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Rebecca Katz: Hi. I’m Rebecca Katz, and you’re watching a replay of a recent live webcast on Vanguard’s 2018 market and economic outlook. We hope you enjoy it.

Rebecca Katz: Well good evening and welcome to this live Vanguard webcast. I’m Rebecca Katz. I have to tell you, this is my favorite time of year, not because we have holidays and presents right around the corner, because this is the time of year I get the best present of all. I get to sit down with Vanguard’s Global Chief Economist and talk about the market and economic outlook for the coming year, for 2018.

During tonight’s webcast, we’re going to cover the global economy, the financial markets, what they might hold in the coming year, and the employment picture, especially here in the U.S.

And joining me tonight is none other than Joe Davis, Vanguard’s Global Chief Economist. Joe, thanks for being here.

Joe Davis: Oh, thank you, Rebecca. Always great to be together.

Rebecca Katz: So as you know, if you’re a regular viewer of these webcasts, this is all about you and your questions. Many of you sent questions in when you registered, and you can continue to send questions to us using the video player that you’re watching on right now. We’ll get to just as many as we can.

Also, a note about that video player. You’ll see a few little icons there that we call widgets. There is a blue widget; if you have any technical difficulties at all, click on that, and live help is standing by. And there’s also a green widget, and I really encourage you to check that widget out because it’s got a lot of great information, including our just hot-off-the-presses Vanguard economic and market outlook for 2018, additional videos that you can watch, and even a great blog post by Joe that we’re going to talk about a little bit during the course of the webcast.

So with that said, Joe, we have a lot of questions that have already come in. But before we jump in and I start putting you in the hot seat, I thought we might take the pulse of our viewing audience.

Joe Davis: Sounds great.

Rebecca Katz: Okay, great. Now we ask this question every year; so on your screen you should see our first polling question. We’re trying to keep track of this year over year. But we would like to know what is your outlook for the financial markets in 2018? Are you optimistic, pessimistic, or uncertain? It certainly has been a good run to date. So respond now, and in just a few moments when we have those results, I’ll come back and share those. But in the meantime, Joe, great to be here with you again. We have a laundry list of questions as there’s been a lot going on this year, so why don’t we just jump right in.

Joe Davis: Let’s go.

Rebecca Katz: Okay, our first question is from Felix in beautiful Bozeman, Montana. And Felix wants to know, “what’s the range of market forecast for next year?” I mean an obvious question; what do we think the markets are going to do? There’s been a lot of political and economic uncertainty, so it must be a little different than ranges in past years. And if you could just explain why we do ranges, and you don’t just say, “Hey, the markets are going to do X next year.”

Joe Davis: Well I think there’s two things, and it’s a really important question. Let’s focus on the stock market, I presume, when talking about the market. Let’s focus on the stock market. I think there’s two things. One is there’s various investment professionals, market prognosticators; I mean the airways are full of them, so everyone has their sort of view of their best estimate of what the stock market may return say in 2018 or beyond. So that in itself has a, there’s a range of opinions.

Rebecca Katz: Sure.

Joe Davis: Vanguard ourselves, we provide a range of outcomes that we think are the most likely reasonable range, and so we have a distinctive approach because we believe, thinking about the future, there’s inherent uncertainty, but there are times when the likelihood of outcomes is higher on say the higher end of returns, and other times they’re at the lower end of the returns. So we always provide a range.

Those range of expected returns for the stock market, let’s focus on the U.S. market as just an example, they have come down for expectations for stock market returns relative to when you and I would have done this webcast last year; and they are lower than say when we did this webcast, believe it or not, seven or eight years ago when we were fairly optimistic, despite a somber environment. I place that in context because we now sit as investors, the second longest, second strongest U.S. bull market in history. Some of that performance has been a catchup to the global financial crisis, but that said, we are starting to see returns starting to deviate above the fundamentals would suggest. So what that means is we have lowered our range of expected returns for the U.S. stock market for the next several years. That’s a statistical methodology we worked through, and so I’d say from a range of expected returns say in the 4% to 6% range for the next several years, historically stock returns in the U.S. have generated on average, reinvested 8% to 10%. So it’s closer to half the expected return we’ve had.

Rebecca Katz: Um-hmm, and certainly not the most recent experience that many of us have had over the last year.

Joe Davis: No, and again, and our range of returns, well, when I say 4% to 6% return, you know, next year we will, the volatility in year to year will really vary. I’m talking about the next five to seven years what is a reasonable range. Our best estimates—and we put a lot of math and thought behind this—they have come down, in part because of the strong performance and part because valuations are starting to rise, meaning the stock market is starting to exceed the earnings growth, which has been pretty good.

So, again, we’re trying to be as realistic as we believe that we can be in this world to help investors make decisions they need to make. And so the answer to the question specifically, roughly 4% to 6% for a stock portfolio over the next several years.

Rebecca Katz: Okay, well let’s pause there and let’s see how our investors, our viewers, are feeling about, at least we said the coming year. We asked you whether you were optimistic, pessimistic, or uncertain about the financial markets in the coming year; and we have the results in. Actually, a lot of uncertainty. So about 53% of the viewers said they were uncertain, 33% said optimistic, and 13% said pessimistic, so a little bit more glass half-full than half-empty, but a lot of confusion.

Joe Davis: Well and, I think, Vanguard investors, I would argue, are smarter than the average, and the number of years we’ve been doing these webcasts, Rebecca, the wisdom of the Vanguard investor in the crowd has been pretty good because I recall seven or eight years ago, you would think there was a lot of pessimism with respect to investors. It was an uncertain environment. Economic expectations were fairly low. There was a pain in the labor market, yet I think investors were more optimistic than I thought they would have been. And they’ve been rewarded for that. It’s understandable to see the uncertainty in part because I think we are living in this sort of paradox of we still have economic challenges; and, yes, you have financial markets that are ebullient, right? And so the closest comparison to recent performance is the late 1990s. It doesn’t feel like that in some metrics, but here we are from a portfolio perspective. I think that’s the returns that some investors are experiencing.

I think uncertain would be a fair characterization. If I had to pick one of those three, it wouldn’t be pessimistic. You can already tell with my comments, it’s not optimism. I think uncertainty is important because there is an air of complacency I think in the financial markets. Volatility is very low. Economists tend to have the same view of what will likely happen in the course of the next year or two. That, in itself, means that there’s a risk of surprise, either positively or negatively. And, again, past returns have been very strong. You put those three together, I think there should be more uncertainty in the near term outlook than I think the financial markets are currently anticipating. So I think our investor base has it right.

Rebecca Katz: That’s great. Now you alluded to the late ‘90s, and the late ‘90s were all about technology and the technology bubble. So we’re going to take this conversation in a little different direction with our second polling question to the audience. So you should see on your screen a second polling question, and this one is about technology. The robots are coming, the robots are coming, right? So how do you think that technology and automation will impact employment over the next ten years? So let’s look at the economy now. Positively, negatively, or there will be no impact? And after you’ve responded, there is actually a great blog post by Joe about technology. Maybe you could tell us a little bit about your thoughts on this. I know this is a passion of yours.

Joe Davis: Yes, and we had the privilege of speaking to certain audiences over two years ago, Rebecca, around what I think is one of the seminal trends of our lifetime and that is the future of work. So how significantly does automation—now, again, there’s always been automation in human civilization, since we’ve had civilization. But the pace and speed seem to be accelerating, and so how beneficial that is or how disruptive that is to future employment across a number of occupations. The answers to that question are, in my mind, the most important economic question we’ll face for the next 10 to 20 years.

The bottom line is, is that there is good news, but there’s also a sense of urgency. The good news is that there will still very likely be more jobs in either the United States or in China or in Europe 10 to 15 years from now when my children, hopefully, are in the workforce, than there are today. However, there will continue to be certain industries, occupations—In fact, we found every occupation in the entire U.S. workforce, the nature of their job will change more significantly in the next 10 or 15 years—think of time spent in the tasks you do—than has occurred over the past 15 years, which has been a remarkable change with the personal computer.

So, again, we need disruption and technological change to have higher standards of living for the next generation to the next, but that doesn’t mean it’ll be either easy or rose-colored, and there will be a number of changes. So I think we can go into more details, but this has implications with respect to policy, education, income inequality, and the type of growth centers that we would hope for as global citizens. So it’s a very important one. It’s something we could probably go to more.

Rebecca Katz: Yes, I think we will probably get some additional questions on that too. Well, let’s take a look at the results from our viewers and see how they’re feeling about technology. So we asked, “How will technology and automation impact employment?”, and 51%, 52% almost, said negatively, so a little bit more pessimistic than our financial market question; 37% said positively and 11% said no impact.

Joe Davis: You know, again, a testament to the Vanguard audience, it’s funny, if you got the leading technology experts in a room with all the leaders of business in the room, and the leading policymakers in the room, and you asked them that very question, is it positive or negative? The room would be split 50/50. And so I think, again, there’s arguments on both sides to either be pessimistic or optimistic with respect to the future, or “How scared should I be with respect to the rise of the machines?” I mean bluntly.

And so I think we have to also think about jobs do not get automated away, tasks do, and most jobs have multiple tasks. Now when the job has only a few set tasks that are repetitive in nature, technology has ultimately over time eventually replaced them. 80% of the occupations that existed 150-200 years ago no longer exist. That’s why, and part of the reason why your standard of living is improved. Now it may not have felt prosperous for those individuals who were in those crosshairs, so I’m not, again, putting rose-colored glasses on this. But whether the future is different, some very smart people are arguing it will be, I think all the more important the need for education and life-long learning, but that’s a topic for another day. We are not going to have material changes in unemployment or job growth in the next two years. I think that would be unlikely.

Rebecca Katz: So it’s interesting you mention the future, and we just got a live question in about predicting the future. So it is difficult to do it accurately, and we’ve looked at the markets and the economy and labor costs and things like that. You know, how have the predictions we’ve made in the past compared to the predictions more recently?

Joe Davis: I think it’s a great question. Vanguard, nor does anyone, have a crystal ball. I think I’m very proud of where I think we’ve had a better track record than most in the industry with respect to outlooks for the financial markets and the economy is, in part, because we take a longer-term view. So the very nature that we try to focus on what are the trends that matter, there’s always noise in the near-term data. There’s wiggles as I call them in the statistics, and does the Federal Reserve raise rates two weeks from now? There tends to be a whole cottage industry focusing on near-term events. And although they may be important, in the grand scheme of things, they are immaterial to the trends that define say the investment landscape of the past 20 or 30 years, which were what, the rise of globalization in China in the world economy, the disinflation since the high inflation rates. Like my dad could tell you the high mortgage rates in the early 1980s and what were the forces driving that, and that set up one of the greatest bull markets for equities and fixed income in our entire lifetime.

So they’re not easy, necessarily, to detect either; but the near-term noise can crowd out the analysis on those trends and the fact that we put everything in a probabilistic setting, it almost enforces us to reveal how much confidence we have in our own outlook. So what does that tend to do? That tends to frame the argument in terms of balance and trying to appreciate the other forces at work. So we’ve been more accurate than most, but we’ve generally had the direction right. Rarely do we get the magnitude right, but generally I’m proud of our framework because that’s helped us with generally the direction of trends.

Rebecca Katz: There’s a little bit more humility in the way that we do it, I think.

So our next question, and again, it’s sort of predicting the future, but it is in terms of probability. We have a question from Carsten in Perkiomenville, Pennsylvania, who says, “What is the probability of a major—meaning maybe 15% or more—negative market correction in the stock market?”

Joe Davis: Well, you know, we actually recently [put out research, Vanguard economic and market outlook for 2018], and it’s on Vanguard’s website, that actually quantifies that risk. So I’ll show two numbers to answer the probabilities.

Historically, in any year, a stock market investor has roughly a 40% chance of realizing or experiencing a stock market correction, which I will define as 10% decline or more. They can be worse, but usually a bear market, which is 20% or more say in the S&P 500, that’s typically and almost inevitably associated with recession. So the bigger the fall, the worse the economic outcomes. But to the person’s question around correction, I’m going to use 10%, historically it’s been 40%. Given how we model future stock returns and the distribution and given how strong performance has been, the level of interest rates in the world economy, and the valuation—say it’s the price of stocks relative to the earnings being accrued and generated by companies—that probability has risen and is now roughly 70%. So I’ve been at Vanguard 15 years. They’re among the highest probabilities that we would have generated.

Now, again, to be clear, I think it’s important to provide, and I would encourage everyone, if they’re interested, to read that report. There’s things you can do about it. One is those probabilities are less for investors that have global diversification in the portfolio. So if you have not just exposure to U.S. equities but global, European, Asia, emerging markets as well, those odds fall to 60%. Again, normal is 40%. This is why one invests in equities, because if there was always generally a low risk for corrections, then why would I hope to expect a higher return? If I had the volatility of a short-term bond fund, then why would I expect a higher return? So that goes with the territory. And then, finally, having a balance, so those probabilities of having a 10% drawdown or negative return in a year for say roughly a 60% equity, a 40% fixed income portfolio, those are materially lower.

Those cases have always been there for global diversification and balance across stocks and bonds, but they are becoming more so. Those tradeoffs are even more pointed now, in part because of the very strong performance of the U.S. equity market over the past several years.

Rebecca Katz: I think one of the challenges with that probability is that we probably have many viewers who are thinking, well, goodness, if I’ve been on the sidelines or I have money to invest, maybe I should wait or do something different. But isn’t the challenge always that you don’t know, maybe it is not an if, it’s a when. But you don’t know when, and you also don’t know when a rebound might come; and we saw that after the global financial crisis.

Joe Davis: Yes, I mean I can tell you what I’m personally doing, and I’m aware of all the data helping to have generated these statistics. I’m looking through it. I think ultimately that 70% number that I’m associated with is part of the reason why we just have a lower central range of expected returns. But I also know that the expected returns on the stocks in my portfolio are higher from the fixed income returns that are going to be generated in my portfolio. And if I have an objective to retire someday, my wife and I—

Rebecca Katz: We’re not going to let you.

Joe Davis: To save for my children’s college education, I am sticking to the plan because, personally, if Joe Davis tries to get too cute and try to time this thing, not only would—I mean, first of all, no one would be able to do that—but even if I thought I could do that, you would have to answer three questions. One is what is the signal that you’re going to get more defensive in the market; and just as importantly, when are you going to go back in? Because roughly 50% of the stock market’s returns over the long period of time come in three or four days of the year. So it’s very concentrated. The peaks can be sharper, so you would have to get it right both at the exit and at the reentry point.

And I have heard stories of investors, in part, because of the trauma from 2009/2010 are still not fully invested in the market. So I think you would just want to think through that arithmetic and how confident you are. I don’t think many investors think that they’re going to be that nimble in doing that.

Rebecca Katz: That’s great. Now you’ve mentioned a few times that fundamentals are, stocks look expensive, price/earnings [PE] ratios are high. So we did have actually two questions. What are the biggest challenges that the markets are facing right now? One of them is that it looks a little bit expensive, but why are stocks so expensive?

Joe Davis: Well, I think part of it is, well, they haven’t been expensive. Some have argued—including some who’ve won Nobel Prizes—that the stocks have been expensive for the past 10 years. We have researched, recently published, that says that’s an overstatement because you have to control for the level of interest rates. The lower the level of interest rates, the higher say P/E ratios in the U.S. stock market or any stock market should be on average. That said, we are even above those sort of levels.

So, you know, I think it’s one of the reasons why stock performance has been so strong is because of the rebound in the global economy. We are going into our seventh year of a global economic recovery. It’s not grown very quickly, but it’s extending in length. Corporate earnings have been fairly strong, the strongest this year relative to the past several years. And so that justifies why stocks are up. The whole question is the magnitude of it and the cumulative track record, and so more it’s just saying, “Hey, let’s just ratchet down our return expectations a little bit,” and that’s what the valuation measures would suggest. To be fair, they are not flashing red as in a financial bubble, to be clear.

So if you and I had been here in 1997 or 1998, the same metrics that I am citing would have suggested that the stock prices are well above, the tech stocks in particular, are well above any justifiable fundamental. Today I’m talking about the differences visually like this. So they’re above it.

Rebecca Katz: That’s good context.

Joe Davis: But 1999, and the paper would have that on the website, 1999’s like that, right? Now people were saying that in ’97, ’98, ’99, another reason why it’s very tough, anyone can’t time it. But in our judgment, we are hard-pressed to find evidence globally of financial bubbles. I think we’re just talking about, hey, have we just gone a little bit too far and so let’s just tap down our return expectations. We are not being alarmists to be clear.

Rebecca Katz: Maybe we’ll come back to bubbles, and we’ll talk about bitcoin in a minute. But you’ve mentioned a few times the world economy, and we just had a question in from Richard who says, “Will the U.S. remain the preeminent factor in the world economy over the long term?” So we’re shifting a little bit from economy to markets. I know those two things are not always correlated 1:1, but let’s talk about that. What is our position?

Joe Davis: Well, I think we’re in the midst of change. I mean by some metrics, we’re no longer the primary driver of the global economy. I think we’re the strongest global economic power, but in terms of the margin, who at the end of the day is the biggest influence on certain parts of the financial markets, China has surpassed us on some fronts. China has more of an imprint at the margin on how certain commodity prices move. Industrial metals as an example, in part, because of the rapid industrialization.

Ultimately, however, the U.S. is still the largest economy in the world no matter how you really measure it; and so we still have the largest accelerant on other countries, but China has quickly risen in some measures.

Rebecca Katz: Well then I guess if we have the largest accelerant, if we get into economic trouble here at home, will that have a knock-on effect across the globe?

Joe Davis: It would. I mean, actually, the biggest downside risk in my judgment, Rebecca, in 2018 is not the United States. It’s actually China. Our leading indicators have softened, in part because China has done actually a fairly respectable job of trying to what Qian, our chief economist for Asia, says is between fight and retreat mode for the Chinese policymakers. They are trying to slow down their economy on a trend basis, but they’re not trying to do it so heavy handed that they fall into a sharp slowdown. So they’re walking a tightrope there, in part because of the restrictive policies on housing, on financial regulation, even on some measures of corruption. We will likely see a slowdown for the first time in 2018. I think that’s anticipated, but there’s always risk to that. So I think the biggest downside risk is China, which is different because the past few years it’s been developed markets. The risk at the margin for growth is on the upside for the U.S. It’s certainly on the upside for Europe, and for the first time in a long time, it’s on the upside relative to expectations for Japan.

Rebecca Katz: Okay, interesting. Yes, well let’s go back to Japan. You know, I started to tease this question out because I’m seeing a lot of live questions, and we have a lot of preregistered questions coming in about U.S. economic policy, U.S. tax policy, so we should probably just address the elephant in the room, and we have one from Joel here, but we have at least 400 questions on this. Do we feel that the trickle-down underpinnings of the new tax bill is valid? What do we think the impacts of the new tax bill will be? So, we’re kind of, I know we try to be apolitical, but there is some—

Joe Davis: So I’ll just give the economic reading and the simulations we’ve done. This is a politically charged issue, but that said, I’m going to answer the question.

Rebecca Katz: We represent millions of people of all different political views.

Joe Davis: Yes, again, first of all, the “final” tax bill legislation, it’s not finalized because the House and the Senate plan have to be rectified. But let’s say there’s a general reconciliation of those two. Our simulations, and just as importantly, those that I’ve seen from bipartisan commissions whose full-time job it is to score and estimate the economic impacts on GDP growth, on employment, inflation for various legislative changes, this is actually mandated by Congress to my understanding.

So I think there will be, if the current law was passed, a marginal but positive modest impact to GDP growth, roughly 30 or 40 basis points. So what that would mean, if growth has been averaging 2% in GDP as a frame of reference, maybe 2.5%. Ironically, if we get 3% growth, there’s a similar question, so modest. That’s just an economic thing. I think there are some things that are important for the United States to see on a relative comparison and that would be a simplified and more competitive corporate tax, so I think that’s one of the primary benefits.

Ironically, if we see stronger growth in 2018, this is not a political statement. If we see stronger growth in 2018, my argument would be it does not necessarily have to come at all from the tax reform package because we are now at a level of unemployment in the United States, believe it or not, that is only roughly 4%. And it’s only at this time, so economists generally make the argument, when the economy’s at full employment, it tends to slow down because there’s no more workers to find. That’s actually not true. What you find is that when you approach full employment, you tend to have the incentive for businesses to invest more in their business, either hiring but also new planned equipment, computers and so forth.

So I bring up investment spending because that has been the relative deficiency in this recovery for the United States for the past several years. Consumers have been spending almost at the same rate as they were before the global financial crisis, believe it or not. The engine that’s been a little bit weaker has been business investment. So, ironically, if we get a stronger than expected economic environment for the U.S. in 2018, it could in part because of business investment, regardless of how the details of the tax plan come out.

Rebecca Katz: Elizabeth in Riverside County did say, “If there’s a corporate tax cut, which we’re talking about, how do we know that would be job growth? Wouldn’t the corporations just continue to build up cash?” Which, there are many corporations sitting on a lot of cash.

Joe Davis: There is a great deal of cash. Some of it’s overseas. However, most of that is concentrated in a handful of companies, in a handful of industries. You know, there has been, higher than in the past, say before the global financial crisis, the earnings that are being generated by companies, a greater percentage has been used through dividend buybacks or through share repurchases, what some will call financial engineering. Sometimes there’s a good reason for companies to do that and a little bit less on the CapEx [capital expenditure] side. That’s why I bring up CapEx, because that leads directly through to GDP growth perspective.

I think we’re at the stage of the business cycle where we may see this threat start to improve, in part because we’re going to see some rising wage costs, which is good for the economy, but I think it changes the calculus that some companies at the margin may be doing over the next year or two.

Rebecca Katz: So, certainly a part of the debate, and we’ve talked about this before when it comes to the tax plan is the U.S. deficit. And Ann in Greenwood Village, Colorado, asks, “Do you think it’s possible for the U.S. to reduce its debt by growing our way out or do you think that we have to take actions like entitlement reform and will the tax plan add to that?”

Joe Davis: Again, responding as an economist, it’s unlikely that we grow our way out of this.

Rebecca Katz: 2.5% growth.

Joe Davis: Many countries throughout civilization, actually, have faced the level of debt that we have and/or will face in our future, which is expected to rise marginally debt-to-GDP over the next 10 years; 30 or 40 years, it’s more eye-watering, to be blunt, that the debt-to-GDP numbers start to rise much more quickly.

Which gets to, you could grow your way out of it. A few countries have been able to do that, but they’re more episodic, and I wouldn’t rest the baseline on that. They’ve generally been growth rates of 5%, 6%, 7%. We could do that, but it’s unlikely we’re going to be growing at the rate of China given how wealthy and productive we’ve already become as a society. So, more likely, we’re going to need to address the—At the end of the day, this is a math problem. It is revenues are roughly 22% of GDP and expenses are 26%. That’s why we get a 4% deficit.

So I don’t care personally. Joe Davis, I won’t even say Joe Davis of Vanguard. Joe Davis, an economist, and as a citizen of the United States, I would like to see over the next ten years a plan that closes those two numbers. Certain political parties want to do it by moving one number to the other number. Other want to do it the entire other way, move the one number back to the other number. As an economist, let me tell you, I don’t care as much about the mix of how we get there as long as over time we have a sustainable deficit.

We came very close five years ago, six years ago now with the Simpson-Bowles Commission, so I’m not being complacent. I think the bond market could give us another several years to get our fiscal house in order, but ultimately if expenditures are part of it, it likely involves entitlement reform because that is the vast majority of why the debt projections from the Congressional Budget Office rise as fast as they do.

Unless, the one-in-a-million shot is that we would have a radical change in technology that would drastically reduce health care cost, because that’s the primary driver. I mean that probability is not zero. To be honest, I don’t know how to handicap that, Rebecca. But that would be the one true surprise, rather than economic growth rate, would be something that would radically drive down the cost, the prices of health care services.

Rebecca Katz: Interesting. That’s a different point of view than I’ve heard before. That’s great.

Well, we have a few more questions. You know, you just briefly mentioned wage growth, and Chris asked if you could talk about that for the next few years. So if we have modest growth, we have tightening labor market, do you expect to see continuing wage growth over the next few years?

Joe Davis: We do, and we talk about in our outlook, Rebecca, we’re only now entering the area of the labor market, the unemployment rate, the tightness where we would think we would expect to start to see a modest acceleration. So for context, for those that don’t follow wage statistics numbers closely, wage growth since 2009, so the past seven years, has been flat at 2%. Historical reference used to be 3% or 4%. Now inflation was higher in the past too, at least as measured by the Consumer Price Index (CPI). This past year, 2.5%.

By our analysis, we are entering a period that over the next year or two, we should see it roughly move up to 3%. Now why not higher, Joe? Because I think the unemployment rate is going to drop below 4%. In fact, at some point in 2018, we will officially have just as many job openings in the United States as we do unemployed Americans. We’ve only had that once since they started collecting statistics, and that, again, was in 1999. So the labor market, there’s always three ways you can improve, but it’s tight by economist measures.

Why we may not see higher ones is because of two reasons. One is because the average cost in inflation rates are lower, so real wages would still be going up. Secondly is, I think, there’s a demographic influence on some of the wage statistics. Why I say that is we are entering with the baby boom. Older workers are generally retiring, more so than the rate of the new entrants. And regardless of who’s coming in and who’s coming out, the average wage rate or salary of a 25-year-old worker is at least half that of the more experienced say 65-year-old or 55-year-old because of the life cycle of the earnings. That is having another effect on wage growth that the aggregate numbers will not accelerate to the same pace that we may have seen in the ‘70s when the dynamic was working in the opposite direction. So that means that although inflation may rise a little bit over the next year or two, cyclically, it’s just another reason why—and this gets back to one of the previous questions around has our outlook been accurate—one of the things we’ve, I think, done a really good job is saying that inflation was not going to materially rise the past several years. This is just another reason why it won’t take off.

Rebecca Katz: Okay, that’s great. Let’s shift gears a little bit. You started talking about China. It’s almost hard to think about them as an emerging market now because they are so strong. But Timothy asked, “What is our opinion on emerging markets?” So let’s run this back out to the globe. We talked about the U.S, what about elsewhere? Strong emerging markets, weaker emerging markets? From an economic perspective perhaps?

Joe Davis: Yes, I mean emerging markets is often viewed as that whole equity segment, but there’s a great deal of heterogeneity across emerging market economies. I think it’s generally a mixed bag in terms of what the economies will do relative to what they have been doing. So let me take four of the largest ones.

Brazil will improve this year from an economic perspective, but it’s coming out of a very deep, sharp slowdown. But I think there’s some positive signs there. Russia, again, also has been under pressure economically; and it still has some headwinds. India now has grown at a faster pace than China, which hasn’t happened in a little while, and they’ve have some positive structural reforms. They have more work to do, but they’ve been, I think, a bright light, and they may continue to be in 2018. China, again, one of the reasons why we’ve had a low-growth outlook for the past several years globally is, in part, because of what everyone would say is the rebalancing and the gradual development of China. So it’s an intentional planned slowdown away less from investment- and export-oriented sectors. That will continue. The whole debate is how much they slow down in their tolerance or aversion for faster than expected slowdown in 2018. But they’re not going to accelerate quickly.

Again, that does not mean emerging markets are a poor investment just because of their growth. I think too much stock is placed on emerging markets growth relative to developed markets. So think of it this way—The past ten years which part of the world has grown faster, the United States or emerging markets from a GDP perspective?

Rebecca Katz: I would assume emerging markets.

Joe Davis: Emerging markets easily by 2X, twice as fast economic growth rate. The stock market performance of the U.S. average return ten years, 10% annualized—oh, actually 15% annualized; emerging markets, 0. But it was the expectations built into emerging markets equities at the start of that period and valuations at the U.S.

So, again, personally I believe in Vanguard’s philosophy of having globally diversified exposure. That includes emerging markets, but I don’t do it from a return perspective. I do it from a diversified economic opportunity set.

Rebecca Katz: I love that. We’ve talked about many times that just because an economy is stronger or weaker, it doesn’t necessarily translate into financial market returns. Those are hard to predict.

So many good questions. We have a few around interest rates, both what we think the Fed will do and what impact that will have both on the U.S. and also on international markets. So we have a question from George in Mission Viejo, California, asking about if interest rates rise in the U.S., will that have an impact globally since the central banks are all so closely knitted together?

Joe Davis: Yes.

Rebecca Katz: Frank wants to know, “What effect will Fed policy have on equity markets?” So maybe we can just explore interest rate policy and what we’re thinking there.

Joe Davis: Yes, and it’s one of the biggest risks we talk about. So we see short-term interest rates going up. More importantly for investors, the bond market is anticipating that as well. That’s why the yields on longer-term bond funds generally have a higher yield than the short-term bond funds, although that difference has narrowed. And our baseline assumption and central tendency is that long-term interest rates, so those that say the ten-year Treasury security, those on a 30-year mortgage that are tied to, those on a long-term bond fund, municipal or taxable, corporate or credit, we’re hard pressed to see a material rise in long-term interest rates with wiggles around that.

That’s, in part, because of what’s happening at short-term interest rates that are controlled by the Federal Reserve, in part, because I think the Federal Reserve will continue on its normalization path. And, if anything, maybe a little bit more aggressive than the bond market’s expecting for 2018. Inflation may tick up a little bit more, and unemployment rate will continue to tick down. So what that means is the Federal Reserve will be extremely likely to raise rates in a week or two, in a week. That will bring the short-term money market equivalent, the fed funds rate at close to 1.5%, and they anticipate raising rates three times next year. The bond markets think it’s best to. For the first time in ten years, I think the Fed actually will be right.

But that puts short-term interest rates—so those that are in money market funds, like my father, in part, savers who have subsidized this financial recovery through negative real interest rates—the good news is that we should see continue with the recovery higher short-term interest rates. But, in part, because that happens, inflation is unlikely to material rise. And so if short-term interest rates rise, the expectation, at least I personally have and our outlook has, is that there’s not a material change in long-term interest rates. So the yield curve will flatten. And I think that’s important to recognize because to say that interest rates are going up, that’s not necessarily have a one-for-one mapping, depending upon what interest rate sensitivity you have to your portfolio. If we’re talking about a material rise in long-term interest rates, which we’ve been on this webcast for several years, there’s been a number of concerns around that, we have not had those concerns. It’s still possible. But I think to do that, it has to be more than just the Federal Reserve raising rates in 2018.

Rebecca Katz: It’s much more tied to inflation.

Joe Davis: It has to be inflation. It also has to be the ECB [European Central Bank]. It has to be Europe central banks raising rates appropriately. That means inflation’s got to be global. We have to have Japan, Bank of Japan, loosening their 0% interest rate target for long-term interest rates. So it’s got to be a much more global, genuine phenomenon rather than simply the U.S. raising rates short term.

Rebecca Katz: And do the short-term moves by the Fed have an impact on the foreign banks and what they have to do?

Joe Davis: They do, but if anything, we’re pulling away from them. So if anything, it will be a slight divergence for 2018. In many ways, the United States is three years ahead of the business cycle for, well, Japan, longer than that, but for Europe. So Europe is starting to see this sort of stronger recovery relative to where they were, much like we saw in 2011, 2012.

Rebecca Katz: I see.

Joe Davis: So they’re several years behind. We’ve said this for several years. We don’t see the European Central Bank raising short-term interest rates—which are negative by the way—until perhaps 2020. So they’re still a little ways off, and they’re allowing their recovery to slowly gain traction.

Rebecca Katz: That’s great. All right, oh my goodness, we have so many questions to get through and so little time. So let’s try to keep moving.

Bob and others have asked, there is really a lot of attention to growing income inequality, and that’s both in the U.S. and abroad we see Gini coefficients that are signaling haves and have-nots. So how will that affect the economy? And in this case, we could start with the U.S., if at all.

Joe Davis: So income inequality’s been rising in the United States for 50 years. I say that, importantly, because that cuts across both political parties. And so the question is why has it been rising? Well, there’s a number of factors, but, ultimately, it’s the nature of technological change in the labor force. It’s the return on education and the change in the labor force, change in jobs we’ve had, and the demand for those jobs going forward. It’s effectively a skills premium. I’m just telling you the economic interpretation of it. So given our work, more so than globalization, it has been technology that explains roughly 85% of the trend rise in income inequality.

If that is true, and if technology is not slowing down, then I’m led to conclude that in income inequality, although it may not get terribly worse, is not going to radically improve unless we see material changes in terms of how technology is interacting with the wages, which is skills premium, wages associated with one occupation versus another; and so that income inequality.

And the other thing is while we know and it’s not a surprise, ultimately, why the primary driver has been what I call technology, is that it’s generally a global phenomenon. These trends are going up. In fact, there was a recent best-selling book on income inequality, which you wouldn’t think would be a best-selling book, on the topic of income inequality. But it’s important. I think it has more political implications than economic. It may at the margin, very modestly, you could argue slowdown growth because wealthier households tend to consume less as a percentage. They consume more dollars, but consume less propensity to spend. And so if you have income concentrated more in wealthier households, you may slow the rate of growth at the margin. But that’s a second order effect. I think, more importantly, it’s an open question. I can’t answer this. It’ll play out more in the policy and the educational sphere than, I think, on the economic sphere.

Rebecca Katz: Great. We have quite a variety of questions. We talked a little bit before the webcast about cryptocurrency and bitcoin. There’s a lot of questions about that, but anyone who’s a Vanguard investor knows what our answer is going to be without you even opening your mouth around bitcoin, but I have to ask, what about bitcoin?

Joe Davis: What about it? I mean is it a bubble or is it not? To be honest, I don’t know how to value it because, in theory, I guess, it could be a store of value. But the first word that jumps to my mind, if you asked me, if this was a trivia question, you say, “bitcoin, “I’d say, “speculation.” So that’s my initial reaction. And this has nothing to do with bitcoin, though. I think we are moving in a world of—certainly in the next 20 years, and we’re seeing it already with payment systems that we’ll have—more of a digital currency. But bitcoin is not necessarily the reason, like the technology we use to do that. In my understanding, the most valuable component of bitcoin is the underlying blockchain technology, which many of the other companies, you don’t need bitcoin to use blockchain technology, which is a way that you could encrypt and do financial transactions. But, yes, that’s been a part head-scratcher for me.

Rebecca Katz: I know. It just reminds me of all the years that we talked about gold again and again and again, and it was like, ugh.

Joe Davis: Yes, I know. Yes.

Rebecca Katz: Don’t do it.

Joe Davis: I know. I know. I mean I’ve seen smart people make the case there’s a nontrivial risk at that price of zero 10 years from now, but that doesn’t mean it couldn’t triple in value between now and then. Who knows?

Rebecca Katz: Right. Well, if you like to speculate. Speaking of currencies, we have quite a number of questions. Seswato asked, “Will the dollar continue to strengthen?” I actually think the dollar’s been weakening.

Joe Davis: Dollar’s been weakening.

Rebecca Katz: So let’s talk a little bit about currency.

Joe Davis: Well, I mean if we’re right that the central risk going into next year, and, again, it’s not an alarmist risk. It’s just, I think, the Federal Reserve will continue to proceed on their gradual normalization path at a time when other central banks are not. Now that was the case this year, but if you pair that in to combine with the risk of the Fed being a little bit more aggressive than other central banks, I would say at the margin short-term interest rates in the U.S. may rise a little bit relative to what’s expected than the others. Because, again, currencies already expect a certain interest rate path for all markets. If U.S. rates rise a little bit more, short-term interest rates more so than all the other countries, then that would imply that the U.S. dollar is going to strengthen. But I don’t see material change.

The only time the U.S. dollar materially appreciates in value, I mean, would be two things. One is a significant divergence in monetary policies. I think we’ve had that several years ago when there were explanations for that. So that’s very good news for the U.S. The other is very bad news, and that is we have a global recession.

Rebecca Katz: Right, crisis.

Joe Davis: Yes, this will affect the quality. Although there’s odds of that, we don’t have that. They’re still fairly low at this present time, certainly for 2018 for the risk of recession.

Rebecca Katz: Okay, great. Let’s see as we have so many different things to cover. We haven’t talked about bonds at all. I mean a little bit with interest rates, but not the bond market as an investor in the bond market what to expect in 2018. So what’s our point?

Joe Davis: I love bonds.

Rebecca Katz: I know.

Joe Davis: I love stocks too, but I love bonds.

Rebecca Katz: You have to love them for the right reasons though.

Joe Davis: I love them for the right reasons. Again, we continue to maintain that the most reasonable expectation for bond returns that investors can do in their planning purposes is kind of look to the yield to maturity on their fund for investment grade portfolios. For high-yield, that’s a little bit more challenging. So if an intermediate-term, high-grade bond fund, whether at Vanguard or somewhere else, let’s say the yield is 2.5%, that’s a general expectation of what a reasonable expectation is over the next three to five years.

So we still think it’s more likely than not that bonds will earn a positive return after the rate of inflation, called cost of living, as measured by the CPI. But that cushion is not great. But that wasn’t great two or three years ago either. Let me put it this way. If there are investors that worry about near-term risk, I think most investors have longer-term orientation. But if they’re worried about, “hey, I don’t want to see significant losses in my portfolio, I don’t want to see a 10% down year, regardless of my asset allocation,” I can tell you those odds of a 10% decline are materially higher, three times higher on an equity-centric portfolio than a fixed-income portfolio despite the fact that interest rates are low and the Federal Reserve are raising rates just because the inherent volatility in equities and then, if anything, just at the margin a little bit extended valuations.

Rebecca Katz: I think it’s always a timing question. So we’ve done many, many of these webcasts, and there’s always this question of, oh, I want to move into an asset class, I want to move into bonds, and is now the right time? We know interest rates are going up. Why wouldn’t I either just buy an individual bond where you don’t risk your price necessarily dropping or should I just wait? And I think that’s the challenge that most have had.

Joe Davis: Yes. Well, the individual bonds I mean I think part of that’s just respectfully. I mean it’s how the data is presented. I mean bonds trade and their prices change, whether it’s an individual security or the fund NAV value every single day. I mean I can tell you from the portfolio managers that I have the pleasure of working with at Vanguard in the Fixed Income Group, the prices of all the bonds that they have in their portfolio are changing every day too. I think this whole notion of individual bonds so I can ladder my portfolio because the price has not changed and so forth, that is part illusional because of the fact that that price is not being marked to market every day.

Sometimes I catch myself doing the same thing in my own home’s value. Just because I haven’t traded, doesn’t mean it hasn’t changed in value.

Rebecca Katz: Wow, that’s true. That’s a great analogy.

Joe Davis: And so I think the power diversification even for very high-net-worth investors, the ability Vanguard has to assemble a diversified portfolio of fixed-income securities—and I can tell you some of the best credit analysts and portfolio managers in the business—I think it’s a really good value proposition.

Rebecca Katz: Well, we have just a smattering of different topics, so this is going to sound a little random, but why don’t we do kind of more of a lightning round of different topics?

Joe Davis: Okay, great, quick fire. Quick fire.

Rebecca Katz: So, well, this is related. So Richard is asking, “What impact do we see from the Fed deleveraging their balance sheet?”

Joe Davis: Modest. Well, zero. Not much if they go according to plan. I think they’ll be reluctant to change it.

Rebecca Katz: And you ought to define what deleveraging the balance sheet means for people who may not know because we hear that term a lot.

Joe Davis: Hold $4 trillion in assets. Most of them are excess reserves, which means we haven’t had inflation because they’re not out in the public domain. They’re on the Fed’s ledger. They’re going to slowly decay to roughly call it $2.5 to $3 trillion, and that’s been publicly announced. That’s what’s called tapering, quantitative easing. They’re securities, mortgage-backed securities as well trade securities on their balance sheet held at the Federal Reserve.

If it’s according to plan because it’s been transparent, I think the Federal Reserve has done a very good job in terms of communicating that plan. If that goes according to plan, in theory, that should have no impact. The Federal Reserve official is arguing it’s going to run in the background.

Rebecca Katz: I see.

Joe Davis: Although it’s still, by its nature, it’s marginally restrictive. I think the trick will come at some point if we continue this gradual normalization in the policy. At some point, economists will stop using the phrase “monetary policy as accommodative” and start using the phrase that we are now “somewhat restrictive,” which financial returns tend to decline a bit in that transition. We were just debating this morning the portfolio managers in the Fixed Income Group, when do we transition from accommodative to restrictive? It’s always easier to look backward and know what it is. It’s less clear to me though, and I don’t think we’ve cross that transom in 2018.

Rebecca Katz: Okay, great. We haven’t talked commodities at all. So Ron is asking, “What about oil prices and other commodities including natural gas?” And we did talk about how some of those are tied to emerging markets and growth there, but any thoughts on that?

Joe Davis: I don’t have any better view than what the commodity prices are generally assuming. They generally assume close to a flat line in commodity. Oil prices, I’ll use as an example, the next two or three years. One person’s opinion, if the reader is asking my opinion, if I say where the risk is to that in the next one or two years, I still think it’s on the downside because of the nature of shale produced in the United States and the dynamics relative to OPEC.

Longer term, I think the distribution’s wide, and I can make a case for either one. I’m not trying to escape the question. I just don’t have high conviction and a view on that. I think assuming where prices are right now, which is close to the extraction point for the median barrel is a reasonable assumption. So I would be arguing differently if we were at $40 a barrel, $80 a barrel. I think where we’re at seems reasonable at least.

Rebecca Katz: Brexit.

Joe Davis: It’ll probably be messy.

Rebecca Katz: Yes. You think there’ll be long-term impacts, and can we see? I mean they’re still negotiating. There’s still a lot of controversy.

Joe Davis: Yes. Now our team, Peter Westaway and Alexis Gray in Europe, so our economics team, we span several continents. They’ve long said that it was more likely than not, although it’s tough to completely handicap, that we were probably headed more for what’s called a hard Brexit, so a sharp break. For the European Union, that looks like that will unfold. There’ll be near-term clear headwinds for the London and the British economy, although they have been more resilient than I would have anticipated over the course of this year.

Rebecca Katz: I would agree.

Joe Davis: Longer term, there are some in the global community that say it’s very deleterious, negative for the British community. I think there will be some wear for our losses with respect to trade and integration, but I think there’s also some great strengths of the British economy. So I don’t think there’ll be a really significant drag longer term. If it would look like it would be, then I think we would need policy change because British policymakers are smart as well. I think there would be blowback effect that if it would turn to be this is really becoming a significant negative pack longer term that’s starting to really stunt the British economy, I think there would be a political conversation to say maybe we can redress this in some way.

Joe Davis: Okay, great. Well, that was a great lightning round. I have to say we got through a lot of very different topics in just a few minutes. But, unfortunately, we’re pretty much out of time.

So, Joe, we covered a lot. We covered the financial markets, we covered the U.S. and global economies, but I do want to let you have the final word and leave our viewers with a few thoughts about what we might think through in 2018. Any tips for them?

Joe Davis: Yes, so I tend to focus here on, because the questions are more interested in what’s going to happen, I would say one is for many investors, congratulations because they’ve successfully navigated, seriously navigated eight or nine years of what was economic challenging times. But I think they’ve been rewarded with being disciplined. Every quarter there was a reason to make radical shifts in the plan, and they haven’t done it. Or if they’ve done it, they’ve done it with eyes wide open and careful consideration, which can be inappropriate. So I’m trying to take a moment of congratulations because the markets have been strong. Not all asset classes. Not for those in conservative vehicles, but generally it’s been a strong environment.

I think that’s important for context because the next several years if we recognize that, the next five years are going to be more challenging for the investment environment than the previous five. They’re going to require even more patience, which I am not a patient person, more diligence and volatility will likely creep up here and there because we’re at fairly low levels.

So, ironically, economic environment may be a little bit better next five years, but the investment environment paradoxically may be a little bit more challenged. It’s something that investors can overcome. I would encourage those investors that didn’t have a chance to have their question addressed if they have more nuance questions or amplification on the outlook for stocks and bonds and questions on China or what have you, also if they need some bedtime reading, they can read some of the detailed outlook, Vanguard economic and market outlook for 2018, because it’s 35 pages. I think it’s a really good analysis, but it’s 35 pages. So if they’re interested, it’s up there.

Rebecca Katz: It’s in the green widget. Just click on the widget.

Joe Davis: It’s in the green widget. Yes.

Rebecca Katz: That’s great. Well, Joe, it’s always a pleasure. The hour always flies by with you. So we’ll have to have you back and maybe we can go into more of those questions. So thanks so much.

And from all of us here, thanks. Congratulations! And, also, since it’s a time of giving thanks, thanks to all of you. We will be sending you out an email with replay of this broadcast, highlights, and transcript for your reading convenience; and that’ll be in a few weeks.

And you’ll see another widget I haven’t mentioned, the red widget, and that’s our feedback widget. And you can ask additional questions, tell us if you like the program, tell us what you’d like to see in the future. We need your ideas so we can keep these fresh. So just take a few seconds and do that, and we would really appreciate it.

And, you know, I just want to say we are so thankful for your loyalty, for putting your trust in us, for taking the long-term point of view. It’s really special to have Vanguard investors who keep that perspective and that patience.

So from all of us here at Vanguard, we hope that you and your families have a wonderful holiday season, and we’ll see you again next year. Thanks.

Important Information

All investing is subject to risk, including the possible loss of the money you invest. 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. Diversification does not ensure a profit or protect against a loss. Past Performance is no guarantee of future returns.

Investments in bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These are especially high in emerging markets.

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