Bogleheads® on Investing Podcast 017 – Joe Davis, host Rick Ferri (audio only)

00:00:00.000 | [MUSIC PLAYING]

00:00:10.720 | Welcome to Bogo Heads on Investing, podcast number 17.

00:00:15.060 | My guest this month is Joe Davis, Vanguard's Global Chief

00:00:19.320 | Economist.

00:00:20.200 | And our topic is Vanguard's Economic and Market

00:00:23.920 | Outlook for 2020, the New Age of Uncertainty.

00:00:27.760 | [MUSIC PLAYING]

00:00:38.860 | My name is Rick Ferry, and I'm the host

00:00:41.040 | of Bogo Heads on Investing.

00:00:43.200 | This podcast, as with all podcasts,

00:00:46.000 | are brought to you by the John C. Bogle Center

00:00:48.760 | for Financial Literacy, a 501(c)(3) corporation.

00:00:54.280 | In this podcast, we have Dr. Joe Davis, Vanguard's Global Chief

00:00:59.480 | Economist and head of Vanguard's Investment Strategy Group,

00:01:03.600 | whose research team is responsible for helping

00:01:05.680 | to oversee the firm's investment methodologies and asset

00:01:09.320 | allocation strategies for both institutional and individual

00:01:12.600 | investors.

00:01:13.600 | In addition, Joe is a member of the Senior Portfolio

00:01:17.120 | Management Team for Vanguard's Fixed Income Group.

00:01:20.080 | Today, we're going to be discussing a new report,

00:01:22.880 | Vanguard Global and Economic Market Outlook for 2020,

00:01:27.040 | the New Age of Uncertainty.

00:01:29.560 | The report is available online at Vanguard.com.

00:01:33.880 | With no further ado, let's bring in Dr. Joe Davis.

00:01:38.920 | Welcome, doctor.

00:01:41.200 | Thanks, Rick.

00:01:41.800 | You can call me Joe, and really, thanks for having me.

00:01:45.760 | Well, thank you so much for being on our show today, Joe.

00:01:48.840 | We're really fans of your work, and you've

00:01:51.980 | given some fantastic presentations

00:01:54.000 | to the Bogleheads over the years.

00:01:55.680 | What I wanted to do today was get your team's outlook

00:02:00.360 | on 2020.

00:02:03.120 | But before we start there, who is Joe Davis?

00:02:06.320 | Can you give us a little background

00:02:07.960 | and some tidbits of your life and your bio?

00:02:11.160 | Sure.

00:02:11.660 | Well, I actually grew up 10 minutes from the Vanguard

00:02:15.040 | building I work in here outside of Philadelphia.

00:02:18.560 | I was attracted to Vanguard because I was an early investor

00:02:22.780 | in the early '90s, and that's thanks to my dad.

00:02:26.220 | He had the wisdom to show me how to start investing.

00:02:29.860 | I came out of graduate school with a PhD in economics.

00:02:32.900 | I was actually thinking I would end up up

00:02:34.980 | on Wall Street in New York.

00:02:36.620 | But again, my dad said, why don't you apply to Vanguard?

00:02:38.980 | So I did.

00:02:39.740 | And my resume found its hands into a group

00:02:43.460 | that they were just starting, a group

00:02:45.660 | that I now have the great pleasure of leading.

00:02:48.820 | I thought leadership group, effectively a research group.

00:02:52.220 | And that was 17 years ago, Rick.

00:02:54.620 | And so it's amazing.

00:02:56.420 | I count myself very lucky and fortunate

00:02:58.420 | to work with such a great company.

00:03:00.780 | And our group has grown from, in those early days in 2002,

00:03:04.420 | 2003, from fewer than 10 crew members

00:03:08.180 | to now we're over 65 and growing.

00:03:11.140 | And we're in multiple countries, including Europe and Asia.

00:03:15.380 | So it's an exciting group to be a part of,

00:03:17.620 | and I count myself fortunate.

00:03:20.300 | One of the Bogleheads did ask, who

00:03:22.660 | is the audience for the work that you're doing?

00:03:25.020 | Because as Bogleheads, we're basically

00:03:27.300 | following buy-hold strategies.

00:03:29.580 | You do a lot of work, and you make a lot of predictions

00:03:33.220 | about GDP growth, earnings growth.

00:03:36.380 | You actually put out marked forecasts.

00:03:38.220 | And so how does a typical individual investor take that?

00:03:42.340 | Is it supposed to be actionable?

00:03:44.020 | Or who's it for, and how should it be taken?

00:03:47.660 | Yeah, see, I see three primary users or use cases

00:03:51.100 | for our annual publication.

00:03:53.060 | First is just, I think for many, is just

00:03:55.980 | to orient or to help provide investors

00:03:59.780 | with what are reasonable expected returns

00:04:02.300 | for the portfolios or investment that they are already in.

00:04:06.420 | This is not and has never been and never

00:04:08.740 | will be supposed to be used as market timing

00:04:11.860 | calls and short-term prognostications, which

00:04:14.860 | I, quite frankly, I see from many in the industry.

00:04:18.060 | This is to help inform what is a reasonable expected

00:04:21.260 | return on a portfolio to help one achieve one's goals.

00:04:25.740 | And before I came to Vanguard, we

00:04:27.060 | did not have forward-looking expectations.

00:04:30.140 | And so that's been a big step forward

00:04:32.540 | for many, including internally at Vanguard.

00:04:35.540 | Secondly, this is an input into the active manage process.

00:04:39.700 | So for those investors that are perhaps in our actively managed

00:04:44.500 | bond funds, whether they're taxable or they're municipal,

00:04:48.180 | our economic outlook is an important ingredient

00:04:51.300 | because in those funds, we are taking modest active risk,

00:04:54.300 | meaning trying to outperform the benchmark in a very

00:04:57.180 | risk-controlled way.

00:04:58.180 | And to try to do that, one of the many levers

00:05:01.220 | that the portfolio management team will pull

00:05:03.860 | will be a risk assessment of what

00:05:06.460 | the markets are pricing in from an interest rate

00:05:08.980 | or, say, an economic growth outlook.

00:05:11.380 | And then how do we view the risk skewed relative to that sort

00:05:15.260 | of view in the marketplace?

00:05:16.580 | Again, all in the interest and the objective

00:05:18.780 | to try to modestly and incrementally

00:05:21.060 | add value for the shareholder in the funds.

00:05:24.060 | Many times, we view that as just as much

00:05:26.860 | not taking excessive risk as it would be

00:05:29.580 | for trying to take more risk.

00:05:31.620 | And a great example is even right now

00:05:33.380 | where I can feel and can sense in the market

00:05:36.140 | is becoming increasingly overly optimistic on growth.

00:05:39.820 | We see pockets of the financial markets

00:05:42.300 | where I would view as frothy risk-taking.

00:05:45.420 | And so for a long-term investor that are in these funds,

00:05:48.700 | we are managing, based upon our outlook,

00:05:51.540 | to not be as aggressive as other funds may be,

00:05:54.780 | which we believe in the long run will reward our investors

00:05:58.300 | in those funds.

00:05:59.300 | And then the third would be for those

00:06:01.340 | that would retain Vanguard from an advice perspective.

00:06:04.300 | Because again, for certain investors

00:06:06.860 | who may have either a fixed spending goal,

00:06:08.900 | it may be an institution that has

00:06:10.420 | to generate a certain spending flow from their portfolio,

00:06:13.940 | or others, the variations in expected returns

00:06:17.980 | in the marketplace-- again, not in the one year,

00:06:20.060 | but in the next five or 10 years--

00:06:21.980 | can then have implications for the asset allocation strategies

00:06:25.340 | that they would pursue.

00:06:26.900 | For some that have a very, very long horizon,

00:06:30.300 | I would tell those investors that they

00:06:32.340 | should ignore all outlooks, including our own,

00:06:35.740 | if they have a very long horizon.

00:06:37.540 | Because the buy and hold, stay the course,

00:06:40.700 | is very much appropriate.

00:06:42.700 | But for years, when I came to Vanguard,

00:06:44.420 | I think what a common refrain would be would be, hey,

00:06:47.020 | does Vanguard have an opinion on x or y?

00:06:49.740 | And I think many, many investors want to stay the course,

00:06:52.820 | but sometimes they also struggle with the headlines.

00:06:55.620 | And so one of the other primary objectives of this piece

00:06:58.500 | is to say, yes, these are the probabilities that

00:07:01.260 | may occur in the future, whether it's

00:07:02.780 | economic risk or financial market volatility,

00:07:05.980 | that we have thought about it, and it's

00:07:07.580 | reflected in our thinking and in the advice that we give clients.

00:07:11.700 | So basically, three ideas.

00:07:13.780 | Number one, your individual investors

00:07:16.180 | already have their portfolios set and their asset allocation.

00:07:20.620 | And so it's just sort of long-term estimates

00:07:23.500 | of expected return from bonds and equities

00:07:26.700 | so that they can do some planning.

00:07:28.540 | And then number two, it's for your active funds

00:07:31.980 | so that they can maybe do some tailoring

00:07:34.100 | and potentially pick up some excess return or some alpha.

00:07:37.580 | And last, you were saying there are large institutional

00:07:39.900 | investors who actually buy your research

00:07:42.460 | or pay you to give this assessment.

00:07:45.380 | And those are the three areas where you

00:07:47.260 | find people use your report.

00:07:50.940 | Yeah, and some will just use it as an input

00:07:53.580 | into assessing the risk.

00:07:55.260 | Because at the end of the day, all of us as investors

00:07:57.420 | are making decisions under uncertainty

00:07:59.700 | in terms of our asset allocation, right?

00:08:01.860 | Even if we haven't changed our asset allocation,

00:08:03.860 | it's still a decision, whether implicit or explicit.

00:08:08.700 | And so the value that we hope to bring

00:08:11.540 | is to convey the range of ultimate outcomes,

00:08:15.100 | particularly with respect to returns.

00:08:17.580 | And respectfully, I think we do it in a very rigorous way.

00:08:20.980 | I mean, we take some of the best techniques in academia,

00:08:24.540 | but we do it in a way where we convey, I believe,

00:08:26.820 | the market outlook as it should be,

00:08:28.740 | which is a range of outcomes.

00:08:30.740 | We're not offering short-term point forecasts.

00:08:33.900 | Vanguard doesn't have an S&P 500 target for the end of 2020.

00:08:37.900 | I actually kind of laugh at those sort of outlooks.

00:08:40.100 | And so I think if we can convey the range of outcomes

00:08:43.260 | and the rationale for why it is today versus perhaps what it

00:08:47.260 | would have been 10 years ago, I think that can be of value.

00:08:50.980 | I'll give you an example where it helped some investors,

00:08:53.860 | Rick, like 10 years ago.

00:08:55.820 | Our first annual outlook publication

00:08:57.740 | came out in the 2009 period, which you can recall.

00:09:01.260 | It was not a fun time in the markets.

00:09:03.460 | And we had a great deal of clients wondering,

00:09:06.740 | should they even be in equities at all?

00:09:08.860 | And this publication helped some in the sense that we said,

00:09:12.540 | listen, the economic environment for the next several years

00:09:15.940 | is going to be where I have elevated unemployment.

00:09:19.540 | It's going to be fairly tepid growth.

00:09:22.140 | Yet the outlook for the financial markets,

00:09:24.220 | as best we can assess over the next five or 10 years,

00:09:27.380 | believe it or not, actually the odds

00:09:29.020 | are tilted towards higher than average expected returns.

00:09:32.820 | And if anything, we turned it out

00:09:34.300 | to be a little too low in our projections, our range.

00:09:37.900 | It came in a little bit higher than expected.

00:09:39.780 | But I think that was helpful because behaviorally

00:09:42.740 | and emotionally at that time, it felt as if--

00:09:47.500 | I would even have friends and colleagues in my family

00:09:49.900 | that said, listen, I feel like I really

00:09:51.580 | should get out of the market.

00:09:53.140 | And so even having that conversation,

00:09:54.940 | the rationale for why the expected returns were even

00:09:57.740 | higher, you could show that for some that are really

00:10:01.500 | mathematically inclined, you could show them statistical

00:10:03.820 | rigor, why historically there's a reason to believe this.

00:10:07.620 | I think that had a service to investors.

00:10:10.340 | This publication is not in any way

00:10:12.420 | intended to pick market tops and bottoms.

00:10:15.780 | We're really trying to inform investors

00:10:17.780 | that this is the range of expected returns

00:10:19.580 | that you could see in your portfolio.

00:10:22.620 | I think that your estimate of a globally diversified 60% stock,

00:10:29.220 | 40% bond portfolio, you have a range of four to six,

00:10:33.180 | so call it the midpoint, about five.

00:10:35.620 | Seems to me to be very realistic and a good planning point.

00:10:39.420 | We have to have something to plan with.

00:10:41.940 | We have to have some number to use.

00:10:44.020 | And I think that your numbers are

00:10:46.060 | as good as anything anybody could come up with.

00:10:49.500 | But the way you get to them, though,

00:10:51.140 | in reading through your report, you

00:10:52.780 | start out by looking at, it seems, the business cycle.

00:10:55.940 | Could you explain about the business cycle

00:10:57.980 | and where do you think we are?

00:11:00.140 | Well, we're at one of the later stages of the business

00:11:02.660 | cycle in the sense of how long this global expansion, which

00:11:06.620 | is going on more than 11 years--

00:11:09.500 | and we expect it to continue into 2020.

00:11:11.780 | And why that matters, assess where you are in the cycle,

00:11:14.740 | it has implications for two things.

00:11:16.780 | One is, historically at least, when

00:11:19.900 | you're in the late stages of any expansion,

00:11:22.980 | two things tend to emerge.

00:11:24.460 | One is you tend to have the financial markets not only

00:11:27.740 | performing very well, which is good,

00:11:30.140 | but you tend to have financial markets outperforming

00:11:33.200 | the fundamentals.

00:11:34.300 | And so in that environment, investors can feel very good.

00:11:38.020 | But precisely because of how we approach

00:11:40.380 | the forward-looking return, we expect the future returns

00:11:43.500 | become more modest.

00:11:44.660 | And so it's important to identify

00:11:46.940 | where you are in that cycle at a high level

00:11:49.380 | because that does inform how one should be thinking

00:11:52.940 | about everything from rebalancing to the return

00:11:55.220 | estimates that they assume.

00:11:56.740 | We estimate that the global economy will more likely

00:12:00.020 | than not continue to expand, but growth will not

00:12:02.880 | accelerate, at least to the extent

00:12:04.700 | that at least parts of the stock market

00:12:06.940 | increasingly already anticipate.

00:12:09.620 | And so it will be one of these somewhat of a paradox in 2020

00:12:13.820 | is that we could have economic growth not be negative,

00:12:17.620 | the expansion continue, and yet you

00:12:19.420 | could have the financial markets underperform for a time.

00:12:23.180 | And just to be prepared for that.

00:12:25.300 | We do not see strong evidence of financial market bubbles,

00:12:30.260 | which occurred late in the business cycle,

00:12:32.040 | say in 1998, 1999.

00:12:34.420 | You could call it a NASDAQ or a dot-com.

00:12:37.300 | We don't see the imbalances in other parts of the economy,

00:12:40.660 | much like we saw in housing, certainly in late 2006

00:12:44.080 | and early 2007.

00:12:46.260 | There are, though, imbalances, I think,

00:12:48.140 | in the high level of corporate debt,

00:12:49.740 | high level of sovereign debt in some countries.

00:12:52.340 | And we've had extended period of very loose monetary conditions

00:12:56.900 | generated by central banks.

00:12:58.260 | So that's what keeps us up at night a little bit.

00:13:00.460 | But I think at the end of the day,

00:13:01.900 | it's not the worst outlook.

00:13:03.180 | It's just one I think we're just trying to set lower,

00:13:06.540 | but I still think reasonable.

00:13:08.060 | And they're not bearish.

00:13:09.300 | It's not a bearish outlook on either the world economy

00:13:12.300 | or the financial market.

00:13:14.400 | I find it interesting that a year ago, after the Fed had

00:13:18.680 | increased rates three times last year,

00:13:22.140 | but then the forecast was for three more rate increases

00:13:27.300 | in 2019.

00:13:29.340 | But in fact, what we had was three rate decreases

00:13:33.520 | rather rapidly.

00:13:35.180 | And in addition, around the world,

00:13:36.980 | monetary policy makers just been decreasing.

00:13:41.420 | Is that a warning sign?

00:13:43.340 | I mean, yeah, I mean, one of our outlook last year,

00:13:46.340 | the theme of it was down but not out.

00:13:49.180 | And it was a boxing analogy, meaning the global economy was

00:13:53.020 | going to weaken significantly based

00:13:54.900 | upon the leading indicators, which we track very closely

00:13:58.980 | internally at Vanguard, again, used in the portfolio

00:14:01.580 | management process.

00:14:02.620 | And they weakened in China in early 2018.

00:14:06.620 | They weakened in the US in 2018.

00:14:08.940 | And so that foretold, at some point in 2019,

00:14:12.840 | roughly around the summer, that we were going to have

00:14:14.960 | what we called growth scares.

00:14:16.460 | And we published that in early 2019,

00:14:18.260 | that we were more likely than not

00:14:19.780 | going to see a slowdown in growth, which many did not

00:14:24.060 | at least anticipate of severity.

00:14:25.940 | Now, in part because of that slowdown,

00:14:28.620 | our probability of recession almost approached 50%,

00:14:32.780 | which unnerved us a little bit.

00:14:34.060 | Because obviously, if you have a recession,

00:14:35.860 | equity market historically has been down at least 20%.

00:14:39.340 | The irony of it is that I think the Federal Reserve and some

00:14:42.140 | other central banks were observing and have

00:14:44.220 | similar models as we do, Rick.

00:14:46.700 | And so I think that ultimately, they

00:14:48.980 | reacted much more aggressively.

00:14:51.660 | And so cut rates, I think, would stabilize the situation.

00:14:55.580 | Quite frankly, they reacted more strongly

00:14:57.700 | than I would have anticipated.

00:14:59.340 | I could have perhaps seen one cut.

00:15:01.500 | Because it was really just in the bond market,

00:15:03.500 | particularly the shape of the yield curve that

00:15:05.500 | seemed the most ominous sign of potential recession.

00:15:08.060 | But other indicators, both in the economy,

00:15:11.820 | outside of manufacturing, as well as the equity market,

00:15:15.300 | were not displaying the same signals,

00:15:17.100 | which is why our probabilities never got above 50%.

00:15:19.540 | So it did surprise me how aggressively they reacted.

00:15:22.660 | But then that was one of the reasons why

00:15:24.280 | the second half of the year, the financial markets

00:15:26.900 | performed as well as they did.

00:15:28.300 | Not the only reason, but that certainly

00:15:29.940 | was a primary catalyst.

00:15:32.180 | Yeah, we went from an inverted yield curve

00:15:35.860 | to now it's getting to look almost more

00:15:39.220 | like a normal yield curve as longer-term rates continue

00:15:43.180 | to creep up here and short-term rates come down.

00:15:46.420 | So there's no longer an inverted yield curve.

00:15:48.340 | Now, some people will say, well, that's good.

00:15:50.340 | That means no recession is coming.

00:15:52.940 | Our probability of recession uses all the signals

00:15:55.660 | in the marketplace, but we combine them

00:15:57.460 | in a way that's actually more accurate in general

00:15:59.900 | than just the bond market alone or the stock market alone.

00:16:02.780 | It's actually the power of a diversified set of signals.

00:16:05.740 | So that'll be the power of diversification,

00:16:07.940 | diversified portfolio.

00:16:08.860 | We use a diversified portfolio of signals, over 100 in all,

00:16:13.260 | that you can use to assess what the risks are in the economy.

00:16:16.060 | And it's improved, although we're not completely out

00:16:18.820 | of the wood yet.

00:16:20.140 | One of the reasons why, although we

00:16:22.260 | don't see a recession in 2020, there's

00:16:25.160 | going to be uneven growth next year.

00:16:27.020 | And so I think the bond market's starting

00:16:29.420 | to come to the realization of that.

00:16:31.500 | The equity market, quite frankly,

00:16:33.300 | has priced in a much better economic outcome

00:16:36.060 | than I even think is reasonable.

00:16:37.660 | And so that's why I still think in the near term,

00:16:40.380 | we just have to be prepared for some volatility.

00:16:43.500 | I've been reading a lot about manufacturing declines

00:16:47.860 | in manufacturing activity.

00:16:50.020 | In fact, the Kansas City Fed recently

00:16:52.060 | announced that their district has had,

00:16:55.220 | I think it's several months in a row now,

00:16:57.540 | a manufacturing decline.

00:16:59.500 | And globally, there appears to continue

00:17:02.220 | to be this manufacturing decline.

00:17:04.860 | And how is that impacting into your GDP growth estimates?

00:17:09.300 | It's been a primary factor.

00:17:11.660 | It's been a factor of why we foresaw significant global

00:17:15.700 | slowdown this year, relative to 2018, which

00:17:19.740 | occurred in almost every market.

00:17:21.140 | One of the reasons that fed into the central bank switching

00:17:23.640 | course in various markets around the world,

00:17:26.300 | and one of the reasons why we're less bullish, so to speak,

00:17:29.380 | than I think many increasingly are for 2020,

00:17:33.220 | there's three reasons why the manufacturing

00:17:35.500 | sector in particular have been underperforming,

00:17:38.300 | or in many parts of the world, including in the United States,

00:17:41.260 | contracting, meaning in recession.

00:17:44.100 | One was set in motion two or three years ago.

00:17:47.260 | And that was it was a high level of inventories

00:17:49.440 | in the manufacturing sector.

00:17:50.740 | And so there's generally been, in the past 10 years,

00:17:53.180 | a three-year sort of expansionary sort of tailwind

00:17:56.940 | to manufacturing, and then it slows down for a time.

00:18:00.180 | And you could see that clearly in our signals.

00:18:03.060 | And we're not completely done that,

00:18:04.860 | but we're still working through it.

00:18:06.900 | And that's why we've seen weakness

00:18:08.340 | across the manufacturing front.

00:18:09.660 | Secondly, it's been in motion for 10 years,

00:18:11.540 | and that is the structural slowdown, intentionally,

00:18:15.160 | in China, as they continue to try to rebalance and escape

00:18:18.540 | what many call the middle income trap, meaning they've become

00:18:21.340 | more developed, become more consumer-based.

00:18:23.680 | And they've been successful to date,

00:18:25.180 | but the past days of even 6% growth, I think, are over.

00:18:29.340 | And so that has particularly impacted parts

00:18:32.060 | of the manufacturing sector.

00:18:33.900 | But the third one, and clearly the most cyclical one,

00:18:36.500 | has been the trade tension between the US and China.

00:18:39.140 | We model that as best we can, and it's

00:18:41.180 | the high level of uncertainty.

00:18:42.420 | In fact, that's the title of our publication this year,

00:18:45.580 | The New Age of Uncertainty, that why we call it that

00:18:48.380 | is that we believe that this recent significant rise

00:18:51.460 | in uncertainty is unlikely to unravel quickly.

00:18:54.540 | That has led to slower than expected business investment,

00:18:58.420 | and that primarily hits, or certainly hits,

00:19:01.060 | the manufacturing sector.

00:19:03.540 | So one of the byproducts of this slowdown in manufacturing

00:19:08.660 | and global manufacturing are corporate profits.

00:19:12.940 | Now, S&P earnings have been increasing,

00:19:16.980 | in part because of tax cuts, in part because of buybacks.

00:19:23.580 | So we have this divergence between S&P earnings

00:19:26.380 | that are increasing and national profits

00:19:30.500 | based on GDP, national accounts, that

00:19:34.200 | has actually been declining.

00:19:35.340 | And a Wall Street Journal article recently

00:19:37.100 | brought this to light, I think, a couple of weeks ago.

00:19:40.460 | Can you comment on that?

00:19:42.980 | Profit margins are still fairly robust

00:19:46.300 | when you look at the aggregate data.

00:19:47.860 | I mean, they have weakened in a growth rate perspective,

00:19:50.300 | but I would say there's two things going on.

00:19:52.940 | One is just the high level of profitability.

00:19:55.860 | It's particularly impressive in the United States.

00:19:58.180 | It's one of the reasons why I think

00:20:00.460 | the US has been among the stronger, or at least

00:20:02.900 | the more stable, economic performers and equity market

00:20:06.260 | performers over the past several years.

00:20:09.060 | It's just the high level of profitability.

00:20:11.060 | Now that the rate of increase has clearly slowed,

00:20:14.420 | part of that is just due to the economic environment.

00:20:18.300 | The weakness, particularly, we've seen overseas.

00:20:20.980 | There was a point in time this year

00:20:23.140 | which we estimate China was growing well below 5%,

00:20:27.260 | perhaps as low as 3% or 4%, which wasn't

00:20:29.860 | reported in the statistics.

00:20:32.140 | We saw significant weakness in other emerging markets

00:20:34.820 | and in Europe, Germany and others, which again, part of

00:20:37.980 | them are exposed to weakness in China.

00:20:39.860 | And so we've seen a deceleration in that.

00:20:43.780 | And then, of course, the equity market

00:20:45.340 | has continued to perform well, I think in part

00:20:48.620 | because corporate profitability didn't go significantly

00:20:51.220 | negative when recession odds were being discussed.

00:20:54.140 | But I think for just other just sentimental reasons,

00:20:58.740 | and so you've had this valuation.

00:21:01.420 | The P/E ratios have just widened further

00:21:03.860 | because earnings haven't been keeping up

00:21:05.540 | to the same level of appreciation as prices.

00:21:08.460 | And then as you noted, Rick, there's

00:21:10.060 | been a more of a longer term, four or five years,

00:21:13.500 | the M&A activity, the buyback activity,

00:21:17.300 | more so than the rate of natural investment in companies

00:21:20.460 | on growth prospects, something I would call sometimes

00:21:23.860 | financial engineering, has been significant pace.

00:21:27.300 | And then another reason, which is not often discussed,

00:21:30.940 | and it won't change quarter to quarter,

00:21:34.100 | but another reason or contributed

00:21:36.300 | to the high level of corporate profitability,

00:21:39.660 | it is a little modestly concentrated

00:21:42.380 | in a handful of firms.

00:21:44.700 | And part of that is, I think, the nature

00:21:46.540 | of the digital economy, what I would call network effects.

00:21:50.260 | And so very large companies may be

00:21:52.580 | able to maintain high profit margins or high profit levels,

00:21:57.700 | whether growth is accelerating or decelerating.

00:22:00.420 | There's longer term issues and behaviors.

00:22:03.100 | I think that can help explain the high level

00:22:05.340 | of corporate profitability.

00:22:06.500 | But then there's also the business cycle effect,

00:22:08.500 | which tends to get most of the press attention.

00:22:11.500 | Let's move into the labor markets,

00:22:13.260 | because I have a real question about this.

00:22:15.100 | I'm a baby boomer.

00:22:17.300 | I'll be 62 next year, and I see all of my compadres

00:22:21.460 | from high school and college getting

00:22:23.860 | ready to leave the labor force over the next year or two

00:22:27.420 | or three.

00:22:28.420 | And if we get a lot of people leaving the labor force

00:22:33.460 | because they're retiring, how is that

00:22:37.300 | going to affect things like inflation, demand, and so

00:22:40.820 | forth?

00:22:41.860 | Yeah, I mean, it's an important issue.

00:22:44.620 | I would put the aging of the workforce alone

00:22:48.460 | as just the slower rate of population growth

00:22:51.100 | we have in the US, and in other countries,

00:22:53.540 | versus, say, 10 or 20 years ago.

00:22:56.860 | Slower demographic forces have already

00:22:59.380 | had, I think, a clear imprint on a number of things.

00:23:03.020 | One is just, what are the expectations for growth?

00:23:06.500 | What's the natural run rate, so-called the average speed

00:23:09.740 | limit for any economy?

00:23:11.900 | We used to talk in the United States

00:23:13.460 | that a reasonable growth rate for, say, real GDP

00:23:16.460 | was 3% in the '90s.

00:23:19.940 | Or the good old days.

00:23:21.140 | Yeah, the good old days.

00:23:22.140 | No, of course, that was propped up

00:23:23.140 | by leverage, which we ended up paying the price for in terms

00:23:25.780 | of the housing market and in the global financial crisis.

00:23:28.540 | But yeah, the natural run rate for the US economy right now

00:23:31.860 | is slightly below 2%.

00:23:33.660 | One of the reasons for that is the aging of the workforce

00:23:37.100 | and just the retirement.

00:23:39.420 | Population growth is not negative,

00:23:41.260 | but it has clearly slowed.

00:23:42.780 | And so the potential growth rate of the economy is lower.

00:23:46.900 | Now, that does have an implication for inflation.

00:23:50.420 | You would say, then, if you have slower potential,

00:23:53.580 | let's call it 1 and 1/2 GDP growth.

00:23:55.780 | And we've been growing in the United States roughly 2%,

00:23:59.740 | the past four or five years, right?

00:24:01.780 | You would then expect inflation to rear its head sooner.

00:24:05.460 | Because even though you're growing slower

00:24:07.180 | than historical averages, you're going above the speed limit.

00:24:10.500 | So inflation is like a speeding ticket, right?

00:24:12.460 | You only get that speeding ticket

00:24:13.800 | if you're going above the speed limit.

00:24:16.180 | I will compliment our team.

00:24:17.340 | We put our finger on this four or five years ago,

00:24:19.420 | that there's been other forces that

00:24:21.340 | have been more than offsetting the inflationary pressures

00:24:24.460 | that you would think from less slack in the economy, which

00:24:28.300 | is really one way of saying, regardless of your growth rate,

00:24:31.300 | if you have fewer available workers,

00:24:33.180 | eventually you're going to see wage pressures and everything.

00:24:35.940 | But one of those forces is digital technology,

00:24:38.500 | which has been a suppressant, keeping prices down.

00:24:42.060 | It's everything from online sales

00:24:44.100 | to just cheaper costs of manufacturing

00:24:47.460 | certain products and services.

00:24:48.860 | And we were one of the first firms

00:24:50.780 | to actually quantify what that drag is.

00:24:53.100 | So what this means, I think the demographic imprint going

00:24:57.300 | forward, it's one of the reasons--

00:25:00.100 | not the only one-- one of the reasons why interest rates are

00:25:03.700 | lower today in the United States and in Europe

00:25:07.100 | and in other parts of the world is because of slower population

00:25:10.820 | growth.

00:25:11.380 | And again, it's tied to lower expected economic growth, which

00:25:15.580 | has led to those lower interest rates.

00:25:18.560 | There's a point with which it'll reverse.

00:25:20.780 | When the global economy-- and it's roughly five years

00:25:23.140 | from now, and again, this is very slow moving.

00:25:26.740 | It won't happen in one month, in any one year.

00:25:29.500 | But with an aging population, over time,

00:25:33.140 | that'll mean that there will actually

00:25:35.180 | be a little bit less demand for very safe assets, which

00:25:41.580 | has been a significant boost to fixed income markets,

00:25:45.260 | as well as the lower rate of inflation.

00:25:47.380 | We had a research report on what are the investment

00:25:50.700 | implications of an aging world and a world

00:25:54.260 | with slower demographic patterns.

00:25:55.980 | And what we did conclude was that it is modestly

00:25:59.980 | inflationary, but those sort of headwinds

00:26:02.700 | don't really come into play until roughly 10 years from now.

00:26:05.980 | Demographics is a-- there's competing forces.

00:26:08.940 | There's some things that can be positive

00:26:11.380 | to the financial markets, bonds or stocks from demographics.

00:26:14.860 | There's other things that can be potentially negative.

00:26:17.980 | But these are slow moving effects.

00:26:20.460 | And so it's important to say, over what horizon

00:26:23.900 | may they matter?

00:26:24.780 | And also to appreciate the other forces,

00:26:26.780 | because demographics are far from the only one that

00:26:29.540 | are affecting an economy and financial market

00:26:32.340 | at any period of time.

00:26:34.540 | I'm going to lump these next three questions into one.

00:26:38.780 | It has to do with your forecast for Fed cuts, number one.

00:26:44.100 | And secondly, do we get to a point

00:26:47.100 | where rates are so low that we're pushing on a string,

00:26:50.660 | another old saying on Wall Street?

00:26:53.620 | Has the Fed's hammer been taken away

00:26:56.300 | because interest rates get so low?

00:26:58.500 | And then finally, what are the prospects for the US

00:27:02.100 | to hit negative interest rates like we

00:27:04.100 | see in a lot of the other developed markets?

00:27:07.260 | Yeah, let me take the last one first, Rick.

00:27:11.940 | I think the odds of us seeing negative interest

00:27:15.380 | rates in the United States are very low and much lower

00:27:18.180 | than other countries.

00:27:19.540 | I wouldn't assign a probability to any outcome zero.

00:27:23.060 | That would be foolish.

00:27:23.940 | But I think there's a number of reasons

00:27:25.820 | why we won't see negative in the United States.

00:27:28.660 | I think one of the reasons is the importance

00:27:31.460 | of short-term funding markets, including money market

00:27:34.140 | funds, which is really a strength and diversified

00:27:37.220 | source of funding for corporations

00:27:39.260 | and lending for short-term collateral.

00:27:42.100 | And so there's both technical as well as

00:27:44.020 | fundamental reasons why I think the Federal Reserve will

00:27:46.260 | be reluctant to test negative interest rates.

00:27:48.980 | And I am not a fan of negative interest rates.

00:27:52.500 | I'm more in the minority in my profession.

00:27:55.300 | I can't prove this, but I think history

00:27:57.100 | will show that the modest negative interest

00:27:59.180 | rates we see in both Japan and in Europe are a mistake.

00:28:02.020 | And we have not seen significant lift

00:28:04.500 | from either of those economies with negative interest rates.

00:28:06.980 | Now, again, I'm not expecting a move from zero interest rate

00:28:11.180 | to negative 0.25%.

00:28:12.980 | It's going to lead to fundamental growth, right?

00:28:15.420 | That would be an unfair criticism.

00:28:18.060 | But I think the risk that negative interest rates play

00:28:22.180 | and why I think we won't ultimately see them in the US

00:28:24.420 | is that there is a risk that when a country sets negative

00:28:27.220 | interest rates, that you can actually

00:28:30.340 | lead some investors to start to believe that we'll

00:28:32.900 | have deflation, meaning falling prices,

00:28:35.780 | or to lower their inflation expectations, which

00:28:38.620 | is precisely the opposite outcome of the rationale

00:28:42.220 | for taking interest rates below zero to begin with.

00:28:44.900 | Yeah, unattended consequences.

00:28:46.940 | Unattended consequences.

00:28:48.100 | So I don't have proof in that, but I

00:28:50.140 | think there is now at least some doubt in some central banker's

00:28:53.580 | mind.

00:28:54.060 | And so I don't think we'll see it.

00:28:55.540 | I think in the next recession, what we will very likely see,

00:28:58.660 | though, is the Federal Reserve cut interest rates

00:29:01.780 | to zero much more quickly than they

00:29:03.900 | may have done in the past, in large part

00:29:05.980 | because they don't have as much room to cut.

00:29:08.140 | And then secondly, although, again, it

00:29:09.860 | may only be modest effects, but I

00:29:11.500 | think we will see potentially expansion of the balance sheet.

00:29:16.140 | And then thirdly, what will gain much more discussion

00:29:19.140 | will be the pairing of monetary policy with fiscal policy

00:29:23.540 | in terms of stimulus.

00:29:24.940 | This will ultimately become a politically charged issue,

00:29:27.780 | and my job is to assess the economic ramifications of this.

00:29:31.460 | I do believe central bankers, generally speaking,

00:29:34.940 | are already pushing on a string.

00:29:37.300 | I don't think the Federal Reserve should

00:29:38.860 | be pushing on the string.

00:29:40.860 | They are trying to, at the end of the day,

00:29:43.700 | maintain full employment and to get inflation actually higher

00:29:47.780 | than where it is.

00:29:49.780 | So the risk is, in our outlook, and one

00:29:52.020 | of the reasons why we think the next move by the Fed

00:29:55.380 | will likely be a cut and not a hike,

00:29:58.180 | even though I personally wouldn't do it

00:30:00.300 | if I was on the Fed, is likely because they

00:30:03.620 | want to make sure that investors still believe there

00:30:06.380 | will be positive inflation in the future,

00:30:08.380 | and they want to continue the expansion as long as possible.

00:30:11.540 | And again, those points are part of their mandate and charge,

00:30:15.500 | but we can all, I think, disagree about whether or not

00:30:17.980 | they should be cutting or not.

00:30:19.260 | We've debated that internally here at Vanguard.

00:30:21.380 | But I've sat in the middle of debates,

00:30:23.140 | and I've actually argued from both sides, which you probably--

00:30:26.380 | would surprise you as an economist.

00:30:28.260 | I use both hands, but at the end of the day,

00:30:31.100 | also my job is to assess, certainly

00:30:32.780 | for the portfolio management teams, not what they should do,

00:30:36.020 | but what ultimately the Federal Reserve and others

00:30:38.260 | will do, because that has the bearing

00:30:40.500 | on the financial markets.

00:30:42.180 | And so I think the bar is high for the Federal Reserve

00:30:44.940 | to cut the rates in 2020, but I think

00:30:47.500 | they're more likely to cut them than they

00:30:50.060 | are to raise them if our assessment of where

00:30:53.100 | the economy may unfold and inflation may unfold this year

00:30:56.340 | is right.

00:30:57.260 | It seems as though everyone hangs on every word

00:31:01.580 | the Fed says.

00:31:04.260 | I think the central banks get too much attention

00:31:07.460 | in the financial markets, because they don't control

00:31:10.260 | long-term interest rates and the stock market as much as,

00:31:14.460 | I think, people think they do.

00:31:16.460 | It seems like that the day of an announcement,

00:31:18.580 | but they really don't influence it as much as they think.

00:31:21.980 | But I think the risk is they focus so much

00:31:25.580 | on preserving the expansion for so long

00:31:28.860 | that they may under-appreciate some of the financial froth

00:31:32.740 | that is building in the system.

00:31:34.620 | And so that's what I worry about,

00:31:36.340 | and that's what I think one of the unintended consequences

00:31:39.180 | could be.

00:31:40.660 | Let's talk a little more about inflation.

00:31:44.260 | And if we define inflation by the prices

00:31:47.380 | we pay for all the goods or services

00:31:50.340 | we purchase as consumers, in fact,

00:31:54.180 | one of the most perplexing questions in economics,

00:31:58.140 | and hence in the financial markets,

00:32:00.100 | Rick, is actually why inflation has been stubbornly

00:32:02.820 | so low for so long.

00:32:05.660 | Almost any central bank without exception in the world

00:32:09.620 | aims to have inflation average roughly 2%,

00:32:13.620 | and then they try to calibrate their short-term interest

00:32:17.100 | rates, which they clearly control,

00:32:19.220 | to try to hit that target, knowing that it's a moving

00:32:21.860 | target, and they're trying to hit it.

00:32:23.660 | For all the golfers out there, they're

00:32:25.220 | 100 yards from the hole, right?

00:32:28.300 | That's where they want inflation to be, on the green,

00:32:31.980 | knowing that they'll never get a hole in one, but close enough.

00:32:35.500 | Could you explain why do central bankers want inflation?

00:32:40.860 | Yeah, it's actually a really good question.

00:32:46.220 | Why any inflation at all?

00:32:49.660 | The reason why, generally speaking,

00:32:52.700 | most economists would argue that you want a stable inflation

00:32:56.940 | rate that's modest, but positive, is for two things.

00:33:00.620 | One is the belief that if you have

00:33:02.740 | a stable and expected inflation rate,

00:33:04.740 | that it makes it easier for planning purposes.

00:33:07.460 | And so you're more likely to have modestly higher investment,

00:33:12.980 | hiring, and then consumption.

00:33:15.420 | And there's some truth to that, right?

00:33:16.960 | Because if you can have better foresight on the increases

00:33:20.660 | in prices and so forth, that reduces uncertainty.

00:33:23.900 | We all know the higher uncertainty, the lower, say,

00:33:26.540 | investment or spending loss equal.

00:33:28.620 | But the big reason why is because in any economy,

00:33:32.820 | you have debt holders, right?

00:33:34.820 | So if you're a consumer, many of the listeners out there,

00:33:38.180 | myself included, my highest debt right now

00:33:42.100 | is the mortgage payment, which has a fixed term.

00:33:45.540 | And it's in fixed dollar amount.

00:33:47.260 | Why central banks want a positive inflation rate

00:33:50.860 | is if you had a consistently negative inflation rate,

00:33:55.020 | say negative 3%, negative 4%, and you have a fixed debt

00:33:58.540 | level, that makes paying back that debt that much harder.

00:34:03.580 | Because your income is falling by 3% or 4%, right?

00:34:07.140 | But I think what economists do a poor job in saying

00:34:09.900 | is when they say it's bad to have deflation, what

00:34:13.140 | they should say, and what I should say,

00:34:16.060 | is that it's bad to have wage deflation.

00:34:20.380 | Because if we see sales at the store,

00:34:22.540 | and that TV one's buying is 20% off, and so forth,

00:34:28.740 | that's not necessarily alarming.

00:34:31.580 | It's alarming when you have all prices going down,

00:34:35.140 | including the prices for our labor, meaning

00:34:37.260 | our wages or our income, and our salaries going down.

00:34:41.260 | That's what happened in the early 1930s, which

00:34:44.820 | led to massive defaults, particularly

00:34:46.780 | among farmers and many companies.

00:34:49.700 | It froze consumer spending, because I

00:34:51.900 | don't think anyone's going to maintain

00:34:53.520 | their same level of consumption if their own income is not

00:34:57.380 | only falling, but expected to fall further.

00:35:00.020 | And we've seen glimpses of how pernicious

00:35:02.220 | this can be on and off in Japan for the past 20 years, right?

00:35:07.380 | Because the bond market today, even in Japan in surveys,

00:35:12.420 | very few Japanese consumers expect inflation

00:35:15.220 | to be positive in the next five or 10 years.

00:35:17.660 | And their wages don't go up by a significant amount.

00:35:21.020 | And so that's where, at the end of the day-- so behind,

00:35:24.060 | when you hear the Federal Reserve is targeting 2%,

00:35:27.340 | and everyone talks about the Consumer Price Index,

00:35:30.220 | where that 2% came from, all the way back from Milton Friedman,

00:35:33.580 | who won the Nobel Prize, and even before that,

00:35:36.740 | it's really around this fear of avoiding wage deflation,

00:35:41.700 | particularly that we saw during the Great Depression.

00:35:44.340 | I recall when we had a negative inflation rate, just

00:35:49.380 | a very minor negative inflation rate a few years ago

00:35:52.980 | after the financial crisis.

00:35:54.820 | There was a big question on the minds of Social Security

00:35:57.820 | recipients were, are they going to cut my Social Security

00:36:00.340 | benefits, which I think would have created riots in Washington

00:36:03.500 | DC.

00:36:04.000 | But imagine that-- and imagine that in an environment.

00:36:10.980 | That's a great point.

00:36:12.020 | Imagine that, then, not just for those that are Social Security

00:36:14.900 | beneficiaries.

00:36:16.020 | Imagine if everyone had the concern that their paycheck

00:36:18.780 | was going to fall.

00:36:20.580 | Yeah, we actually had this in the United States on and off

00:36:22.980 | in almost every economic crisis in the 19th century.

00:36:26.060 | Many workers' wages were set by the day,

00:36:29.220 | and so you had a lot of recessions.

00:36:30.900 | This is long before the Federal Reserve was created.

00:36:33.820 | This is 19th century.

00:36:34.780 | You had financial panics and so forth,

00:36:36.440 | and you would have unemployment rates go up by 10% or 20%,

00:36:41.300 | and there's a very short time.

00:36:43.500 | And you'd have very deep, even if they were short,

00:36:46.300 | you'd have very deep downturns, a very volatile period.

00:36:49.140 | One of the reasons for that is you

00:36:51.060 | would have wages that were falling significantly

00:36:54.140 | for periods of time in many cities in the United States,

00:36:57.580 | on the eastern seaboard.

00:36:58.620 | And I know that because that's why I did my dissertation on it.

00:37:01.700 | And so that is ingrained in central bank theory, which

00:37:05.620 | I think could be--

00:37:06.540 | hopefully, we don't experience too much,

00:37:08.180 | but it actually could be the irony of negative interest

00:37:10.260 | rates going forward, is that at that margin,

00:37:12.140 | if that pushes down inflation expectations,

00:37:14.860 | that's the very outcome that they're trying to--

00:37:16.940 | so hard to avoid.

00:37:18.980 | Let's get back to the global economy and talking about how

00:37:21.740 | this glut of manufacturing capacity overseas

00:37:26.180 | is affecting growth, probably worldwide and also here

00:37:29.940 | in the United States.

00:37:31.260 | And what is going on in Germany?

00:37:33.380 | What is going on in Japan?

00:37:34.460 | What's going on in China?

00:37:35.860 | What's going on in the UK?

00:37:37.020 | And talk about Brexit and this whole global package

00:37:39.960 | that I'm asking you to talk about.

00:37:41.860 | The broadest stroke is that the global economy is still

00:37:46.700 | expanding, but growth is uneven, and it's fragile right now.

00:37:52.180 | One of the underappreciated reasons

00:37:53.940 | we believe and we talk about in The Outlook

00:37:55.820 | is the high level of policy uncertainty.

00:37:59.340 | Now, again, for those listeners, there's

00:38:01.220 | always uncertainty in the world and in life.

00:38:03.500 | But there's times when policy uncertainty-- you just

00:38:05.900 | mentioned one with Brexit.

00:38:07.620 | It's Brexit.

00:38:08.500 | It's US-China trade tensions.

00:38:11.780 | It is other trade tensions with other countries,

00:38:15.140 | between two countries all across the world.

00:38:17.140 | And then there's actually increased

00:38:19.140 | political disagreement between and among political parties

00:38:22.860 | in almost every country around the world.

00:38:24.980 | There is strong statistical evidence,

00:38:27.180 | including what we have done, that when

00:38:29.500 | you have those high levels of uncertainty,

00:38:31.580 | you will tend to see a lower investment

00:38:34.460 | than you would otherwise, which I

00:38:36.140 | think makes intuitive sense.

00:38:37.900 | And that's one of the things that I

00:38:39.580 | think we see going on, that we saw a drastic increase

00:38:43.820 | in policy uncertainty, not just in the United States,

00:38:46.740 | but we clearly saw it in China.

00:38:49.220 | And one of the reasons for this cyclical slowdown

00:38:52.260 | that we're still working through this year, Rick,

00:38:54.380 | and so that's still working through the system.

00:38:56.740 | And Germany has a very high exposure

00:38:59.820 | to manufacturing, particularly to the China consumer.

00:39:03.580 | And it was the slowdown and the deterioration

00:39:06.220 | in private sector confidence in China,

00:39:08.740 | sometimes which is not widely reported,

00:39:11.260 | which led to a significant slowdown there,

00:39:13.140 | which I think also increased the odds more recently that we

00:39:17.580 | saw a phase one trade deal.

00:39:18.940 | Because I think Chinese policymakers were

00:39:23.020 | battling on several fronts.

00:39:24.580 | And so they were increasingly concerned that they

00:39:26.540 | were going to have growth much weaker than expected.

00:39:28.740 | And so they were, I think, a little bit more willing

00:39:32.740 | to at least have a phase one deal than what

00:39:34.540 | it would have been otherwise the case a few months prior.

00:39:36.940 | So I'd hang some of it, not all of it, on uncertainty.

00:39:41.460 | Because it's by these measures that we

00:39:43.140 | track, which are based upon news reports

00:39:45.220 | and other statistical measures to measure and quantify

00:39:48.100 | uncertainty, which can seem ephemeral and tough to put

00:39:51.300 | your hands on, they're the highest

00:39:53.260 | that they've been in over 30 years.

00:39:55.940 | It's not surprising that it is at least stunting or hampering

00:39:59.660 | some investment.

00:40:01.580 | It isn't hampering the US consumer,

00:40:03.740 | because he or she is still chugging along fairly well.

00:40:07.740 | But it has been a reason why we've

00:40:09.340 | been mixed signals on the global economic front.

00:40:13.740 | So let me just go over quickly your forecast for US equities,

00:40:19.700 | non-US equities, and fixed income.

00:40:23.020 | So we all have a general framework

00:40:24.700 | to work from before I get to the questions from the Bogle heads.

00:40:28.700 | Your expectations or your forecast

00:40:32.340 | is over the next 10 years for US equities to give nominally--

00:40:39.020 | that means with inflation included--

00:40:41.100 | 3.5% to 5.5% annualized.

00:40:45.300 | Non-US, you're a little bit more optimistic, 6.5% to 8.5%.

00:40:51.220 | And I want to get back to that in a minute.

00:40:53.380 | And then fixed income, 2% to 3%, which

00:40:58.060 | means that a balanced portfolio of stocks and bonds, 60/40,

00:41:01.980 | somewhere between 4% and 6%, and call the midpoint about 5%.

00:41:07.380 | But let's get back to the non-US, 6.5% to 8.5%.

00:41:12.060 | Is that because valuations are lower?

00:41:15.340 | Is this, by the way, dollar-adjusted,

00:41:16.980 | meaning is this in US dollars?

00:41:18.580 | So the dollar is going to contract?

00:41:20.820 | Yeah, it's in US dollars.

00:41:22.980 | There is a currency effect.

00:41:24.420 | But the primary reason why the expected range of returns

00:41:30.220 | are better than the US is, to your point,

00:41:33.900 | Rick, it is valuation-based, which is, again,

00:41:35.900 | another great reason.

00:41:37.460 | You don't need this reason for a globally diversified portfolio.

00:41:40.420 | But certainly, the US markets have just

00:41:43.380 | outperformed every other part of the world.

00:41:45.380 | In fact, the S&P 500 index has arguably

00:41:48.500 | outperformed any investment, public or private,

00:41:51.340 | any part of the world.

00:41:52.740 | It's been that strong, which has been great.

00:41:55.660 | But it's also why the expected returns are among the lowest.

00:41:58.580 | So I'd say three broad points on our outlook

00:42:01.700 | for the financial markets.

00:42:02.820 | One is the principles of asset allocation

00:42:05.500 | will stand, even in a lower return environment,

00:42:08.020 | because over the next 5 to 10 years,

00:42:10.740 | it is much more likely than not that a diversified stock

00:42:14.260 | portfolio will outperform bonds.

00:42:16.940 | And a diversified bond portfolio will outperform a money market,

00:42:22.020 | which is good to hear.

00:42:24.260 | Rarely would you see those expectations not be that.

00:42:28.060 | It would have to be in a bubble-like environment, where

00:42:30.700 | you could actually reasonably generate other expectations.

00:42:34.500 | But we don't have them.

00:42:35.860 | Secondly is that a globally diversified portfolio

00:42:39.140 | should outperform the US over the next 5 or 10 years.

00:42:41.860 | Finance theory tells us, almost by definition,

00:42:44.540 | that a globally diversified portfolio is, quote unquote,

00:42:47.060 | "more optimal" than a US-only portfolio,

00:42:50.140 | because you use diversified company

00:42:52.220 | risk across multiple markets, right?

00:42:54.940 | And you at least double the number of securities.

00:42:57.460 | So the global portfolio is always the most efficient one

00:43:00.220 | on the frontier.

00:43:02.140 | Over the next 5 or 10 years, that's

00:43:04.460 | where a valuation comes in.

00:43:05.980 | And that should be a little bit more of a tailwind

00:43:08.340 | for the European, other developed markets, and even

00:43:12.100 | parts of the emerging markets.

00:43:13.420 | So now again, the US has outperformed the non-US

00:43:17.540 | over the past several years.

00:43:19.060 | It's more likely than not, where valuations are,

00:43:22.140 | that that will happen.

00:43:23.740 | And so we use valuations in how we model.

00:43:27.020 | That's the sort of simulation engines behind the scene

00:43:29.780 | that we then show those results in the paper.

00:43:32.700 | We are the first to acknowledge, we project ranges of returns,

00:43:36.100 | because our models are good, but they're far from infallible,

00:43:39.380 | and they have error in them.

00:43:42.540 | But I can tell you, our framework--

00:43:44.180 | we've published it in the academic community--

00:43:46.180 | our framework is generally twice as

00:43:48.980 | more accurate for long-range forecasting, twice more

00:43:52.860 | accurate than either the historical average, which

00:43:55.460 | is what I think that most investors have generally used.

00:43:58.500 | If you don't have any other method,

00:44:00.000 | you just use the historical average.

00:44:01.140 | It's twice more accurate than that,

00:44:02.640 | and twice more accurate than some of the popular ones

00:44:05.460 | that Bob Shiller made famous at Yale, part of the reason why

00:44:09.180 | he won the Nobel Prize.

00:44:10.260 | So we use those valuation approaches

00:44:13.380 | to inform the investors of what those expected returns are.

00:44:16.340 | So they're lower than historical average.

00:44:19.260 | We compare those returns versus, say,

00:44:21.540 | the average return since 1980.

00:44:24.100 | I don't think we need any mathematical framework, Rick,

00:44:26.820 | to tell us that the future returns will be lower

00:44:29.660 | than they were since 1980, because since 1980, we've

00:44:33.060 | had, I think, the best financial market

00:44:36.580 | performance in the United States that has ever been seen,

00:44:40.300 | and could very well ever be seen,

00:44:42.340 | at least for the next 100 years.

00:44:44.140 | Certainly in our lifetime.

00:44:45.580 | I mean, it's been a great run.

00:44:47.700 | Sometimes I don't wish I would be back in 1980, 1982,

00:44:52.220 | but it was a great time.

00:44:54.160 | It didn't feel like it at the time,

00:44:55.620 | but we had double-digit interest rates,

00:44:57.740 | and we had P/E ratios of below 10.

00:45:02.460 | I mean, I think the 10-year treasury was even higher

00:45:04.620 | than the P/E ratio.

00:45:06.460 | And since that time, we all know interest rates have come down.

00:45:10.580 | The economy has expanded, and valuation multiples

00:45:12.940 | have actually increased.

00:45:13.980 | And so what a great starting point

00:45:17.940 | that has effectively run its course,

00:45:22.340 | which has led to double-digit average returns for not just

00:45:26.220 | all equity portfolios, but even 80/20 portfolios,

00:45:30.140 | and at times, 60/40 portfolios.

00:45:33.140 | So that doesn't mean the outlook is somber.

00:45:35.140 | It's just more of like going forward.

00:45:37.460 | It's a little bit-- it's certainly below the recent--

00:45:40.100 | it's clearly below the recent historical average.

00:45:42.220 | And that's almost regardless of whether we

00:45:44.900 | have stronger or weaker economic growth this year coming.

00:45:48.300 | Yeah, I always look at the DuPont formula,

00:45:50.540 | if you recall from your days of study you had.

00:45:54.100 | I mean, what are the three levers of return on equity?

00:45:58.260 | It is your operating leverage.

00:46:00.740 | It's your financial leverage.

00:46:02.540 | And it's your taxes.

00:46:04.260 | And what that basically means is operating leverage

00:46:07.420 | is how much you actually get as a rate of return

00:46:09.860 | on the product that you're selling.

00:46:11.500 | But financial leverage is lowering of interest rates.

00:46:14.580 | As interest rates come down, you get a bump in return on equity

00:46:17.940 | because your financing costs are low.

00:46:20.300 | And then as your taxes come down,

00:46:21.860 | you get a bump in return on equity

00:46:23.940 | because your taxes are lower.

00:46:25.380 | Well, we can't get too much lower on interest rates.

00:46:28.420 | We can't get too much lower on corporate tax rates.

00:46:31.740 | I mean, the only thing we have left

00:46:33.420 | is the operating leverage, which is productivity

00:46:37.300 | through technology.

00:46:38.420 | And as we talked about before, population growth--

00:46:42.060 | and that's at least the population growth side--

00:46:44.140 | is beginning to decline.

00:46:45.380 | So I look forward and I say, well,

00:46:47.260 | where can the earnings growth come from over the next 10

00:46:51.180 | or 15 years?

00:46:51.940 | It's not going to come from your lowering of interest rates.

00:46:55.940 | It's not going to come from lowering tax rates.

00:46:58.260 | And baby boomers are retiring.

00:47:00.100 | And we have slower population growth.

00:47:01.700 | So where does it come from?

00:47:03.500 | The one area that it could come from

00:47:05.140 | is the area that's actually arguably

00:47:06.660 | the most important for long-term growth.

00:47:08.420 | And that's innovation.

00:47:09.980 | Economists call it productivity.

00:47:11.260 | But think of the rate of innovation.

00:47:12.780 | How much more efficient?

00:47:13.860 | New product, services, business lines, right?

00:47:16.020 | It's new technologies like the internet coming in.

00:47:19.220 | That's what I call pure oxygen. I mean,

00:47:21.740 | why innovation can be beautiful in that sense

00:47:24.740 | is that you get higher operating leverage, meaning ROI.

00:47:27.300 | Natural, right?

00:47:28.980 | It's generally non-inflationary.

00:47:30.620 | So it's market-friendly.

00:47:32.700 | That can lead to higher inflation-adjusted rates.

00:47:36.740 | So that's good for bond investors, right?

00:47:38.420 | Because it generally adds to the risk-free rate for all asset

00:47:42.420 | expected returns.

00:47:43.380 | And then clearly that can be positive

00:47:45.020 | for equities and companies.

00:47:46.500 | So that's one of the reasons why we have low growth.

00:47:49.220 | Yes, it's demographics.

00:47:50.420 | But the bigger disappointment has been productivity growth.

00:47:53.460 | And that's worldwide, which is why some have argued

00:47:56.300 | this notion of stagnation.

00:47:57.660 | Ultimately, innovation, I strongly believe, will return.

00:48:02.140 | And we have a report coming out in the next few weeks

00:48:05.020 | talking about the future of innovation

00:48:06.860 | based upon a lot of deep research we've done.

00:48:09.020 | That's encouraging.

00:48:10.020 | It probably won't show up in 2020.

00:48:13.260 | But longer term, I'm less pessimistic when

00:48:16.700 | I look out 10 years than some, knowing that the world has

00:48:19.740 | challenges, to be sure.

00:48:21.940 | I think on our more muted return outlook,

00:48:25.500 | ironically, there's two broad things for this.

00:48:27.940 | Because I talk to financial market reporters.

00:48:31.460 | And they're thinking about it from the active management side.

00:48:34.300 | Or they'll say, then, OK, well, what's

00:48:36.140 | the best asset class to invest in if it's lower returns?

00:48:39.820 | Which is not really, I think, the right way

00:48:41.860 | to think about it.

00:48:42.860 | I think what this is is all the more reason

00:48:45.460 | for this to stay the course and staying fully invested.

00:48:48.860 | Because if it's a lower return environment,

00:48:50.940 | that means that we have to have our money at work

00:48:53.180 | in our portfolio every day of the week, right?

00:48:56.940 | Because returns are lumpy.

00:48:58.260 | And it's tough to know when the stock market will

00:49:00.260 | go up any day, week, or month.

00:49:02.420 | And then, secondly, that's where the planning and focusing

00:49:06.180 | on the costs and just the diversification--

00:49:09.300 | I call those free lunches of the portfolio.

00:49:11.180 | They're going to be that much more important.

00:49:13.100 | Now, I know that your listeners appreciate this.

00:49:16.500 | But I think we're going to have to--

00:49:18.780 | I think to be a service to others that are not,

00:49:21.420 | I would ask, at least we turn up our volume on this a little bit.

00:49:24.500 | Because I think it may not be as important to someone

00:49:28.340 | of lower cost or diversification when you get a--

00:49:31.220 | almost any portfolio gives you 10% return.

00:49:34.180 | I think it matters much more to our friends and family

00:49:37.860 | if we're talking about expected returns of 4% or 5%.

00:49:40.980 | Because the margin for error is just lower.

00:49:42.900 | Much lower.

00:49:43.460 | So it doesn't mean we can't overcome it.

00:49:46.420 | It's the bond arithmetic that's really going to, I think,

00:49:49.300 | hurt equity markets not as shiny as it was, too.

00:49:52.860 | But that just means I think we just

00:49:55.100 | have to grit our teeth a little bit

00:49:56.540 | and focus on those fundamentals.

00:49:59.380 | When you talk to some--

00:50:00.580 | not on this podcast, Rick, but we talk to some, right?

00:50:02.980 | It doesn't sound as exciting, right?

00:50:04.300 | You go on the TV and you say, oh, you're

00:50:05.620 | just going to have to save a little bit more

00:50:07.020 | and stick to the fundamentals.

00:50:08.780 | They look at you as like, really?

00:50:10.620 | There's not a secret panacea on this?

00:50:13.460 | When you don't like the forecast,

00:50:14.860 | you just go find a new economist.

00:50:17.060 | Yeah.

00:50:17.580 | Well, there's no silver bullet on that, right?

00:50:19.580 | There is no silver bullet.

00:50:21.700 | Do you have a recommended international stock allocation

00:50:25.780 | for your typical bogelhead investor?

00:50:29.220 | I mean, I would personally start any investor

00:50:31.620 | at 40% non-US equity exposure.

00:50:35.500 | And this is something that we actually

00:50:37.500 | do in our advice units.

00:50:39.620 | It's also the default non-US equity exposure

00:50:43.700 | in our target date funds.

00:50:45.540 | That is consistent across Vanguard.

00:50:48.980 | And so that's where I would start.

00:50:50.900 | It's not a fully market cap.

00:50:53.380 | The non-US market, it's a little bit higher percentage.

00:50:57.260 | But I think how I generally approach

00:50:59.780 | it is by following that 40%.

00:51:01.780 | You start there, and then if you have less comfort or more

00:51:05.300 | comfort, deviating from that.

00:51:06.980 | But I think if you can start there, that's an important--

00:51:10.980 | and because that really reduces the volatility of the portfolio.

00:51:14.540 | That's the so-called, quote, unquote,

00:51:16.140 | if there's a sweet spot, quote, unquote.

00:51:18.420 | You have the lowest standard deviation in returns

00:51:21.380 | when you have that mix.

00:51:22.820 | The returns differentials between the US and non-US

00:51:25.540 | will bounce around in a year.

00:51:27.700 | They have, and they will continue to.

00:51:29.340 | But the volatility of that portfolio

00:51:31.620 | is generally lowest when you're at that point.

00:51:34.580 | An area that you're negative on is less quality or lower

00:51:38.860 | quality corporate bonds.

00:51:41.180 | I know that your research does influence some of the more

00:51:44.740 | active Vanguard funds.

00:51:47.660 | Are they going to be taking this and shifting?

00:51:51.340 | I know you can't say they will do it.

00:51:53.780 | But will they use this data to possibly shift out

00:51:57.220 | of an area where you're not really hot on,

00:52:01.300 | which is the amount of BBB-rated bonds that

00:52:04.620 | are in the corporate bond side?

00:52:07.420 | Yeah, well, for those investors that

00:52:10.180 | have some of our actively managed bond funds--

00:52:14.060 | and again, our bond funds, almost all of them

00:52:16.860 | are managed internally by our fixed income group.

00:52:19.100 | So I have the great pleasure of sitting

00:52:22.260 | on what we call the hub.

00:52:24.220 | But it's a senior investment committee

00:52:26.060 | for all the actively managed bond funds.

00:52:28.700 | I don't chair that committee.

00:52:29.940 | That's the global head of fixed income, John Hollyer.

00:52:32.300 | And there are several of us on that committee.

00:52:35.020 | And we take these sort of discussions

00:52:37.300 | that you and I are having today, Rick,

00:52:38.860 | and we take that into consideration

00:52:41.660 | of building the most viable and what

00:52:44.460 | we think is appropriate bond strategy for the investor

00:52:48.180 | in that fund.

00:52:48.740 | Now, again, those funds have hundreds

00:52:51.180 | of funds that's supported by a deep team of credit analysts

00:52:54.500 | and portfolio managers.

00:52:56.660 | Over time, they add a lot of value

00:52:58.140 | by picking the right bond over another bond,

00:53:01.260 | what we would call idiosyncratic risk or alpha.

00:53:04.700 | What we're primarily trying to do

00:53:06.540 | is just make sure that the portfolio is optimally

00:53:10.740 | structured so that if we like corporate bonds,

00:53:13.660 | generally speaking, because the economy doesn't

00:53:15.820 | look like it will fall in recession,

00:53:17.660 | we're trying to pair that with interest rate diversification

00:53:20.980 | should we get weakness.

00:53:22.180 | And so we would generally be, say, long duration.

00:53:24.300 | You'd actually be overweight treasuries

00:53:26.700 | if you're overweight corporate bonds.

00:53:28.300 | And so, yes, this is reflected.

00:53:30.820 | But it's not just solely like, OK, we think growth is higher.

00:53:33.740 | We'll take more risk.

00:53:34.660 | We do this in terms of how we assess the distribution

00:53:37.700 | of, say, economic growth or inflation.

00:53:40.020 | We always do it relative to what we assess the market is already

00:53:43.980 | anticipating.

00:53:45.420 | And that's what I think is often lost by,

00:53:47.860 | at least when you watch certain shows,

00:53:49.780 | you read certain press reports.

00:53:51.660 | Because I think there's this assumption that, I don't know,

00:53:54.620 | higher growth or higher inflation means a direct--

00:53:58.460 | well, one should do directly something to the portfolio.

00:54:01.100 | What I think is lost sometimes is

00:54:02.540 | that the financial markets may be already

00:54:04.940 | pricing in a weaker or stronger than that scenario.

00:54:08.740 | And a great example right now is the stock market,

00:54:11.460 | which by our calculus is already assuming GDP for 2020

00:54:15.380 | will be 3%, let alone 2%.

00:54:19.060 | And so if one says, oh, we're bullish on the US economy,

00:54:21.940 | we're 2%, 2 and 1/2%, that may not

00:54:23.820 | mean that in some of these active strategies

00:54:26.420 | that we would modestly take more risk.

00:54:28.020 | It's all relative to what the market is already pricing in.

00:54:30.780 | So hopefully that's helpful.

00:54:32.020 | It is.

00:54:32.540 | Thank you.

00:54:33.180 | One last question, because this seems

00:54:34.980 | to be an emerging issue when it has

00:54:37.420 | to do with climate change, ESG, this type of strategy.

00:54:42.380 | Are you seeing that having any effect on the markets'

00:54:46.460 | valuations, where people are putting their money?

00:54:51.020 | I've seen clearly interest from advisors,

00:54:54.660 | from individual investors, some institutions in particular,

00:54:58.860 | just on environmentally sensitive investing,

00:55:03.900 | ESG-type strategies or SRI strategies,

00:55:06.620 | socially responsible investing.

00:55:08.220 | There's clearly more interest.

00:55:09.500 | Right now, I'd say more of the interest is on what is it,

00:55:13.580 | because there's different types of those approaches.

00:55:16.860 | You can either screen and not own

00:55:18.700 | certain securities versus maybe be more proactive

00:55:22.180 | and owns certain companies outright.

00:55:25.920 | So we're seeing more interest in that.

00:55:27.540 | And we've obviously launched certain products

00:55:29.700 | that are consistent with those approaches.

00:55:32.180 | Time will tell how widespread they become

00:55:34.660 | in terms of investment dollars.

00:55:37.580 | So I have heard the interest.

00:55:39.140 | I think the academic research community is starting

00:55:41.980 | to focus on it more in the economic space.

00:55:44.520 | So I'd say more to come on that.

00:55:47.380 | It's something I could see us doing a little bit more

00:55:49.420 | deeper research going forward.

00:55:51.840 | - Joe, it's been a real pleasure to have you

00:55:53.340 | on the "Bogleheads on Investing" podcast.

00:55:54.980 | I hope we could maybe make this an annual event.

00:55:57.420 | - That would be great, that would be great,

00:55:59.980 | if you'll have me, yeah.

00:56:00.940 | - Oh, definitely.

00:56:02.020 | - Oh, and for everyone, happy new year

00:56:04.240 | and best of luck in 2020.

00:56:06.340 | - This concludes the 17th episode

00:56:08.540 | of "Bogleheads on Investing."

00:56:10.940 | I'm your host, Rick Ferry.

00:56:13.100 | Join us each month to hear a new special guest.

00:56:16.460 | In the meantime, visit bogleheads.org

00:56:19.820 | and the "Bogleheads" wiki.

00:56:21.580 | Participate in the forum and help others find the forum.

00:56:25.820 | Thanks for listening.

00:56:27.300 | (upbeat music)

00:56:29.880 | (upbeat music)

00:56:32.500 | (upbeat music)

00:56:35.080 | (upbeat music)

00:56:37.660 | (upbeat music)

00:56:40.240 | [BLANK_AUDIO]

Bogleheads® on Investing Podcast 017 – Joe Davis, host Rick Ferri (audio only)

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