, but as we get into 2017, I would imagine it would.

Rebecca Katz: Right, and I think we have to see what policies—

Joe Davis: Oh yes, but again, that will be a good policy discussion.

Rebecca Katz: Great. It’s hard to believe we’re about halfway through but not nearly halfway through the questions. We’re going to keep going. You know, turning back to the question we had on reducing bond allocations, we have a question from Patrick, who says, “Is there any reason to change my allocation to international equities based on the recent political or central bank events?”

Joe Davis: When a change, you know, is again it’s loose guidance, you know, we’ve always said to investors that first of all they should have certainly exposure to international stocks, international equities, over and above whatever exposure U.S. stocks have to overseas markets, right. The so-called, you know, diversification benefit particularly accrues in the 20% to 40% range. So, if you have 20% or 40% of your equity allocation, stock allocation, say in an international fund, or ETF, or so forth, that’s a good diversification benefit and we’ve seen that, even this year.

Emerging markets in the U.S. up and other parts overseas weak, so it’s been that, that sort of diversification and I would see that as a good starting point going forward. You know, I think at the margin we’ve seen some investors, at least aggregate dollar, go more to U.S. markets than overseas. So, I think it would be good, you know, a good dedicated investment strategy at the minimum is rebalancing. So, if you look at the past five years, U.S. equity markets have strongly outperformed—

Rebecca Katz: International.

Joe Davis: —Internationally. So, if you haven’t looked at it, it may be time as you go into the beginning of the year to look at that allocation and is it the balance you want. I would be cautious in not making too strong of changes, based upon, you know, what one is seeing in the headlines. U.S. markets are a little bit more expensive on a valuation perspective than the other markets, but you could also make the argument that part of that is justified given some of the sort of pressure points we see overseas in emerging markets and in Europe. But I think you still want to maintain overseas exposure.

Rebecca Katz: Great. Well, why don’t we talk about a little bit more about emerging and developing markets? Andre in Salt Lake City wants to know what your outlook is for emerging markets? You just said that stocks were strong there; how were we thinking about both the economic outlook and the financial market outlook?

Joe Davis: Yes, well, you know, the economic outlook, you know, we articulated in last year’s outlook as well, Rebecca, we were a little bit more pessimistic on the economic front for emerging markets than I think many economists were. I think our general view was proven correct. The consensus was that the emerging markets were going to rebound strongly this year, the Brazils, Argentinas, the Chinas, and so forth.

Rebecca Katz: Their economies?

Joe Davis: Their economies, because commodity prices were going to rebound and so— We’ve diagnosed the reasons why growth was low is part because of what we call structural or longer-term issues. If there’s been an area of the world whose debt, private corporate debt, has risen markedly or strongly over the past several years and missed the window on our mind of reordering their economy better, it was the emerging markets, broadly speaking, and so, we remain guarded on the economic front.

On the financial front, it’s a little bit better, in part because the markets have been, or at least until recently, even more pessimistic than the economic growth environments. So, we’ve had disappointments across the board in some of the economies and a lot of political challenges and so, I think that gets back to what you and I were talking about at the beginning there. You know, the emerging markets are probably the most disappointing area of the global economy this year. They were also one of the strongest performers on the equity market and so I think part of that will go into next year.

So again, for every challenge they have, they tend to underperform. When the Federal Reserve is raising rates modestly, growth is still modestly on the downside with respect to emerging market economy, but the equity markets are trying to already anticipate that and price that in. So, you know, when we’ve talked before about international allocation, I certainly would— It would be unfair to say we are pessimistic with respect to the emerging market equities or fixed income for that matter.

Rebecca Katz: How is China doing? You said we don’t expect a hard landing, but their growth has slowed from sort of double-digit growth.

Joe Davis: Remember, this time last year, we were having a violent reaction in the global financial markets and that was coming out with news and concerns that China was drastically slowing much more than expected, and then of course, those fears subsided. But there was a strong fear that China was going for a hard landing, which means instead of growth of 6% or 7% GDP, they were going to drop perhaps as low as 3% or 4%, which is really low. We did not share those concerns based upon analysis we did, so as we sit here today, they are likely growing more slowly than their official growth statistics of 6%.

We have proprietary indicators, for two years they have been showing growth numbers, they’re estimates, of roughly 5%. So, not a recession, not a hard landing. I think this is kind of to be expected from China. I think what we anticipate the next two years is when Chinese growth disappoints, every six months, we view them as in fighting and retreat mode, and we talk a little bit about this in the outlook, we will see some stimulus, fiscal and otherwise, that there will then kind of— Housing—

Rebecca Katz: Boost it back up.

Joe Davis: —Housing stimulus that will boost it back up, and so you’ll oscillate between roughly 5% and 6% in the official statistics. So, we’re not as bearish as some on China’s economy for the next two or three years. Longer-term, we have more concerns and if they drag their feet, if China drags their feet in opening their financial system to global capital markets, if they drag their feet on restructuring some of their private state-owned enterprises, and if they do not, you know, let their currency more freely float, then I think— We’re more pessimistic relative to consensus longer-term for China. I think they could care today, but there’s a non de minimis risk, and we talk about it in our outlook, that they face, at least the risk, that they become a little bit more like Japan and really slow down.

So, China, if they have a risk, it’s their fear of short-term economic growth weakness and their fear of letting market sources take more of an impact on their economy.

Rebecca Katz: Okay, great. Speaking of economy, they do affect currencies, and so we have a question just in from Robert who asks, “What are your thoughts on currency movements against the dollar and how these changes might influence decisions on non-U.S. investments?” So, this one might bear a little explanation, especially if you’re a U.S. investor in an international mutual fund, certainly, you feel the changes in currency.

Joe Davis: So, for those viewers— Okay, I’m a U.S. investor, right, I have over— I have international equity holdings. So all else equal, if the U.S. dollar, you know, weakens, right, and that value of overseas investments can be boosted, right, and vice versa. So, the value of the currency of the U.S. dollar can influence overseas, overseas investments. I know there’s a lot of focus on the U.S. dollar, it’s risen very strongly over the past two years. I think we’re starting to wade in on the territory— I think 2017 could very well be the case where we see a slowdown in the rate of appreciation in the U.S. dollar.

Why I say that, Rebecca, is not because the Federal Reserve may not raise rates. I think it’s in large part because one, some of those expectations are already expected by the currency markets. Secondly, there’s a limit with which the U.S. dollar can continue to rise. So, if the U.S. dollar will continue to strengthen very quickly and very strongly, I think another 5% would just be a sign of U.S. economic growth, which wouldn’t forestall any further rise. But you start to generate another 10% or 20% rise in the U.S. dollar, that will start to crimp, you know, U.S. export activity, other, you know, the operations of some U.S. products sold overseas. That would then lower growth expectations, which would undo the very reasons why the U.S. dollar is rising in the first place.

So I think there’s a ceiling with respect to where the U.S. dollar can rise. We were coming from very low levels. We’ve risen strongly and the U.S. economy has weathered that, but I think we’re starting to wade in the territory where, you know, I think one of the wild cards could be in 2017 is even in an environment where the Federal Reserve is modestly raising rates, you don’t see actually a sharp rise in the U.S. dollar.

Rebecca Katz: Well, it seems every time there is a headline in Europe, you know the dollar—

Joe Davis: Well, and there’s a flight to quality and so what happens, U.S. Treasury bond prices rise, and the value of our currency rises in times of stress and I don’t see that dynamic changing in the near term.

Rebecca Katz: Okay, great. Let’s touch on a little bit of what I think a lot of people are hearing. Actually, in speaking with you, I feel a little bit more calm than I did before this webcast, but Ira in Bethesda, Maryland, says that he’s really newly fearful of the social and political environment, and he wonders if this environment should on its face influence how somebody diversifies their portfolio? So, we talked about changes to international and that we would believe that you should still have an international exposure, but are there things that people should be thinking about doing if they are concerned about the next few years, or longer-term? We have a lot of uncertainty; we don’t know what policy changes will happen.

Joe Davis: Yes, well I think, you know, you go back to— If everyone has their statement, or you wait till the year end and you get your statement, or you can go on vanguard.com and look at your account, so what is your broad allocation? Everyone can pull up that pie chart, right, and so you look at the pie chart and you say— Personally, so this is not advice, this is not counsel or guidance. I’d say, what does that pie chart look like? What did that look like three years ago? Now, look at it today and you say two things, one, is that pie chart today, is that consistent with where I’m thinking I need my portfolio to go? Is it— Am I saving a down payment, is it for long-term retirement, is it retirement in the next three years? That horizon really does matter.

You know, the shorter the horizon the more conservative the investments. Also, the higher the pie should be in cash and fixed income and smaller the pie into equity. But again, that’s just rough rules of thumb. Our website has a great deal of tools and commentary on that.

And then secondly, I’d say relative to three years ago is that for some investors the natural tendency is to not make changes to the portfolio, which is good, but there is— I would argue there is greater risk in the equity markets today than either the fixed income markets or the equity markets in a long time, in terms of investor portfolios, because the equity market, the stock market, has gone up so strongly.

So, it could very well— If someone was to have say, just hypothetically, 60/40 a portfolio in, say, 2010, so here we are, a long six years later, you could easily be north of 80% equities, 20% fixed income. Now, that may be consciously what one is doing, but that is a much more aggressive portfolio, which may be consistent with someone’s goals, but again, that’s a more aggressive and naturally more volatile, expected more volatile portfolio. So, I think that’s the sort of logic one wants to get to, anddid you feel comfortable with that.

Then I think these are questions I can’t answer for someone, perhaps a personal advisor could answer, or if they’re doing it themselves say is this something— And with their tools there, if this portfolio is down 10% or 20%, can I weather that. If one is so sick to one’s stomach then one can’t, then I think you have to look at that pie chart regardless of what the headlines are saying. But, we do have what we think are reasonable central tendencies for expected returns in that document to help investors if they’re trying to map their goals with that pie chart, their allocations, to kind of make the two, because expected returns for broad asset classes, for all investments are generally lower today than they were five years ago.

Rebecca Katz: It all goes back to your goals. your risk tolerance, your asset allocation.

Joe Davis: You save more, you spend less, that tends to not get one on TV saying that, but we don’t apologize for it, right. But then some may not have flexibility with that. The only other third avenue is to take greater risk. There’s no free lunch there, but those first two are very powerful. The third one is more eyes-wide-open if one’s going to do it.

Rebecca Katz: We only have time for a couple more questions. We are actually getting a lot of questions about the market economic outlook, which as I mentioned in the beginning, we have a little resource widget, it’s the green widget on your screen, and I believe it is the first or second link there. The first link under the resources page, you can download that and read it. It’s a pretty hefty document.

Joe Davis: Yes, it’s not light bedtime reading. Then for someone who had to write it?

Rebecca Katz: Unless you have insomnia. No, I’m just kidding, Joe. Just kidding, Joe. But, I think after hearing the discussion today, it will make a lot of sense, so please take a look at that. Here’s a question, it is uncertain times, it’s new times for many of us. Steve in Southampton, Pennsylvania, asks, “What can Vanguard do to advocate for our clients during these uncertain times?” Are there things that we are doing to ensure our clients’ best interests are represented as we go forward into 2017?

Joe Davis: Well, yes, on a number of fronts. First, it’s just where we continue to lower the all-in cost of investing globally. I was just in London two weeks ago and you see the Vanguard operations there and providing ETFs and mutual funds to investors in Europe; in Canada in the same way we’re doing it in the U.S. So, that in itself, that is our flywheel, right, Bill McNabb has talked about, right, lower the cost for all of you as shareholders, that’s job one.

And then, you know, what investors may not see behind the scenes, with our government relations team, the conversations Ann Combs and her peers have with policy makers. Our portfolio managers talk with policy makers, with market makers, to make sure markets are functioning, in our view, on everything from certain policies to trade organizations with the investment companies to the ICI.

So, I’m very proud of an organization that put shareholder investors certainly first, but so much so that, you know, the investment management group, and Ann Combs’s group, and other groups at Vanguard spend a lot of time speaking with policy makers or with individuals, you know, to make sure that our perspective is heard and so that is something that investors may not see when you go to a website. But rest assured, Vanguard is a strong voice increasingly globally with respect to these issues.

Rebecca Katz: Well, we represent 20 million clients and almost $4 trillion in assets, so luckily the folks down in Washington tend to want to hear from us.

Joe Davis: It’s Washington, it’s New York, and increasingly it’s overseas. So, it’s Vanguard weighing in on a number of topics.

Rebecca Katz: Alright. Joe, it’s really hard, I think we have time for about one question and then I do want to get your final thoughts. You know, one of the things we did not touch on today at all were commodities. We always get a ton of questions on commodities, including Chiffon in Texas, who asked about oil.

Joe Davis: Oil, yes.

Rebecca Katz: No surprise there. But, I mean, do you have kind of a brief outlook on what we think will happen with commodities over the coming year?

Joe Davis: I mean, our best estimate is that they’re pretty much flat over the next several years. I mean, if you look at the oil market, there’s still roughly, you know, significant excess supply in the global commodities sphere. And for commodities broadly, so whether we’re talking copper prices, or steel, or so forth, we’ve come off the nadir, which was really low through 2016, by the best estimates, and you know, we research as well through some of our own, I’d be shocked if we see a marked further rise in commodity prices which are already, I think, reflecting some potential global, at the margin, more fiscal stimulus in infrastructure.

The reason why they wouldn’t rise materially further is, I think one of the biggest reasons is, you know, until we see, you know, some of the significant rebalancing of the Chinese economy there is— You know, China accounts for a large percentage of the global excess capacity in the commodities, broad— Really not oil, but everything else and so until we see that, what I call take it out of the system, we still have excess capacity there. So, I think we’re— Unless we’ve fallen into a global recession, it’s unlikely we’ll revisit the lows we saw in 2016 at large.

But I think sort of whatever prices are today, kind of a flat bias is our operating assumption for 2017. And to be fair, anything plus or minus 10% of that doesn’t materially change the economic environment. You have to really push it outside of that for that to matter.

Rebecca Katz: Great. Well, Joe, it’s been an hour. It went like that.

Joe Davis: It does go quick.

Rebecca Katz: So, we’ll have to have you back to talk some more, but I wanted to give you the opportunity for any closing thoughts and key takeaways.

Joe Davis: Well, key takeaways, you know, one is a thank you to investors, you know, not only the trust that you all place in Vanguard, but I— And again, I just speak from the heart, I think Vanguard investors, the more I interact with, you know, both overseas as well as here, I think Vanguard investors take the lead in terms of demonstrating what it means to be a long-term investor.

You see it in the cash flows and the behavior of Vanguard investors for the broad financial community, which incorporates everyone and to be able to look through that noise, it’s not easy. It doesn’t mean one doesn’t make changes to their portfolio, but it’s more deliberate, it’s thought through, one’s situation may change, but just to stick to that discipline.

I would say that the investment environment for the next five years is going to be more challenging for us than the previous five, which is ironic because we’ve been through a lot of fun stuff, Rebecca, right, the past five years economically. It’s because of just the more muted return outlook and so, even if the economy doesn’t have some challenges as it did four or five years ago globally, the investment environment is going to require more patience than less. You can say in hindsight, but in 2010, unless one bailed on the financial markets, one has been rewarded very handsomely, which has been fantastic. And so, I think going forward, it’s just going to be a little more challenging, and stick to the knitting.

I’m not a very patient person, so it’s a little bit more frustrating for me. So I think, as long as we have that set, and we talk more on it in the outlook, but a little bit more challenging but it doesn’t mean withdrawal from the markets. I think you have to look through it, but just stick to that plan. It’s going to require that dedication the next five years.

Rebecca Katz: I think that is, I will dare say, great advice for our investors. So, Joe, thank you so much for being with us tonight.

Joe Davis: Thank you, Rebecca.

Rebecca Katz: Thanks to all of you for sharing a little bit of your evening with us tonight. Now, a couple more things if we can have just a few seconds of your time. In a few weeks we’ll send you an email with a link to highlights of this broadcast and a transcript for your reading pleasure, and if you look at your video player, there is a red survey widget at the bottom of your screen. Please tell us what did you like about our talk here tonight, what could we do better in the future. So, from all of us here in Valley Forge to all of you at home, we don’t have any more webcasts for this year, so we wish you and your family a really lovely holiday season and a happy and healthy new year. Thanks.

Important information

All investing is subject to risk, including the possible loss of the money you invest.

Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

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