Bogleheads® on Investing Podcast 065: Dr. Qian Wang, Vanguard economic and market outlook of 2024
00:00:00.000 | [MUSIC PLAYING]
00:00:10.320 | Welcome, everyone, to the 65th edition
00:00:13.280 | of Bogle Heads on Investing.
00:00:15.120 | This month, my special guest is Dr. Tian Wang.
00:00:18.360 | Dr. Wang is Vanguard's Asian Pacific Chief Economist
00:00:21.680 | and Global Head of Vanguard's Capital Markets Model.
00:00:25.280 | Today, we'll be discussing current global economic
00:00:27.880 | conditions and Vanguard's forecast for 2024
00:00:31.720 | global financial market returns.
00:00:33.680 | [MUSIC PLAYING]
00:00:43.480 | Hi, everyone.
00:00:44.240 | My name is Rick Ferry, and I am the host
00:00:46.400 | of Bogle Heads on Investing.
00:00:48.360 | This episode, as with all episodes,
00:00:50.880 | is brought to you by the John C. Bogle Center
00:00:53.520 | for Financial Literacy, a nonprofit organization that
00:00:57.120 | is building a world of well-informed, capable,
00:01:00.080 | and empowered investors.
00:01:01.720 | Visit the Bogle Center at boglecenter.net,
00:01:05.200 | where you will find a treasure trove of information,
00:01:08.000 | including transcripts of these podcasts.
00:01:11.200 | This month, my special guest is Dr. Tian Wang.
00:01:14.640 | Dr. Wang is Vanguard's Asian Pacific Chief Economist
00:01:17.440 | and Global Head of Vanguard's Capital Markets Model Team.
00:01:20.720 | She's also a member of Vanguard's Strategic Asset
00:01:23.120 | Allocation Committee, which determines the asset
00:01:25.520 | allocation strategies of global multi-asset class
00:01:28.560 | portfolios, such as Vanguard's target date retirement funds.
00:01:32.920 | Dr. Wang earned her PhD in Business Administration
00:01:36.080 | from Stanford University, a Master of Arts in Economics
00:01:39.480 | from Duke University, and a Bachelor
00:01:41.920 | of Arts in International Economics
00:01:43.680 | from Beijing University.
00:01:45.280 | She has been at Vanguard since 2014.
00:01:47.960 | Today, we'll be discussing Vanguard's economic and market
00:01:51.040 | outlook for 2024, a report that was recently published
00:01:55.320 | and is available to you online.
00:01:57.680 | So with no further ado, let me introduce Dr. Tian Wang.
00:02:02.080 | Welcome to the podcast.
00:02:03.480 | Thank you, Rick, so much.
00:02:04.760 | First, I would say, great job pronouncing my name,
00:02:07.880 | which is not easy.
00:02:10.360 | My name, Tian, has the same pronunciation in Chinese
00:02:13.880 | as money.
00:02:14.880 | Oh, no kidding.
00:02:15.920 | So Rick, money is coming to your podcast today.
00:02:19.560 | Well, there we go.
00:02:20.760 | We hope money comes to all of our listeners as well.
00:02:24.440 | Tian, you are on a very powerful team.
00:02:27.800 | Vanguard's global economics and markets team
00:02:31.480 | consists of four PhDs, and you are one.
00:02:34.560 | And Joe Davis is the global chief economist.
00:02:37.440 | And you are the Asia-Pacific chief economist
00:02:40.040 | and the global head of Vanguard's capital markets
00:02:43.480 | model, which we'll get into in a bit.
00:02:46.040 | But before we get into this report that you helped publish,
00:02:50.520 | I want to ask about your background.
00:02:52.400 | Tell us a little bit about yourself
00:02:53.960 | and how you ended up at Vanguard.
00:02:56.120 | The true meaning of my name, obviously it's not money,
00:02:59.120 | is actually a short name for my hometown.
00:03:01.680 | So if you read Chinese, people can easily
00:03:03.800 | tell where I come from.
00:03:06.040 | I remember back in early '90s, China just
00:03:08.320 | started a market economy.
00:03:10.120 | Yet in the college, the teacher still taught us Marxism,
00:03:14.360 | where only labor, not capital, creates value.
00:03:17.560 | And then I wonder, if capital doesn't create a value,
00:03:20.800 | then who's willing to make investment at all?
00:03:24.240 | So I remember in 1997, when I graduated from college,
00:03:28.400 | I traveled all the way to the US for my graduate study,
00:03:32.040 | first in the East Coast, Duke University, go Blue Devil,
00:03:36.160 | and then come to the West Coast, Denver, for my PhD.
00:03:41.000 | So after graduate, I have been working
00:03:43.240 | as a professor, a Southside economist,
00:03:46.000 | Sovereign Wealth Fund.
00:03:47.400 | And then eventually, when I come to Vanguard,
00:03:50.200 | I feel like I found the answer to a lot of my questions.
00:03:54.320 | So great place to be.
00:03:56.160 | Well, we're certainly happy to have you.
00:03:58.160 | And every year, we interview a different economist.
00:04:01.880 | We've had Joe Davis on a few years ago.
00:04:04.120 | Last year, we had Ed Yardeni.
00:04:05.800 | And you are the noted economist this year.
00:04:07.720 | So again, thank you for joining us.
00:04:09.720 | Thank you.
00:04:10.280 | I want to get into your report, which
00:04:12.920 | is the Vanguard Economic and Market Outlook for 2024.
00:04:17.600 | And the byline is a return to sound money.
00:04:23.160 | So before we get into the meat of the report,
00:04:25.920 | what do you mean by a return to sound money?
00:04:28.960 | By sound money, we are talking about a persistent real interest
00:04:33.960 | rate.
00:04:34.720 | Basically, that means what we have
00:04:36.560 | seen, the nominal interest rate, that
00:04:38.200 | is going to be higher than inflation.
00:04:41.040 | This actually, in our view, is the single best
00:04:44.640 | financial development over the past two decades.
00:04:47.520 | It really set the foundation for a solid risk-adjusted return
00:04:52.040 | for our long-term investors.
00:04:53.840 | By that, do you mean just short-term, like T-bills?
00:04:56.240 | Or you're talking about a 10-year treasury?
00:04:58.800 | What do you mean by a real rate of return over the inflation
00:05:03.680 | rate?
00:05:04.520 | For all asset classes, we talk about higher interest rate
00:05:08.200 | environment.
00:05:09.000 | Part of the reason is because we feel
00:05:10.920 | like the risk-free rate, which is determined by our star,
00:05:14.760 | the neutral rate.
00:05:15.600 | We can talk about that later.
00:05:17.520 | It's higher.
00:05:18.480 | Now, you think about it.
00:05:19.840 | Risk-free rate is the foundation for all asset returns.
00:05:23.880 | You get the yield for long-duration bond risk return
00:05:27.120 | plus term premium.
00:05:28.640 | You get the yield for credit.
00:05:30.600 | You plus credit spread, equity risk premium.
00:05:34.000 | You get the earnings yield, so equity return.
00:05:37.160 | So leaving the price change aside,
00:05:40.600 | then higher risk-free rate means you
00:05:43.280 | get higher expected rate for all asset classes.
00:05:46.800 | Isn't that good?
00:05:47.720 | I think it's good to actually outperform the inflation rate
00:05:50.800 | because, of course, we haven't factored in taxes yet.
00:05:53.600 | To outperform inflation is a good start.
00:05:56.360 | Central bank has been literally going to zero,
00:06:00.080 | or in some places, negative interest rate.
00:06:03.120 | And that raises a lot of concerns,
00:06:05.160 | especially when investors also see a significant fiscal policy
00:06:08.880 | expansion.
00:06:09.840 | That raises a lot of concern about future inflation
00:06:13.360 | and also devaluation of fiat currency.
00:06:16.560 | I think that's one of the reasons why cryptocurrencies
00:06:19.120 | start to gain its popularity.
00:06:21.200 | So now, I think when central banks are exiting
00:06:23.960 | those ultra-accommodated monetary policy,
00:06:27.160 | that together with some kind of more prudent fiscal policy
00:06:30.160 | down the road, I think that will restore people's confidence
00:06:33.640 | in the fiat currency.
00:06:35.120 | And to me, that's another way to interpret this,
00:06:38.200 | the return to sound money.
00:06:39.480 | Well, it's kind of interesting that you bring up
00:06:41.320 | cryptocurrencies and this.
00:06:42.600 | But I never really thought about it.
00:06:43.760 | But you're right.
00:06:44.520 | The fear that monetary policy would cause a devaluation
00:06:50.200 | of the dollar--
00:06:51.120 | most people who are big followers of cryptocurrencies
00:06:53.960 | believe that this is needed in order to just have
00:06:56.800 | a stable currency--
00:06:58.640 | that if the new policy, long term,
00:07:01.240 | is to have positive real rates, then that solves the problem.
00:07:06.880 | The budget deficit, though, how does that
00:07:08.480 | work into all of that?
00:07:09.680 | How do you maintain real rates above inflation
00:07:13.760 | when we have such a large budget deficit and it keeps growing?
00:07:16.880 | Yeah, totally.
00:07:18.080 | So this is where, when I say the transition into a higher
00:07:21.080 | interest rate environment is best
00:07:23.040 | a financial development for in the long term.
00:07:25.880 | But I'm also saying that the transition could be very bumpy.
00:07:29.800 | When everybody is adjusting to that higher interest rate
00:07:33.520 | environment, for household, saving will be more attractive.
00:07:37.600 | But for corporate, that also means
00:07:40.080 | when you make investment, you're going to be more prudent.
00:07:42.560 | And you need to allocate the resource
00:07:45.200 | to the most productive, profitable opportunities.
00:07:48.720 | I think that also has very profound implications
00:07:51.720 | for government fiscal policy.
00:07:54.400 | You could have a very vicious cycle
00:07:57.640 | between higher government budget deficit
00:08:00.080 | and also higher interest rate.
00:08:01.800 | That would raise a lot of concern
00:08:03.800 | about fiscal sustainability.
00:08:06.120 | I think this is one of the questions a lot of people
00:08:08.320 | were asking at this moment.
00:08:10.200 | Now, one thing I would say is that Vanguard actually
00:08:13.240 | has quite some research there trying
00:08:15.880 | to think about how much can the fiscal expansion
00:08:18.720 | go down the road.
00:08:20.480 | So one of the exercises we did is
00:08:22.360 | that we tried to calculate the maximum sustainable debt
00:08:26.240 | burden for the US.
00:08:27.720 | Because at this moment, the US federal government debt
00:08:31.400 | is about 100% of GDP by the end of 2022.
00:08:35.080 | You could say, wow, that's high.
00:08:36.640 | Because remember, people always have the 60% number in mind.
00:08:40.880 | That's what European Union said.
00:08:43.320 | That's a limit.
00:08:44.440 | But then you think about Japan.
00:08:46.200 | Japan has government debt at 260% of GDP,
00:08:49.640 | yet the government's still running.
00:08:51.280 | But Japan has had negative interest rates forever.
00:08:55.720 | Exactly.
00:08:56.560 | So the maximum sustainable debt burden
00:09:00.080 | is actually different across countries,
00:09:02.320 | really depending on three things.
00:09:05.120 | One, the maximum primary balance the government
00:09:08.080 | is willing to or able to implement.
00:09:11.160 | Basically, the primary balance of payment,
00:09:13.720 | that means the difference between your revenue
00:09:16.200 | and spending, netting out the interest rate payment.
00:09:19.840 | And then the second is interest rate,
00:09:21.920 | as you point out correctly.
00:09:24.360 | And the third is the country's economic growth in the future.
00:09:28.480 | So Japan, yes, that was sustainable
00:09:30.560 | because of low interest rate.
00:09:31.800 | But even for Japan, now we are talking
00:09:33.640 | about they're going to lift up interest rates down the road.
00:09:36.760 | So this kind of higher interest rate, higher debt-serving cost
00:09:41.080 | will make fiscal sustainability into question.
00:09:44.560 | We assume that if the US government is
00:09:47.080 | willing to run our primary budget surplus of 2%,
00:09:52.520 | and if we follow the CBO, Congress Budget Office,
00:09:55.920 | forecast of interest rate and economic growth down the road,
00:09:59.920 | then we estimate that maximum sustainable debt GDP
00:10:02.720 | ratio for the US is actually 225%.
00:10:06.360 | Don't give them any ideas now.
00:10:08.040 | Come on.
00:10:08.920 | I know.
00:10:09.320 | I know.
00:10:09.800 | I hope nobody in Washington DC is listening to this.
00:10:12.320 | But the condition is that they need
00:10:14.600 | to run a fiscal surplus of 2% surplus.
00:10:19.560 | And guess what we are going to do down the road?
00:10:22.760 | The CBO office is estimating, projecting
00:10:25.960 | a deficit of greater than 3% of GDP in coming decade.
00:10:31.480 | So the government is going to significantly
00:10:33.880 | eat into this fiscal buffer over the coming years.
00:10:38.200 | And the fiscal space, the estimation,
00:10:40.400 | is based on some quite favorable projection of interest rate
00:10:44.040 | and economic growth.
00:10:45.400 | What if we end up with another severe recession?
00:10:48.600 | What if the demographic trends worsen?
00:10:50.920 | Or what if the investors panic and interest rate
00:10:54.400 | grows more than expected?
00:10:56.440 | And then in that case, the fiscal space
00:10:58.360 | will be much lower.
00:10:59.760 | So to us, the rising debt has become
00:11:03.040 | an issue that must be tackled by this generation, not the next.
00:11:07.400 | So that's where we caution against complacency.
00:11:10.240 | And you mentioned a maximum taxation level.
00:11:14.440 | And you had done this work on a report.
00:11:16.520 | And what did you come up with?
00:11:18.560 | Well, this is where we think the government,
00:11:21.440 | instead of running the 3% structural deficit,
00:11:24.800 | persistent fiscal deficit, they have
00:11:27.400 | to be more prudent with how much they spend
00:11:30.440 | and also what kind of tax revenue they collect.
00:11:33.280 | So turning from over 3% deficit into a 2% surplus
00:11:38.320 | takes a lot of efforts there.
00:11:40.680 | So this is where we think either they
00:11:42.760 | may want to minimize unproductive spending,
00:11:45.480 | limiting contingent liability, and make them more targeted,
00:11:49.880 | and also increase taxes where the revenue are
00:11:52.600 | low by international standard.
00:11:54.640 | That should be helpful.
00:11:56.120 | So overall, I think it's very critical
00:11:58.400 | to maintain a prudent approach to the government finance
00:12:01.880 | down the road.
00:12:02.520 | Well, we could get into this for hours.
00:12:04.160 | But we're going to move on to the next level.
00:12:07.400 | Now, the Fed has two mandates.
00:12:09.040 | One is to limit inflation.
00:12:11.520 | And their target is 2%.
00:12:13.320 | And the other is to maintain low unemployment.
00:12:16.600 | In an era where there was zero interest rate environment
00:12:20.440 | or negative real interest rate environment,
00:12:22.280 | it became really hard for the Fed
00:12:24.080 | to do anything to stimulate the economy.
00:12:27.720 | Do you feel as though now this has been resolved
00:12:30.280 | because we have higher interest rates that Fed policy
00:12:33.160 | may become more effective?
00:12:35.480 | So thank you, Rick.
00:12:36.600 | I do think that the transition to a higher interest rate
00:12:40.160 | actually works well for central banks.
00:12:42.360 | Because in the case of economic downturn or a recession,
00:12:46.440 | where you do have GDP contracting, labor market
00:12:49.680 | softening, unemployment rates are rising,
00:12:52.200 | then the Fed has more room to cut interest
00:12:54.760 | rate to support the economy.
00:12:57.040 | But I think at this time, one thing we do want to highlight
00:12:59.880 | is that we are expecting an economic downturn,
00:13:02.840 | a minor recession in the second half of 2024.
00:13:06.160 | And we do expect the Fed will cut interest rate,
00:13:08.880 | the Fed fund rate, probably starting in July.
00:13:12.200 | But one thing we do want to highlight
00:13:14.040 | is that we don't think that it will cut back to zero
00:13:16.920 | anytime soon this time.
00:13:18.640 | I think a very important part of that
00:13:21.200 | is indeed because of the r-star.
00:13:23.400 | Neutral rate is higher.
00:13:24.560 | Could you explain what r-star is?
00:13:27.280 | Yes.
00:13:28.240 | r-star is our equilibrium interest rate level
00:13:32.480 | that is consistent with stable growth, full employment,
00:13:36.920 | and 2% inflation.
00:13:39.080 | So that is a theoretical interest rate level
00:13:42.680 | that is neither stimulating or restricting economic growth.
00:13:46.120 | And what level is that, do you believe?
00:13:48.920 | Yeah, one thing, Rick, is that neutral rate is not observable.
00:13:53.040 | So you can only infer that from how
00:13:56.560 | the economy is faring in the face of monetary policy
00:13:59.960 | tightening.
00:14:00.600 | So one thing we will say is that, well, it
00:14:03.200 | was estimated that before the pandemic,
00:14:07.960 | during after the GFC period, it was
00:14:10.480 | estimated that the neutral rate is about 2.5% in nominal terms,
00:14:15.760 | 2% inflation plus 0.5% real rates.
00:14:19.200 | And this is a T-bill.
00:14:20.280 | This is very short-term money.
00:14:22.160 | Yes, very short-term.
00:14:23.680 | The fact that after the pandemic in the last several years,
00:14:27.240 | that the economy has fared so well
00:14:29.560 | in the face of aggressive monetary policy tightening,
00:14:32.400 | literally 500 base point hike in less than two years,
00:14:36.320 | actually is telling us that the neutral rate, the equilibrium
00:14:40.080 | interest rate level, should be higher.
00:14:42.880 | It should be higher than 2.5 nominally,
00:14:45.920 | which if the Fed's target is 2% would mean a half a percent.
00:14:48.800 | So you're saying it actually should be higher
00:14:50.720 | than a half a percent real.
00:14:53.240 | Yes.
00:14:53.840 | I think then the next question is, how much higher?
00:14:57.120 | That would have been my next question, yes.
00:14:59.640 | So this is where we actually have done our estimation model,
00:15:03.680 | now metrics model, to estimate what
00:15:06.360 | is exactly the level of the neutral rate at this moment.
00:15:09.520 | And our model shows us, because of this demographic changes,
00:15:14.360 | because of this persistent structural deficit,
00:15:18.480 | fiscal deficit, and also because of higher productivity growth
00:15:22.520 | down the road, we do see that the neutral rate in the US
00:15:26.360 | nowadays is 100 base points higher than what
00:15:29.800 | we have seen in the past.
00:15:31.600 | We are actually expecting a 3.5% of neutral rate
00:15:35.680 | in nominal terms at this moment.
00:15:37.760 | So at 3.5%, if the Fed gets inflation down to 2%,
00:15:42.960 | and you could get 3.5% from a money market,
00:15:46.840 | and then you have about 10 years,
00:15:48.240 | and you've got to pick up 1% there as well,
00:15:50.640 | so you're at 4.5%, that's going to compete against equities.
00:15:55.520 | Will it not?
00:15:56.920 | Yeah.
00:15:57.560 | I mean, totally.
00:15:58.280 | I mean, Rick, this is where we say, at this moment,
00:16:00.880 | one of the big messages from our paper is that the bond is back.
00:16:04.880 | Bond is back.
00:16:06.280 | Yeah, bond is back.
00:16:07.720 | I think in the past decade, when you have very low yield
00:16:11.640 | from the bond market, then essentially, I
00:16:14.360 | think it's a very tough time for our bond investors.
00:16:17.560 | Basically, the only return you get
00:16:19.840 | is because of the price changes.
00:16:21.800 | For bond, you have two components of return.
00:16:24.600 | One is the coupon income, and the other is a price change.
00:16:28.240 | When your coupon income is very low or zero,
00:16:31.000 | then you actually suffer a lot from the volatility
00:16:34.240 | in price changes.
00:16:35.240 | But down the road, what we have, the coupon income return
00:16:38.760 | is back.
00:16:39.640 | I think when you could have, let's say, 4.5%
00:16:43.520 | from this long-duration bond return,
00:16:46.200 | the valuation is reasonable.
00:16:48.000 | That's decent to return from your fixed income portfolio.
00:16:52.280 | Now, on the other hand, you have equity valuation
00:16:56.240 | pretty stretched at this moment, especially in the US market.
00:17:00.960 | This is where we actually see the US equity market.
00:17:04.080 | The valuation is currently about 15%
00:17:06.880 | above our fair value estimate.
00:17:09.200 | So given this very compressed equity risk premium,
00:17:13.400 | we would actually prefer to go into bond,
00:17:16.960 | go into fixed income portfolio more in a balanced bond equity
00:17:21.360 | portfolio.
00:17:22.280 | We're going to get to the market model.
00:17:24.840 | But I wanted to continue to move on
00:17:26.400 | with the implications for a higher interest
00:17:29.800 | rate to consumers.
00:17:32.920 | Go to buy a car, it's going to cost more money.
00:17:36.000 | Go to buy a house, mortgage rates are going to be high.
00:17:39.120 | And this is going to drain money from consumers.
00:17:44.200 | And so how did this new regime of higher real rates
00:17:49.800 | in the long term affect consumer spending?
00:17:53.680 | Yeah, higher risk obviously will make saving much more
00:17:57.120 | attractive for consumers.
00:17:59.080 | And I think they will also be more discreet in making
00:18:02.920 | boring decisions as housing, also big ticket items that
00:18:08.600 | are often financed with debt becomes more expensive.
00:18:12.880 | So I think this actually will bring consumers
00:18:15.880 | into a more healthy situation, which is actually
00:18:19.640 | going to benefit the economy, make the economy more
00:18:22.360 | resilient in the longer term.
00:18:24.680 | Because there would be propensity for people
00:18:27.320 | to save more and maybe spend a little less.
00:18:31.120 | Your forecast for GDP growth, economic growth in the United
00:18:35.640 | States, still positive, but much lower
00:18:38.480 | than it's been, say, even in the last 12 months.
00:18:43.520 | Yeah.
00:18:44.400 | Rick, I think this is where we differentiate
00:18:46.360 | our more long term outlook with our more near term outlook.
00:18:50.840 | When you think about why the economy has
00:18:54.240 | stayed so resilient in the face of over 500 base
00:18:58.120 | points tightening by Fed, consumer, right?
00:19:01.760 | Consumption spending is one of the very important factors
00:19:05.040 | behind that.
00:19:06.080 | Consumption has been holding up so well in 2023.
00:19:10.720 | There are several setting factors, fiscal support.
00:19:15.000 | When you think about a lot of the fiscal support
00:19:17.360 | during the pandemic to the household, the small business,
00:19:20.240 | and also the fact that we cannot really
00:19:22.800 | spend that much during the pandemic.
00:19:24.680 | And consumers end up with a lot of excess savings.
00:19:27.560 | And we haven't seen that excess saving
00:19:29.720 | being exhausted at this moment.
00:19:32.200 | We'll soon, but not yet.
00:19:34.200 | And then they also have very healthy balance sheets
00:19:37.800 | and leverage on the other side.
00:19:39.720 | Let's compare now to 2008 during the GFC period.
00:19:43.920 | A lot of the consumer loans at this moment are fixed rated.
00:19:49.280 | So only 8% of consumer credit at this moment
00:19:52.680 | is based on variable rate compared to 40% in 2008.
00:19:57.400 | So that actually shelled them from the pain of higher
00:20:01.200 | interest rate.
00:20:02.120 | And also more excess saving on their balance
00:20:04.080 | sheet means that they don't need to borrow
00:20:05.800 | that much at this moment.
00:20:07.120 | Plus, labor market is so tight.
00:20:09.880 | Wage growth is pretty decent.
00:20:11.880 | So all of those actually has supported consumer spending
00:20:15.360 | so far.
00:20:16.320 | Now in 2024, what we expect is that some of those offsetting
00:20:21.440 | factors will fade.
00:20:23.200 | So we do have excess savings will largely exhausted
00:20:26.880 | probably towards the middle of next year.
00:20:29.240 | It has already exhausted for low income cohorts of household.
00:20:33.440 | And then some of the fiscal support actually will fade.
00:20:37.400 | And then you also have labor market that will start to cool.
00:20:40.840 | And also another reason, when you look at the business side,
00:20:44.880 | I think in the last several years,
00:20:46.960 | we had a lot of industry that financed industry policy
00:20:50.520 | from the government.
00:20:51.560 | Actually, that supported a booming pace
00:20:54.600 | of investment in the infrastructural and also
00:20:57.120 | construction space.
00:20:58.560 | Those things are actually supporting the economic growth
00:21:01.960 | in the past 12, 24 months.
00:21:03.920 | But the pace could also slow down the road.
00:21:06.800 | So this is why we are expecting the economic growth to slow,
00:21:10.840 | especially when monetary policy finally becomes more restrictive
00:21:16.320 | when inflation fall.
00:21:17.520 | So in real terms, monetary policy
00:21:19.840 | will become more restrictive and start to bite.
00:21:22.640 | So this is where we expect the economy to cool down,
00:21:25.560 | labor market to cool.
00:21:27.560 | And then the economy comes into a minor recession
00:21:30.400 | in the second half.
00:21:31.640 | I am 65 years old.
00:21:34.040 | I live in an over 55 community with a whole bunch
00:21:37.040 | of people around me who are in their late 50s, 60s, 70s.
00:21:42.000 | People around here are spending money,
00:21:43.680 | but their homes are paid off.
00:21:45.280 | They've got money in the bank.
00:21:46.680 | They've got Social Security coming in.
00:21:48.880 | They've got 401(k)s that have a good amount of money in it.
00:21:52.680 | They're spending money.
00:21:54.000 | So these higher interest rates don't
00:21:57.000 | affect certain demographics.
00:21:59.640 | And the boomers are a huge demographic.
00:22:02.160 | I just see that this will continue for a while
00:22:04.400 | until my generation gets older and doesn't
00:22:07.400 | go on as many vacations.
00:22:09.160 | How is that affecting the scenario
00:22:11.280 | that you just laid out?
00:22:12.920 | Rick, I think that's one of the reasons
00:22:14.880 | we expect the recession to be a pretty mild one.
00:22:18.720 | The consumer fundamentals is actually--
00:22:21.560 | the private sector fundamental is pretty resilient,
00:22:24.400 | pretty solid.
00:22:25.640 | So I think this is where it's very different from 2008
00:22:29.200 | during the subprime crisis, GFC, when the consumer sector is
00:22:33.360 | so highly leveraged.
00:22:35.080 | And then when you have the subprime crisis,
00:22:37.800 | this trigger a much deeper downturn
00:22:40.520 | led by the deleveraging of the private sector.
00:22:43.520 | Now, I think when you look at what we have right now,
00:22:46.760 | especially in the consumer sector, as we just mentioned,
00:22:49.680 | balance sheet look pretty solid.
00:22:51.680 | And then the labor market, what we are expecting
00:22:55.080 | is that because of a structural labor
00:22:57.280 | shortage in this economy, even in a minor recession,
00:23:00.760 | in a recession, we are not expecting the unemployment rate
00:23:04.000 | to shoot up significantly.
00:23:06.440 | In a typical recession, unemployment rate
00:23:08.520 | will shoot up to, say, over 6%.
00:23:10.960 | What do we expect?
00:23:12.120 | We're expecting 4.8%, like 1% higher than what we have today.
00:23:17.240 | This is higher than what Fed is expecting.
00:23:19.840 | But still, it's not a big jump.
00:23:22.280 | So I think overall, those things coming together,
00:23:25.600 | I think that's helped to explain why the economic downturn
00:23:30.240 | and the economic recession will be rather mild.
00:23:32.760 | People will be more prudent when they spend,
00:23:35.440 | but they probably will continue to spend.
00:23:37.600 | Well, let's look outside the United States,
00:23:40.120 | the rest of the world.
00:23:41.760 | Are we leading the world, or are we in line with the world,
00:23:45.000 | or are we behind the rest of the world
00:23:46.680 | as far as the recovery from COVID?
00:23:50.000 | I mean, I think in the past several years,
00:23:52.280 | the US obviously has been leading
00:23:55.000 | the global economic recovery.
00:23:56.920 | I think that's also one of the reasons why the US
00:23:59.400 | dollar has been so strong.
00:24:00.920 | Because the currency is like a horse race.
00:24:03.480 | It's not just about how fast you run,
00:24:05.080 | but also how fast or slow the other horses run.
00:24:08.920 | This is what we call the US exceptionalism,
00:24:11.880 | US economy being strong.
00:24:13.480 | And then that is where we are seeing the currency actually
00:24:16.760 | has been strong.
00:24:18.160 | But I think in 2024, what we are expecting
00:24:21.240 | is that what we call the fading of US exceptionalism.
00:24:24.960 | In 2023, what do we have in terms of economic growth?
00:24:29.000 | It's 2.5% to 3%, well above the trend growth
00:24:33.320 | that in our estimate is about 1.8%.
00:24:36.320 | So now you think about the US economy
00:24:38.120 | has been holding so well in 2023 to the very resilient
00:24:43.720 | private sector and also a lot of the offsetting factors.
00:24:46.880 | In fact, in our estimation, we think the US growth
00:24:49.840 | could have been 0% growth this year
00:24:53.480 | without those offsetting factors.
00:24:55.600 | But instead, this year what we see
00:24:58.560 | is about 2.5% to 3% growth.
00:25:00.760 | But in 2024, what we expect is a slowdown
00:25:06.320 | in the US economic growth.
00:25:08.040 | We are actually expecting only about 0.5% growth to 1%
00:25:13.280 | in 2024.
00:25:14.800 | And then the rest of the world, the Europe,
00:25:17.520 | will stay muted around 0.5% as well.
00:25:21.240 | And then emerging market is actually
00:25:23.480 | going to hold up pretty well.
00:25:25.560 | In fact, I would say a milder recession from the US
00:25:28.080 | is probably the second best thing for emerging market.
00:25:30.960 | A recession means Fed will cut interest rate.
00:25:33.560 | And then a milder recession means the growth shock
00:25:36.600 | won't be too big for emerging market.
00:25:38.600 | So with US actually slowed down more evidently,
00:25:42.200 | then this is what we call a fading of US exceptionalism.
00:25:46.360 | Probably US is no longer leading the global recovery next year.
00:25:50.520 | Interesting that you said when the Fed cuts,
00:25:52.960 | the emerging markets benefit.
00:25:54.680 | Could you explain that a little bit more?
00:25:56.400 | How do the emerging markets benefit when our US Fed cuts?
00:26:00.280 | So when you think about the link between the emerging market
00:26:04.400 | economy and the US, emerging market actually
00:26:07.360 | face significant the global financial condition.
00:26:10.760 | That actually will significantly influence emerging market.
00:26:13.920 | A lot of emerging market actually
00:26:15.440 | gets funding, US dollar funding, rely
00:26:18.200 | on the international capital flow for their funding.
00:26:21.840 | So when US, the Fed, start to cut, US dollar weaken.
00:26:27.000 | And risk appetite will start to turn more positive
00:26:30.400 | towards more risky asset.
00:26:32.400 | And that's where money actually will flow back
00:26:35.600 | to emerging market.
00:26:37.080 | This is where emerging market central banks,
00:26:39.800 | they also get more room to cut their own interest rate.
00:26:43.120 | So that's where I would say they could actually
00:26:45.240 | benefit from the Fed cut.
00:26:46.760 | You said that it's been a muddled recovery in Europe
00:26:49.800 | for several years, and it's going to continue.
00:26:52.440 | What's holding Europe back?
00:26:54.480 | Yeah, there's a lot of structural problem in Europe.
00:26:57.640 | But it is really about the monetary policy tightening.
00:27:00.680 | The monetary policy tightening is actually
00:27:03.040 | much more effective in Europe compared to the US,
00:27:05.960 | because they don't really have those offsetting factors.
00:27:09.520 | And also when you think about the monetary policy
00:27:12.160 | transmission channel in Europe, the European economy
00:27:15.640 | is much more reliant on the bank credit.
00:27:19.080 | So that is where banks can quickly
00:27:21.120 | adjust those interest rates.
00:27:23.280 | So that's where higher interest rate actually
00:27:25.400 | bites into the European economy much faster than what
00:27:29.000 | we've seen in the US.
00:27:30.280 | And then that's where we see the European economy is already
00:27:33.200 | flirting with a recession by the end of this year.
00:27:36.400 | So their economic growth was very muted in 2023,
00:27:40.720 | and also will continue to be muted in 2024.
00:27:44.680 | And plus, they don't have the fiscal policy buffer.
00:27:48.040 | This is very different from the US as well.
00:27:50.480 | Fiscal policy has been restrictive in 2023,
00:27:53.680 | and also in 2024 for Europe.
00:27:56.520 | Well, let's go to the other side of the world
00:27:59.560 | and speak to us about China.
00:28:02.280 | Our presidents just got together trying to bring
00:28:05.560 | in an era of better cooperation.
00:28:08.360 | It seems as though they need us.
00:28:11.080 | We need them.
00:28:12.440 | And so let's talk about our differences.
00:28:15.320 | That's the way I see it, but you have much better insight.
00:28:18.200 | Could you tell us your views on what's
00:28:20.320 | going on with China and the US and the relationship,
00:28:23.960 | and also China's economy?
00:28:26.280 | Yeah, I mean, Rick, there's a lot of uncertainty
00:28:28.800 | around the US-China relationship since the 2018 trade war.
00:28:33.720 | I think that's also one of the reasons why
00:28:36.120 | the domestic confidence, especially
00:28:38.240 | among the business person, is pretty low at this moment.
00:28:42.480 | Now, for the US-China relationship,
00:28:45.160 | I think one thing we have to understand,
00:28:48.000 | this is a structural issue that cannot be solved overnight
00:28:51.520 | or just by a meeting between the two presidents.
00:28:55.120 | I think there are two reasons for that.
00:28:57.400 | One is that between the two countries,
00:29:00.000 | there are so many discrepancies on many fundamental issues,
00:29:05.200 | like the economic model, the role of the government,
00:29:08.640 | intellectual property protection, investment,
00:29:11.800 | and even many political or geopolitical issues.
00:29:16.520 | And second, I think, let's say, even China, say,
00:29:19.880 | continue to make the market reforms or even
00:29:23.360 | get into political reform, I think
00:29:25.800 | the long-term competition between US and China
00:29:28.320 | is still unavoidable.
00:29:30.280 | From a historian perspective, there
00:29:32.480 | will always be competition, tension
00:29:34.840 | between a rising superpower and an existing superpower.
00:29:38.480 | That's what people call the "suicidist trap."
00:29:41.000 | I think the tension between the US-China
00:29:43.440 | will just continue in coming years and probably decades
00:29:46.480 | as well.
00:29:47.480 | Now, of course, I would say G7 realized
00:29:50.840 | that it may not be realistic or possible to entirely cut
00:29:55.320 | the economic tie with China, given how much China is
00:29:59.080 | actually integrated in the global trade,
00:30:01.880 | the global economy, and increasingly nowadays
00:30:05.040 | in the global financial system.
00:30:07.240 | So I think that's where they raise the concept to say,
00:30:10.840 | it's not about decoupling from China.
00:30:12.960 | It's de-risking, de-risking.
00:30:15.600 | So that is a 3C strategy.
00:30:18.160 | They're going to collaborate in some areas,
00:30:20.480 | for example, climate change.
00:30:22.240 | They're going to compete in certain areas,
00:30:24.680 | like technology.
00:30:26.600 | And then they're going to confront
00:30:28.120 | in some areas, like human rights and geopolitical issues.
00:30:32.240 | So I think this will be the strategy down the road.
00:30:35.120 | And it's not going to be surprising
00:30:36.920 | that this will have profound implications
00:30:39.680 | for the whole world.
00:30:40.760 | We are going to see a slower and also more fragmented
00:30:45.040 | globalization down the road.
00:30:47.000 | We don't think it's de-globalization.
00:30:48.960 | But the pace is going to be slower and more fragmented.
00:30:52.920 | And this actually will have negative implication
00:30:56.040 | on the resource allocation across the world.
00:30:59.200 | Think about capital, technology, and talent.
00:31:02.760 | So I think this will be a hit on the productivity growth
00:31:06.720 | and economic growth everywhere, for everybody.
00:31:09.680 | - Interesting.
00:31:10.680 | Can we talk about Japan?
00:31:13.280 | There seems to be a renaissance starting in Japan, finally,
00:31:17.440 | since basically the market collapsed in 1990,
00:31:22.440 | and it hasn't been back since.
00:31:25.160 | - Yeah.
00:31:27.080 | You know, I think Japan has suffered three decades, right?
00:31:29.800 | It's not just one lost decade.
00:31:31.320 | It's lost three decades ever since the market collapsed.
00:31:35.200 | So I think over the past 30 years,
00:31:37.560 | I think the biggest problem for the Japan economy
00:31:40.920 | is actually lack of confidence.
00:31:43.040 | People don't really see the future.
00:31:44.840 | Now, one of the thing over the past three years,
00:31:47.360 | you know, some people call balance sheet recession.
00:31:49.720 | It's basically deleveraging.
00:31:51.680 | Both household and corporate,
00:31:54.000 | they are trying to clean up their balance sheet,
00:31:56.760 | reduce their leverage, their assets.
00:32:00.280 | And then because of this lack of confidence
00:32:03.800 | about the future outlook,
00:32:05.480 | then there is no incentive for people to spend,
00:32:08.360 | especially when there's deflation,
00:32:10.440 | and there's no incentive for business to make investment.
00:32:14.280 | After all, demographic
00:32:16.000 | is one of the very important factor there.
00:32:18.560 | By the United Nation estimation,
00:32:20.960 | Japan population will be 40% lower
00:32:24.520 | by the end of the century.
00:32:26.120 | - Yes.
00:32:27.040 | - If you don't really see people,
00:32:29.000 | and we know that immigration policy in Japan
00:32:32.040 | has been more strict,
00:32:33.600 | then who are you gonna invest for?
00:32:36.280 | You know, you build up the factory,
00:32:37.720 | you produce those products for whom, right?
00:32:40.440 | So I think a very important thing,
00:32:42.960 | you know, happened over the past 30 years.
00:32:45.600 | Two things.
00:32:46.440 | One, deleveraging for the private sector.
00:32:49.680 | That's also why the Japanese government debt is so high,
00:32:53.360 | because without private demand,
00:32:55.160 | it's really the government public spending
00:32:57.000 | that's holding up the economy.
00:32:58.720 | And second, the lack of confidence.
00:33:00.960 | So coming to now, 30 years later, what do we have?
00:33:05.120 | One, the private sector balance sheet
00:33:07.200 | is pretty healthy at this moment.
00:33:08.680 | They have a lot of money to spend.
00:33:11.400 | And second, the confidence has finally start to turn around,
00:33:15.240 | because inflation is now up, right?
00:33:17.800 | People see inflation down the road.
00:33:19.400 | And there is a structural change in the price setting,
00:33:24.320 | and which setting behavior,
00:33:26.040 | which growth is finally picking up,
00:33:28.160 | because of the structural labor shortage.
00:33:31.240 | And then behind the scene,
00:33:32.240 | the government has done a lot of reform,
00:33:33.880 | trying to push for labor market reform,
00:33:35.960 | corporate governance reform.
00:33:37.720 | So I think at this moment,
00:33:39.440 | this kind of higher inflation after the pandemic
00:33:41.920 | was really just a trigger.
00:33:43.600 | When inflation is back, confidence is back,
00:33:46.840 | private sector has money to spend.
00:33:49.040 | That's where we think the Japanese economy
00:33:51.800 | will actually start to continue to grow down the road.
00:33:55.680 | - I just have one more country that I wanna ask about,
00:33:57.920 | because it's been coming up so much in the news,
00:33:59.880 | and it seems really interesting, and that's India.
00:34:02.920 | Can you tell us a little bit about outlook for India?
00:34:06.320 | - Yeah, I think from an economic perspective,
00:34:11.680 | we are indeed quite positive about India.
00:34:16.000 | This is a vast market with a very large population.
00:34:20.960 | It will resemble China a little bit,
00:34:23.640 | almost 30 or 40 years ago.
00:34:25.720 | And especially when the government,
00:34:28.360 | the Modi government is actually starting
00:34:30.160 | to do a lot of structural reform,
00:34:32.080 | land reform, building up the infrastructural,
00:34:34.440 | financial reforms, right?
00:34:36.080 | So this is where actually they are ready
00:34:38.320 | to leverage the significant potential of the economy.
00:34:42.360 | In fact, most recently you do see
00:34:44.320 | that India is benefiting
00:34:45.920 | from this global supply chain adjustment as well.
00:34:49.000 | They are actually getting more FDI,
00:34:51.800 | foreign direct investment, building up factories.
00:34:54.600 | So I think this is where India actually will benefit
00:34:58.160 | from this global supply chain adjustment
00:35:01.120 | and continue to unleash its gross potential down the road.
00:35:05.160 | Now, I think the question for investor is again,
00:35:09.160 | the most important question,
00:35:10.280 | what is the price we are paying for that?
00:35:12.840 | Because sometimes what I see is
00:35:15.040 | that investor get too optimistic,
00:35:17.600 | and we know that structural reforms is not that easy.
00:35:22.120 | I think there's a lot of encouraging progress in India,
00:35:25.160 | structural reforms, macro reforms,
00:35:27.920 | they do come up with a decent macro policy framework
00:35:31.320 | like monetary policy, fiscal discipline.
00:35:33.560 | A lot of them are very encouraging,
00:35:36.000 | but structural reforms,
00:35:37.440 | especially when it involves vested interest group,
00:35:40.880 | you know, sometimes it takes much longer
00:35:43.200 | than people expect it.
00:35:44.600 | So I think that is where we would say,
00:35:46.840 | yes, on the economic front, we see a lot of potential,
00:35:50.160 | but on the equity side,
00:35:51.720 | I think on the investment side,
00:35:53.120 | I think investors should be careful
00:35:54.920 | about what price we are paying for that
00:35:57.040 | and what is priced in by the market.
00:36:00.000 | - Interesting.
00:36:00.960 | Let's go ahead and get into the second part of this,
00:36:03.080 | which is valuation and actual investing.
00:36:05.960 | So we're gonna take the economic side
00:36:09.000 | of everything that we talked about,
00:36:10.600 | and we're going to equate it back to expected returns
00:36:15.280 | from US stocks, international developed market stocks,
00:36:19.400 | emerging market stocks, bonds,
00:36:21.720 | both in the US and internationally.
00:36:23.800 | And we're just gonna go through these asset classes.
00:36:26.720 | And again, this is Vanguard's view
00:36:28.760 | based on your economic outlook.
00:36:31.200 | And starting with the US stock market,
00:36:33.080 | I'm just using a very simple model of expected return,
00:36:37.440 | which would be three parts,
00:36:39.680 | which would be earnings growth,
00:36:41.720 | a dividend yield, which would include some buybacks,
00:36:44.880 | and valuation change.
00:36:47.760 | So using that as a backdrop
00:36:50.240 | for looking at the US stock market,
00:36:52.200 | you see lower returns going forward.
00:36:55.680 | And how would that break down among earnings growth,
00:36:59.000 | dividends, and change in valuation,
00:37:01.520 | which is price to earnings ratio?
00:37:03.560 | - Yeah.
00:37:04.400 | When you look at the three components,
00:37:06.840 | I think what is driving lower return in the US market,
00:37:11.360 | the one biggest thing I would say
00:37:12.840 | is indeed the valuation change.
00:37:15.000 | In fact, I would say what is really driving
00:37:18.440 | the outperformance of the US equity market
00:37:20.960 | in the past decade,
00:37:21.800 | it was really because of the significant
00:37:24.120 | validation expansion.
00:37:25.720 | Now that I think it has something to do
00:37:27.480 | with the macro environment,
00:37:28.800 | a low interest rate, low gross environment,
00:37:31.280 | and also the nature of the US equity market.
00:37:34.200 | As we know that US equity market
00:37:36.040 | was more tilting towards gross company,
00:37:38.080 | like IT technology companies,
00:37:40.240 | where their cashflow usually happens
00:37:42.920 | much later in the future.
00:37:44.920 | So a low interest rate environments,
00:37:47.440 | the discount rate for future cashflow is pretty low.
00:37:51.080 | That gives you a higher price.
00:37:52.800 | And also in a low gross environment,
00:37:55.080 | investors gross is scarce,
00:37:57.840 | and then investors are willing to pay
00:37:59.480 | a higher price for gross.
00:38:01.840 | So this actually explain the valuation,
00:38:04.560 | significant valuation expansion in the US market.
00:38:09.040 | - And particularly those mega cap eight stocks,
00:38:12.760 | whereas the rest of the market,
00:38:14.080 | the small cap, mid cap really didn't see that.
00:38:16.600 | - No.
00:38:17.480 | I think it's perfectly fine for investor
00:38:20.400 | to be forward looking.
00:38:21.600 | You incorporate a future news into today's price,
00:38:24.640 | but sometimes investor just get too optimistic,
00:38:28.120 | and sometimes we get ahead of ourselves.
00:38:31.160 | So I think at this moment,
00:38:32.960 | what we've seen is that the US market
00:38:35.280 | is quite overvalued at this moment.
00:38:38.480 | We have a fair value estimation,
00:38:40.520 | and we found that at this moment,
00:38:42.680 | the US equity market is about 15%
00:38:45.640 | above the fair value estimate.
00:38:48.160 | We say trees does not grow to the sky.
00:38:51.240 | It will have to eventually converge.
00:38:53.600 | Now, first it will converge to its fair value,
00:38:56.440 | and then even the fair value itself
00:38:58.440 | will start to decrease in a higher interest rate environment.
00:39:02.160 | So this valuation normalization or contraction
00:39:05.600 | is one of the bigger reason that we expect
00:39:08.240 | the expected return for the next decade
00:39:11.320 | will be much lower than what we have seen
00:39:13.560 | in the past decade.
00:39:15.520 | You talk about the building blocks,
00:39:17.320 | other than the valuation contraction,
00:39:19.800 | then the other ones obviously is also earnings growth.
00:39:23.440 | Earnings growth will be lower, right,
00:39:26.040 | than what we have seen in the past.
00:39:28.040 | Now, I think a very important reason
00:39:30.160 | is because of the profit margin
00:39:32.320 | that will start to come down.
00:39:33.960 | Important reason like the nearshoring, unshoring.
00:39:37.240 | When we focus the global supply chain adjustment
00:39:40.240 | focus more on resilience, security,
00:39:43.360 | in addition to efficiency,
00:39:44.960 | then that tells you there will be more cost involved.
00:39:47.960 | And then also the slower pace of globalization,
00:39:51.560 | more fragmented, also means that we may not be able
00:39:54.800 | to enjoin the low labor cost across the world
00:39:57.600 | in the best way.
00:39:58.600 | That also increase labor cost.
00:40:00.560 | And we know there is a structural labor shortage
00:40:02.920 | even domestically as well.
00:40:05.120 | So this is where we actually see earnings growth
00:40:08.120 | will also be lower down the road.
00:40:11.160 | - And yet, when we look at the valuations
00:40:13.640 | of small cap stocks and mid cap stocks,
00:40:16.720 | the PEs, forward looking PEs are at the lowest
00:40:19.960 | they've been in decades.
00:40:23.040 | Do you see any improvement there?
00:40:25.760 | - Yeah, I mean, Rick, I think that's exactly what you said.
00:40:29.080 | Yes, overall, it seems like the US equity market
00:40:32.200 | is overvalued, but not for everybody.
00:40:35.320 | If you think about the market performance,
00:40:37.600 | this year, it was pretty much all because
00:40:40.880 | of the Magnificent Seven.
00:40:42.720 | - Yes.
00:40:43.560 | - There could be opportunities, actually,
00:40:44.960 | if you look into the market.
00:40:47.520 | What we see is that large cap and also gross company
00:40:51.560 | are pretty overvalued.
00:40:52.960 | But on the other hand, we do see opportunities
00:40:55.600 | of value company as well as small caps,
00:40:58.240 | especially when we get into a higher interest rate
00:41:00.960 | environment, and those company will benefit more.
00:41:04.040 | - So let's go outside the US.
00:41:05.880 | We don't have the high valuations.
00:41:07.920 | PEs are almost half, not quite, but price to book,
00:41:12.480 | return on equity, everything showing foreign stocks
00:41:16.600 | look very much like mid cap value companies.
00:41:19.840 | So what is your outlook for expected returns
00:41:23.480 | from developed markets and then emerging markets?
00:41:26.400 | - Right, so when you look across the world,
00:41:29.160 | what we have seen is that non-US development market
00:41:32.680 | valuation are pretty reasonable.
00:41:34.440 | They didn't really expand that much over the past decade.
00:41:37.640 | So at this moment, I would say they are actually
00:41:40.960 | reasonably valued, and in some places, even undervalued.
00:41:44.760 | And then emerging markets is also undervalued in our view.
00:41:48.760 | So this is where, in terms of the outlook
00:41:51.400 | for the next 10 years, we actually expect
00:41:54.440 | international market, that's non-US market,
00:41:56.640 | to outperform the US.
00:41:58.520 | Let me give you some numbers here.
00:42:00.360 | We actually expect about the annualized return
00:42:03.840 | in the coming decades, about 4.2 to 6.2% for the US market.
00:42:08.840 | But on the other hand, our expectation
00:42:11.960 | for non-US developed market is about 7 to 9% per year
00:42:15.400 | over the next 10 years, and 6 to 6 to 8.6% per year
00:42:20.160 | for emerging market.
00:42:21.480 | So this is where we would encourage our investors
00:42:24.840 | to have a globally diversified portfolio.
00:42:27.600 | - And part of this is the currency change.
00:42:31.000 | You're expecting the dollar to be softer,
00:42:34.520 | say, over the next several years,
00:42:36.720 | and this will boost up international stock returns
00:42:40.120 | because they trade in native currency.
00:42:42.040 | According to your report, about 1.1% or 1%
00:42:44.960 | as you're expecting.
00:42:46.080 | - Right.
00:42:46.920 | First, I would say the US dollar is also expensive.
00:42:49.800 | We also estimate that the US dollar is about 12%
00:42:53.520 | above our estimates of fair value.
00:42:56.080 | And the second thing, in the coming decade,
00:42:58.360 | we do think that there's more headwinds to the US dollar
00:43:01.800 | than tailwinds because of the structural fiscal deficit,
00:43:05.920 | and also because of the current account deficit as well.
00:43:09.040 | Those do not bode that well for US dollar.
00:43:12.080 | So we do expect the US dollar to depreciate
00:43:14.800 | in the coming decade.
00:43:16.280 | But Rick, one thing I would emphasize
00:43:18.400 | is that when we make those forecast,
00:43:20.920 | it's really for the long-term, right?
00:43:23.560 | So they expected a return.
00:43:26.320 | We are not saying that every year, you know,
00:43:28.720 | international market will give 8% return.
00:43:31.360 | We're saying that on an annualized basis,
00:43:34.280 | this will be realized.
00:43:35.960 | It could be that in the near term,
00:43:37.920 | especially if we get into a sharper economic downturn,
00:43:41.120 | investor risk appetite start to decrease significantly
00:43:45.200 | and everybody fly to safe assets.
00:43:47.760 | But we are talking about when your investment horizon
00:43:50.920 | is actually much longer,
00:43:52.360 | then the fundamental will reassert themselves.
00:43:55.680 | And that is where we see the US dollar
00:43:58.080 | is heading towards depreciation.
00:44:00.640 | And this is indeed one of the reason
00:44:02.840 | we expect international equity to outperform
00:44:06.520 | in US dollar terms.
00:44:08.800 | - So before we get to your Vanguard capital markets model,
00:44:12.960 | where you provide guidance on percentages
00:44:16.040 | to each one of the asset classes,
00:44:17.440 | I just wanna summarize what the report says.
00:44:20.560 | And there are three parts.
00:44:22.560 | The first one is monetary policy will bear its teeth.
00:44:26.920 | - Yep.
00:44:27.760 | So I think this is where we all know
00:44:30.680 | that there is a long and variable lag
00:44:33.720 | of monetary policy transmission.
00:44:35.680 | And then we also had a lot of offsetting factor in 2023
00:44:40.360 | that actually keeps the economy gross pretty solid, right?
00:44:45.360 | In 2023.
00:44:46.520 | However, in 2024, we expect those offsetting factors
00:44:50.720 | will fade and then monetary policy
00:44:53.560 | will become increasingly restrictive when inflation fall.
00:44:57.800 | So monetary policy will be more restrictive in real terms.
00:45:01.600 | And that actually will weigh on the economy
00:45:04.320 | where we see the economics actually get into
00:45:07.760 | a minor recession in the second half of next year.
00:45:10.880 | - But we also see our start,
00:45:14.160 | which is the neutral rate where it's neither recessionary
00:45:18.120 | nor expansionary, that this number you believe
00:45:22.720 | is actually going to be moving higher
00:45:25.200 | and has moved higher and will stay higher.
00:45:27.680 | - Yeah.
00:45:28.520 | - And you mentioned that you thought it would be about
00:45:30.760 | a real return of about 1.5% on short-term money,
00:45:35.320 | which would be T-bills.
00:45:37.200 | - Yes.
00:45:38.040 | This come to the monetary policy,
00:45:39.280 | what Fed will do in response to that economic downturn.
00:45:43.560 | We think of Fed and global central banks
00:45:46.040 | will cut interest rate next year.
00:45:48.480 | But even if they cut, we don't think we will get back
00:45:51.560 | to zero interest rate anytime soon.
00:45:54.040 | Zero rates are just yesterday's news.
00:45:56.640 | You know, beyond this business cycle,
00:45:58.400 | we believe we will settle
00:45:59.800 | into a higher interest rate environment.
00:46:02.240 | A very key important reason, as you just mentioned,
00:46:04.800 | is because of the R star, the equilibrium interest rate
00:46:08.600 | that is neither stimulating nor restricting
00:46:11.320 | the economic growth is permanently higher.
00:46:14.000 | In the U.S., we estimate that neutral rate level
00:46:17.240 | is now 3.5%, 100 base point higher
00:46:21.600 | than what we have seen in the past decade.
00:46:24.040 | - And so all this leads for investors to bonds are back,
00:46:28.720 | U.S. stocks, not so much, but developed markets
00:46:32.760 | and particularly emerging markets look good.
00:46:35.200 | - Yeah.
00:46:36.040 | I think it's a great news for our bond investors,
00:46:38.480 | not just that coupon income is back,
00:46:41.200 | but also, you know, at this more reasonable valuation
00:46:44.800 | and higher yield, the diversification benefit of bond
00:46:48.400 | actually is coming back as well.
00:46:50.880 | With bond actually being returned,
00:46:53.640 | outlook being pretty attractive,
00:46:55.720 | and also because the equity market evaluation
00:46:58.280 | is somewhat stretched, especially in the U.S.,
00:47:01.360 | we would actually, number one, of course,
00:47:03.800 | they continue to stay diversified, stay long-term.
00:47:06.640 | But on the other hand, I think that they could actually
00:47:09.040 | come up with a more defensive portfolio.
00:47:11.480 | That is where we could overweight bond
00:47:14.080 | and underweight equity a little bit.
00:47:16.520 | And then within the equity,
00:47:18.560 | we would also overweight international equity.
00:47:22.240 | And that includes emerging market
00:47:23.760 | as well as non-U.S. development market as well.
00:47:27.680 | - Well, let's go ahead and get into that model.
00:47:29.880 | And the model is the Vanguard Capital Markets model,
00:47:34.800 | which you chair the committee?
00:47:36.360 | - Yes.
00:47:37.200 | - This is your thing.
00:47:38.040 | - Yeah.
00:47:38.880 | - It's in the report, so you can look at it.
00:47:40.560 | It has all the breakdown,
00:47:41.960 | not only just U.S. stocks, international stocks,
00:47:43.920 | but it gets into factors, you know, value versus growth.
00:47:46.720 | - Yeah.
00:47:47.560 | - So let's go ahead and go through
00:47:48.400 | just the numbers really quickly.
00:47:49.720 | You compared it to our basic 60/40 portfolio,
00:47:53.280 | 60% stocks, 40% bonds,
00:47:55.320 | where 36% of these stocks were U.S.
00:47:58.640 | and 24% were international,
00:48:01.120 | which is the global split between U.S. and international.
00:48:04.640 | And on the bonds, you had 28% U.S.
00:48:07.720 | and then international, you had 12%.
00:48:09.840 | So that's the benchmark.
00:48:11.080 | - Right.
00:48:11.920 | - That never changes.
00:48:13.200 | - Right.
00:48:14.040 | - But your time varying asset allocation,
00:48:17.000 | if you were going to be a tactical,
00:48:20.480 | I know you maybe don't like that word tactical,
00:48:22.560 | but I'm using it.
00:48:24.040 | If you were gonna be tactical,
00:48:26.520 | it would look much different.
00:48:28.240 | First of all, the stock and bond mix
00:48:30.400 | would be far less equity.
00:48:33.240 | I see here you have equities overall
00:48:36.080 | would be just over 40%
00:48:38.800 | and bonds or fixed income overall
00:48:40.800 | would be just shy of 60%.
00:48:43.080 | So talk about that first
00:48:44.280 | and then we can get into the nitty gritty.
00:48:46.680 | - I think the first thing, Rick,
00:48:48.040 | is that our time varying asset allocation model
00:48:51.280 | is different from a tactical asset allocation.
00:48:54.040 | - Okay.
00:48:54.880 | - Because as it's long-term and also strategic in nature.
00:48:58.920 | So I think when we say time varying, what do we mean?
00:49:01.440 | We mean, we take the current market evaluation
00:49:04.320 | into consideration because through our research,
00:49:07.360 | we do find that starting valuation,
00:49:09.600 | both for bond and equity,
00:49:11.240 | is the most reliable predictor
00:49:14.000 | for the long-term expected return,
00:49:16.440 | not for the short-term, for long-term.
00:49:18.600 | So that is where we actually get more confident
00:49:21.040 | with this forecast when the time horizon gets longer.
00:49:25.160 | And then we are still trying to maximize
00:49:27.440 | the risk-adjusted long-term return of a balanced portfolio.
00:49:31.800 | In this case, we actually have a 10-year time horizon.
00:49:35.400 | I think this is a critical difference
00:49:36.840 | between us and a tactical asset allocation.
00:49:39.440 | We are not focusing on the performance in the short-term.
00:49:42.880 | And then I think coming to this,
00:49:46.160 | how we allocate and make an allocation, right?
00:49:48.280 | We look at the global 60/40.
00:49:50.000 | I think sometimes when people talk about global 60/40,
00:49:53.400 | is really that exact number?
00:49:55.280 | I doubt.
00:49:57.120 | I think the 60/40 is really like symbolized
00:50:00.200 | the concept of diversification.
00:50:02.440 | It's a mix between bond and equity
00:50:04.760 | when you have bond as a ballast to the portfolio
00:50:07.920 | when you are experiencing equity downturn, right?
00:50:11.520 | So I think it is really about
00:50:12.720 | that concept of diversification.
00:50:15.400 | But I think coming down the road,
00:50:17.480 | I think when we use the global 60/40 as a benchmark,
00:50:21.280 | so we say, if we want to achieve the same expected return
00:50:24.800 | for global 60/40 in 10 years,
00:50:27.320 | and then we take into the current valuation
00:50:29.840 | into consideration, what can we do?
00:50:31.960 | And we found that if we go 59% fixed income
00:50:36.640 | and 41% equity, that still give us the same expected return
00:50:41.480 | as global 60/40, but at a lower risk.
00:50:45.120 | So essentially we end up with higher risk adjusted return.
00:50:48.480 | Very good.
00:50:49.320 | So on the equity side, it's interesting
00:50:51.600 | because rather than having total market equities,
00:50:55.160 | total U.S. market being 60% and international being 40%,
00:50:59.520 | you are taking a heavier weighting towards value
00:51:03.120 | and a lesser weighting towards growth.
00:51:06.400 | You are taking a larger weighting towards small cap.
00:51:09.560 | You are taking quite an equal weighting
00:51:13.880 | between emerging markets and developed markets.
00:51:16.320 | These are pretty radical shifts.
00:51:19.200 | I mean, you're not ignoring U.S. large cap growth.
00:51:22.200 | You're not ignoring developed markets,
00:51:24.440 | but you're really focusing on value,
00:51:27.320 | small cap, emerging markets,
00:51:29.720 | the ones where you see valuation.
00:51:31.320 | Yes, this is where we do see the value,
00:51:34.800 | the opportunity in the longterm.
00:51:37.000 | A large part of that is because of the valuation
00:51:39.560 | that we just mentioned.
00:51:40.960 | We do see that relatively speaking,
00:51:43.600 | value, small cap, and also emerging market
00:51:46.720 | and non-U.S. developed market
00:51:48.400 | are relatively more reasonably valued,
00:51:51.920 | or even in some cases, undervalued.
00:51:54.040 | So that is where we do see higher expected return
00:51:58.880 | in the longterm.
00:52:00.160 | Now, I think there are several things
00:52:02.360 | I do want to highlight.
00:52:03.760 | When we talk about valuation,
00:52:05.520 | and I just mentioned,
00:52:06.520 | valuation is the most reliable indicator
00:52:09.040 | for longterm expected return.
00:52:12.000 | But even so, I would say,
00:52:14.000 | remember the keyword of longterm.
00:52:16.320 | It doesn't mean that immediately
00:52:18.640 | the valuation will converge,
00:52:20.360 | will contract or increase.
00:52:22.560 | I would say valuation is never really a good timing tool
00:52:25.600 | for the short-term development.
00:52:27.920 | In fact, valuation can stay overvalued
00:52:31.200 | or undervalued for a very longterm,
00:52:33.560 | especially if the macro environment,
00:52:35.600 | say interest rate has stayed persistently lower for longer,
00:52:39.120 | or higher for longer, right?
00:52:40.600 | So I think that's one caveat.
00:52:42.480 | Don't use that, say, to predict value
00:52:45.280 | or small cap will immediately outperform
00:52:48.240 | next year or next month, right?
00:52:49.840 | So that's one caveat.
00:52:50.920 | - I think that small cap value investors
00:52:53.320 | have learned that lesson over the last several years.
00:52:55.760 | - Yeah.
00:52:56.600 | And the other thing I do want to say
00:52:57.920 | is that our performance is not guaranteed.
00:53:01.400 | So this comes back to our Vanguard capital market model.
00:53:04.880 | The VCMI model operates in a probabilistic framework.
00:53:09.040 | When we predict about the future,
00:53:10.480 | it's not just one scenario.
00:53:12.320 | We actually do 10,000 simulation.
00:53:15.080 | There could be 10,000 scenarios in the future.
00:53:18.200 | And that gives you a probability distribution of the future.
00:53:22.560 | Everything is about probability.
00:53:24.920 | So let me use the international versus US as an example.
00:53:29.960 | Back in 2015, we say, oh, there is a 65% chance
00:53:33.840 | for international market to outperform
00:53:36.200 | in the next 10 years.
00:53:38.480 | And today, the chance actually increased to 70%.
00:53:42.120 | So you could always argue there is still a chance
00:53:45.080 | that the US continue to outperform over the next decade.
00:53:48.400 | But even if that happens,
00:53:49.960 | our analysis suggests that it will still be difficult
00:53:53.160 | for the US to outperform to the same degree
00:53:55.560 | as it did over the last decade
00:53:57.720 | because of the higher interest rate environment.
00:54:00.960 | So I think in the end, this is where we still say,
00:54:03.960 | we say we caution our US investor
00:54:06.120 | against a very strong home bias,
00:54:08.160 | or we caution against, let's say,
00:54:09.880 | putting all your bet into one sector.
00:54:12.640 | Diversification is still the best preparation
00:54:15.880 | and also stay long-term
00:54:17.400 | for all kinds of possible outcomes in the future.
00:54:20.600 | - Let's get to your fixed income asset allocation
00:54:23.080 | because here, again, you've got almost 60% allocated
00:54:28.000 | to fixed income, of which a little bit more than half
00:54:32.120 | of that is allocated to the US fixed income markets.
00:54:35.920 | But a large majority of this,
00:54:38.000 | almost all of it is allocated to treasury bonds,
00:54:42.520 | and a very minor amount is allocated
00:54:45.520 | to the aggregate bond market,
00:54:46.840 | which would also have corporate bonds, mortgages, and so forth.
00:54:50.160 | So you see a real undervaluation
00:54:52.760 | relative to credit risk and mortgage risk.
00:54:56.160 | You see intermediate-term treasuries as the place to be.
00:55:00.560 | - Yeah, I think that actually is based
00:55:03.360 | on our assessment of the valuation,
00:55:06.040 | where we actually see the treasury is more fairly valued.
00:55:09.640 | On the other hand, I would say,
00:55:11.320 | when you think about the credit spread,
00:55:13.880 | to us at this moment, it's still somewhat pretty tight.
00:55:16.840 | The credit market may not have priced in
00:55:19.360 | a lot of the downside risk down the road,
00:55:21.880 | especially if we get into a recession
00:55:24.200 | and also in a higher interest rate environment,
00:55:27.400 | then the profit margin of the company will also get squeezed.
00:55:31.600 | So this is where we are a little bit cautious
00:55:33.880 | about the credit.
00:55:35.360 | We think on the treasury side,
00:55:37.000 | that is where the valuation is pretty decent at this moment.
00:55:40.760 | - And you also think international bonds
00:55:43.400 | would deserve a higher allocation,
00:55:45.400 | being almost 50% of the fixed income is in international,
00:55:48.320 | whereas the 60/40, it's far less than that.
00:55:52.400 | Now, is this hedged or non-hedged?
00:55:55.520 | - Hedged.
00:55:56.360 | Rick, this is a difference between our equity investment
00:55:59.600 | and also bond investment.
00:56:01.720 | Equity investment is unhedged.
00:56:04.560 | When you invest in the international market,
00:56:07.000 | that's why we need to watch for the currency change.
00:56:11.080 | That will have an impact on the relative performance.
00:56:14.040 | But on the other hand, the bond market,
00:56:16.480 | we do actually hedge the currency risk.
00:56:19.800 | To that extent, in the end,
00:56:21.520 | the U.S. bond expected to return,
00:56:23.760 | and the return from the international bond market
00:56:26.720 | is actually very similar.
00:56:28.520 | We actually had a U.S. bond to return
00:56:30.480 | a nominal annualized 4.8 to 5.8% over the next decade,
00:56:35.280 | and then it's 4.7 to 5.7%
00:56:37.920 | from the international bond market.
00:56:39.600 | It's not that different.
00:56:40.960 | But this is where I think we come to a very important concept
00:56:44.800 | about why we want to go international.
00:56:47.680 | It's more than just the return outlook,
00:56:50.320 | both in the equity side and also the bond side.
00:56:53.720 | It's because of the diversification benefit.
00:56:56.240 | When you think about the rest of the world,
00:56:58.720 | they may not be perfectly aligned with the U.S. market
00:57:02.200 | in terms of their business cycle,
00:57:03.880 | in terms of their policy cycle.
00:57:06.400 | So especially for emerging market,
00:57:08.400 | and even to a certain extent China,
00:57:10.480 | the correlation there could be even lower.
00:57:13.320 | So I think regardless of the outlook,
00:57:16.200 | bring in those into a diversified portfolio,
00:57:19.760 | help you to harvest those diversification benefit.
00:57:23.080 | Essentially, that's where you reach
00:57:24.800 | the same expected return, but with lower risk.
00:57:27.480 | - Well, that's all the time we have.
00:57:28.880 | It's Qian, been a very interesting discussion.
00:57:31.840 | So I want to thank you so much for being with us today.
00:57:34.720 | - Thank you.
00:57:35.680 | - This concludes this episode of "Bogleheads on Investing."
00:57:39.760 | Join us each month as we interview a new guest
00:57:42.480 | on a new topic.
00:57:43.560 | In the meantime, visit boglcenter.net, bogleheads.org,
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00:58:01.920 | Thanks for listening.
00:58:03.840 | (upbeat music)
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