Welcome to Bogo Heads on Investing, podcast number 17. My guest this month is Joe Davis, Vanguard's Global Chief Economist. And our topic is Vanguard's Economic and Market Outlook for 2020, the New Age of Uncertainty. My name is Rick Ferry, and I'm the host of Bogo Heads on Investing. This podcast, as with all podcasts, are brought to you by the John C.

Bogle Center for Financial Literacy, a 501(c)(3) corporation. In this podcast, we have Dr. Joe Davis, Vanguard's Global Chief Economist and head of Vanguard's Investment Strategy Group, whose research team is responsible for helping to oversee the firm's investment methodologies and asset allocation strategies for both institutional and individual investors. In addition, Joe is a member of the Senior Portfolio Management Team for Vanguard's Fixed Income Group.

Today, we're going to be discussing a new report, Vanguard Global and Economic Market Outlook for 2020, the New Age of Uncertainty. The report is available online at Vanguard.com. With no further ado, let's bring in Dr. Joe Davis. Welcome, doctor. Thanks, Rick. You can call me Joe, and really, thanks for having me.

Well, thank you so much for being on our show today, Joe. We're really fans of your work, and you've given some fantastic presentations to the Bogleheads over the years. What I wanted to do today was get your team's outlook on 2020. But before we start there, who is Joe Davis?

Can you give us a little background and some tidbits of your life and your bio? Sure. Well, I actually grew up 10 minutes from the Vanguard building I work in here outside of Philadelphia. I was attracted to Vanguard because I was an early investor in the early '90s, and that's thanks to my dad.

He had the wisdom to show me how to start investing. I came out of graduate school with a PhD in economics. I was actually thinking I would end up up on Wall Street in New York. But again, my dad said, why don't you apply to Vanguard? So I did.

And my resume found its hands into a group that they were just starting, a group that I now have the great pleasure of leading. I thought leadership group, effectively a research group. And that was 17 years ago, Rick. And so it's amazing. I count myself very lucky and fortunate to work with such a great company.

And our group has grown from, in those early days in 2002, 2003, from fewer than 10 crew members to now we're over 65 and growing. And we're in multiple countries, including Europe and Asia. So it's an exciting group to be a part of, and I count myself fortunate. One of the Bogleheads did ask, who is the audience for the work that you're doing?

Because as Bogleheads, we're basically following buy-hold strategies. You do a lot of work, and you make a lot of predictions about GDP growth, earnings growth. You actually put out marked forecasts. And so how does a typical individual investor take that? Is it supposed to be actionable? Or who's it for, and how should it be taken?

Yeah, see, I see three primary users or use cases for our annual publication. First is just, I think for many, is just to orient or to help provide investors with what are reasonable expected returns for the portfolios or investment that they are already in. This is not and has never been and never will be supposed to be used as market timing calls and short-term prognostications, which I, quite frankly, I see from many in the industry.

This is to help inform what is a reasonable expected return on a portfolio to help one achieve one's goals. And before I came to Vanguard, we did not have forward-looking expectations. And so that's been a big step forward for many, including internally at Vanguard. Secondly, this is an input into the active manage process.

So for those investors that are perhaps in our actively managed bond funds, whether they're taxable or they're municipal, our economic outlook is an important ingredient because in those funds, we are taking modest active risk, meaning trying to outperform the benchmark in a very risk-controlled way. And to try to do that, one of the many levers that the portfolio management team will pull will be a risk assessment of what the markets are pricing in from an interest rate or, say, an economic growth outlook.

And then how do we view the risk skewed relative to that sort of view in the marketplace? Again, all in the interest and the objective to try to modestly and incrementally add value for the shareholder in the funds. Many times, we view that as just as much not taking excessive risk as it would be for trying to take more risk.

And a great example is even right now where I can feel and can sense in the market is becoming increasingly overly optimistic on growth. We see pockets of the financial markets where I would view as frothy risk-taking. And so for a long-term investor that are in these funds, we are managing, based upon our outlook, to not be as aggressive as other funds may be, which we believe in the long run will reward our investors in those funds.

And then the third would be for those that would retain Vanguard from an advice perspective. Because again, for certain investors who may have either a fixed spending goal, it may be an institution that has to generate a certain spending flow from their portfolio, or others, the variations in expected returns in the marketplace-- again, not in the one year, but in the next five or 10 years-- can then have implications for the asset allocation strategies that they would pursue.

For some that have a very, very long horizon, I would tell those investors that they should ignore all outlooks, including our own, if they have a very long horizon. Because the buy and hold, stay the course, is very much appropriate. But for years, when I came to Vanguard, I think what a common refrain would be would be, hey, does Vanguard have an opinion on x or y?

And I think many, many investors want to stay the course, but sometimes they also struggle with the headlines. And so one of the other primary objectives of this piece is to say, yes, these are the probabilities that may occur in the future, whether it's economic risk or financial market volatility, that we have thought about it, and it's reflected in our thinking and in the advice that we give clients.

So basically, three ideas. Number one, your individual investors already have their portfolios set and their asset allocation. And so it's just sort of long-term estimates of expected return from bonds and equities so that they can do some planning. And then number two, it's for your active funds so that they can maybe do some tailoring and potentially pick up some excess return or some alpha.

And last, you were saying there are large institutional investors who actually buy your research or pay you to give this assessment. And those are the three areas where you find people use your report. Yeah, and some will just use it as an input into assessing the risk. Because at the end of the day, all of us as investors are making decisions under uncertainty in terms of our asset allocation, right?

Even if we haven't changed our asset allocation, it's still a decision, whether implicit or explicit. And so the value that we hope to bring is to convey the range of ultimate outcomes, particularly with respect to returns. And respectfully, I think we do it in a very rigorous way. I mean, we take some of the best techniques in academia, but we do it in a way where we convey, I believe, the market outlook as it should be, which is a range of outcomes.

We're not offering short-term point forecasts. Vanguard doesn't have an S&P 500 target for the end of 2020. I actually kind of laugh at those sort of outlooks. And so I think if we can convey the range of outcomes and the rationale for why it is today versus perhaps what it would have been 10 years ago, I think that can be of value.

I'll give you an example where it helped some investors, Rick, like 10 years ago. Our first annual outlook publication came out in the 2009 period, which you can recall. It was not a fun time in the markets. And we had a great deal of clients wondering, should they even be in equities at all?

And this publication helped some in the sense that we said, listen, the economic environment for the next several years is going to be where I have elevated unemployment. It's going to be fairly tepid growth. Yet the outlook for the financial markets, as best we can assess over the next five or 10 years, believe it or not, actually the odds are tilted towards higher than average expected returns.

And if anything, we turned it out to be a little too low in our projections, our range. It came in a little bit higher than expected. But I think that was helpful because behaviorally and emotionally at that time, it felt as if-- I would even have friends and colleagues in my family that said, listen, I feel like I really should get out of the market.

And so even having that conversation, the rationale for why the expected returns were even higher, you could show that for some that are really mathematically inclined, you could show them statistical rigor, why historically there's a reason to believe this. I think that had a service to investors. This publication is not in any way intended to pick market tops and bottoms.

We're really trying to inform investors that this is the range of expected returns that you could see in your portfolio. I think that your estimate of a globally diversified 60% stock, 40% bond portfolio, you have a range of four to six, so call it the midpoint, about five. Seems to me to be very realistic and a good planning point.

We have to have something to plan with. We have to have some number to use. And I think that your numbers are as good as anything anybody could come up with. But the way you get to them, though, in reading through your report, you start out by looking at, it seems, the business cycle.

Could you explain about the business cycle and where do you think we are? Well, we're at one of the later stages of the business cycle in the sense of how long this global expansion, which is going on more than 11 years-- and we expect it to continue into 2020.

And why that matters, assess where you are in the cycle, it has implications for two things. One is, historically at least, when you're in the late stages of any expansion, two things tend to emerge. One is you tend to have the financial markets not only performing very well, which is good, but you tend to have financial markets outperforming the fundamentals.

And so in that environment, investors can feel very good. But precisely because of how we approach the forward-looking return, we expect the future returns become more modest. And so it's important to identify where you are in that cycle at a high level because that does inform how one should be thinking about everything from rebalancing to the return estimates that they assume.

We estimate that the global economy will more likely than not continue to expand, but growth will not accelerate, at least to the extent that at least parts of the stock market increasingly already anticipate. And so it will be one of these somewhat of a paradox in 2020 is that we could have economic growth not be negative, the expansion continue, and yet you could have the financial markets underperform for a time.

And just to be prepared for that. We do not see strong evidence of financial market bubbles, which occurred late in the business cycle, say in 1998, 1999. You could call it a NASDAQ or a dot-com. We don't see the imbalances in other parts of the economy, much like we saw in housing, certainly in late 2006 and early 2007.

There are, though, imbalances, I think, in the high level of corporate debt, high level of sovereign debt in some countries. And we've had extended period of very loose monetary conditions generated by central banks. So that's what keeps us up at night a little bit. But I think at the end of the day, it's not the worst outlook.

It's just one I think we're just trying to set lower, but I still think reasonable. And they're not bearish. It's not a bearish outlook on either the world economy or the financial market. I find it interesting that a year ago, after the Fed had increased rates three times last year, but then the forecast was for three more rate increases in 2019.

But in fact, what we had was three rate decreases rather rapidly. And in addition, around the world, monetary policy makers just been decreasing. Is that a warning sign? I mean, yeah, I mean, one of our outlook last year, the theme of it was down but not out. And it was a boxing analogy, meaning the global economy was going to weaken significantly based upon the leading indicators, which we track very closely internally at Vanguard, again, used in the portfolio management process.

And they weakened in China in early 2018. They weakened in the US in 2018. And so that foretold, at some point in 2019, roughly around the summer, that we were going to have what we called growth scares. And we published that in early 2019, that we were more likely than not going to see a slowdown in growth, which many did not at least anticipate of severity.

Now, in part because of that slowdown, our probability of recession almost approached 50%, which unnerved us a little bit. Because obviously, if you have a recession, equity market historically has been down at least 20%. The irony of it is that I think the Federal Reserve and some other central banks were observing and have similar models as we do, Rick.

And so I think that ultimately, they reacted much more aggressively. And so cut rates, I think, would stabilize the situation. Quite frankly, they reacted more strongly than I would have anticipated. I could have perhaps seen one cut. Because it was really just in the bond market, particularly the shape of the yield curve that seemed the most ominous sign of potential recession.

But other indicators, both in the economy, outside of manufacturing, as well as the equity market, were not displaying the same signals, which is why our probabilities never got above 50%. So it did surprise me how aggressively they reacted. But then that was one of the reasons why the second half of the year, the financial markets performed as well as they did.

Not the only reason, but that certainly was a primary catalyst. Yeah, we went from an inverted yield curve to now it's getting to look almost more like a normal yield curve as longer-term rates continue to creep up here and short-term rates come down. So there's no longer an inverted yield curve.

Now, some people will say, well, that's good. That means no recession is coming. Our probability of recession uses all the signals in the marketplace, but we combine them in a way that's actually more accurate in general than just the bond market alone or the stock market alone. It's actually the power of a diversified set of signals.

So that'll be the power of diversification, diversified portfolio. We use a diversified portfolio of signals, over 100 in all, that you can use to assess what the risks are in the economy. And it's improved, although we're not completely out of the wood yet. One of the reasons why, although we don't see a recession in 2020, there's going to be uneven growth next year.

And so I think the bond market's starting to come to the realization of that. The equity market, quite frankly, has priced in a much better economic outcome than I even think is reasonable. And so that's why I still think in the near term, we just have to be prepared for some volatility.

I've been reading a lot about manufacturing declines in manufacturing activity. In fact, the Kansas City Fed recently announced that their district has had, I think it's several months in a row now, a manufacturing decline. And globally, there appears to continue to be this manufacturing decline. And how is that impacting into your GDP growth estimates?

It's been a primary factor. It's been a factor of why we foresaw significant global slowdown this year, relative to 2018, which occurred in almost every market. One of the reasons that fed into the central bank switching course in various markets around the world, and one of the reasons why we're less bullish, so to speak, than I think many increasingly are for 2020, there's three reasons why the manufacturing sector in particular have been underperforming, or in many parts of the world, including in the United States, contracting, meaning in recession.

One was set in motion two or three years ago. And that was it was a high level of inventories in the manufacturing sector. And so there's generally been, in the past 10 years, a three-year sort of expansionary sort of tailwind to manufacturing, and then it slows down for a time.

And you could see that clearly in our signals. And we're not completely done that, but we're still working through it. And that's why we've seen weakness across the manufacturing front. Secondly, it's been in motion for 10 years, and that is the structural slowdown, intentionally, in China, as they continue to try to rebalance and escape what many call the middle income trap, meaning they've become more developed, become more consumer-based.

And they've been successful to date, but the past days of even 6% growth, I think, are over. And so that has particularly impacted parts of the manufacturing sector. But the third one, and clearly the most cyclical one, has been the trade tension between the US and China. We model that as best we can, and it's the high level of uncertainty.

In fact, that's the title of our publication this year, The New Age of Uncertainty, that why we call it that is that we believe that this recent significant rise in uncertainty is unlikely to unravel quickly. That has led to slower than expected business investment, and that primarily hits, or certainly hits, the manufacturing sector.

So one of the byproducts of this slowdown in manufacturing and global manufacturing are corporate profits. Now, S&P earnings have been increasing, in part because of tax cuts, in part because of buybacks. So we have this divergence between S&P earnings that are increasing and national profits based on GDP, national accounts, that has actually been declining.

And a Wall Street Journal article recently brought this to light, I think, a couple of weeks ago. Can you comment on that? Profit margins are still fairly robust when you look at the aggregate data. I mean, they have weakened in a growth rate perspective, but I would say there's two things going on.

One is just the high level of profitability. It's particularly impressive in the United States. It's one of the reasons why I think the US has been among the stronger, or at least the more stable, economic performers and equity market performers over the past several years. It's just the high level of profitability.

Now that the rate of increase has clearly slowed, part of that is just due to the economic environment. The weakness, particularly, we've seen overseas. There was a point in time this year which we estimate China was growing well below 5%, perhaps as low as 3% or 4%, which wasn't reported in the statistics.

We saw significant weakness in other emerging markets and in Europe, Germany and others, which again, part of them are exposed to weakness in China. And so we've seen a deceleration in that. And then, of course, the equity market has continued to perform well, I think in part because corporate profitability didn't go significantly negative when recession odds were being discussed.

But I think for just other just sentimental reasons, and so you've had this valuation. The P/E ratios have just widened further because earnings haven't been keeping up to the same level of appreciation as prices. And then as you noted, Rick, there's been a more of a longer term, four or five years, the M&A activity, the buyback activity, more so than the rate of natural investment in companies on growth prospects, something I would call sometimes financial engineering, has been significant pace.

And then another reason, which is not often discussed, and it won't change quarter to quarter, but another reason or contributed to the high level of corporate profitability, it is a little modestly concentrated in a handful of firms. And part of that is, I think, the nature of the digital economy, what I would call network effects.

And so very large companies may be able to maintain high profit margins or high profit levels, whether growth is accelerating or decelerating. There's longer term issues and behaviors. I think that can help explain the high level of corporate profitability. But then there's also the business cycle effect, which tends to get most of the press attention.

Let's move into the labor markets, because I have a real question about this. I'm a baby boomer. I'll be 62 next year, and I see all of my compadres from high school and college getting ready to leave the labor force over the next year or two or three. And if we get a lot of people leaving the labor force because they're retiring, how is that going to affect things like inflation, demand, and so forth?

Yeah, I mean, it's an important issue. I would put the aging of the workforce alone as just the slower rate of population growth we have in the US, and in other countries, versus, say, 10 or 20 years ago. Slower demographic forces have already had, I think, a clear imprint on a number of things.

One is just, what are the expectations for growth? What's the natural run rate, so-called the average speed limit for any economy? We used to talk in the United States that a reasonable growth rate for, say, real GDP was 3% in the '90s. Or the good old days. Yeah, the good old days.

No, of course, that was propped up by leverage, which we ended up paying the price for in terms of the housing market and in the global financial crisis. But yeah, the natural run rate for the US economy right now is slightly below 2%. One of the reasons for that is the aging of the workforce and just the retirement.

Population growth is not negative, but it has clearly slowed. And so the potential growth rate of the economy is lower. Now, that does have an implication for inflation. You would say, then, if you have slower potential, let's call it 1 and 1/2 GDP growth. And we've been growing in the United States roughly 2%, the past four or five years, right?

You would then expect inflation to rear its head sooner. Because even though you're growing slower than historical averages, you're going above the speed limit. So inflation is like a speeding ticket, right? You only get that speeding ticket if you're going above the speed limit. I will compliment our team.

We put our finger on this four or five years ago, that there's been other forces that have been more than offsetting the inflationary pressures that you would think from less slack in the economy, which is really one way of saying, regardless of your growth rate, if you have fewer available workers, eventually you're going to see wage pressures and everything.

But one of those forces is digital technology, which has been a suppressant, keeping prices down. It's everything from online sales to just cheaper costs of manufacturing certain products and services. And we were one of the first firms to actually quantify what that drag is. So what this means, I think the demographic imprint going forward, it's one of the reasons-- not the only one-- one of the reasons why interest rates are lower today in the United States and in Europe and in other parts of the world is because of slower population growth.

And again, it's tied to lower expected economic growth, which has led to those lower interest rates. There's a point with which it'll reverse. When the global economy-- and it's roughly five years from now, and again, this is very slow moving. It won't happen in one month, in any one year.

But with an aging population, over time, that'll mean that there will actually be a little bit less demand for very safe assets, which has been a significant boost to fixed income markets, as well as the lower rate of inflation. We had a research report on what are the investment implications of an aging world and a world with slower demographic patterns.

And what we did conclude was that it is modestly inflationary, but those sort of headwinds don't really come into play until roughly 10 years from now. Demographics is a-- there's competing forces. There's some things that can be positive to the financial markets, bonds or stocks from demographics. There's other things that can be potentially negative.

But these are slow moving effects. And so it's important to say, over what horizon may they matter? And also to appreciate the other forces, because demographics are far from the only one that are affecting an economy and financial market at any period of time. I'm going to lump these next three questions into one.

It has to do with your forecast for Fed cuts, number one. And secondly, do we get to a point where rates are so low that we're pushing on a string, another old saying on Wall Street? Has the Fed's hammer been taken away because interest rates get so low? And then finally, what are the prospects for the US to hit negative interest rates like we see in a lot of the other developed markets?

Yeah, let me take the last one first, Rick. I think the odds of us seeing negative interest rates in the United States are very low and much lower than other countries. I wouldn't assign a probability to any outcome zero. That would be foolish. But I think there's a number of reasons why we won't see negative in the United States.

I think one of the reasons is the importance of short-term funding markets, including money market funds, which is really a strength and diversified source of funding for corporations and lending for short-term collateral. And so there's both technical as well as fundamental reasons why I think the Federal Reserve will be reluctant to test negative interest rates.

And I am not a fan of negative interest rates. I'm more in the minority in my profession. I can't prove this, but I think history will show that the modest negative interest rates we see in both Japan and in Europe are a mistake. And we have not seen significant lift from either of those economies with negative interest rates.

Now, again, I'm not expecting a move from zero interest rate to negative 0.25%. It's going to lead to fundamental growth, right? That would be an unfair criticism. But I think the risk that negative interest rates play and why I think we won't ultimately see them in the US is that there is a risk that when a country sets negative interest rates, that you can actually lead some investors to start to believe that we'll have deflation, meaning falling prices, or to lower their inflation expectations, which is precisely the opposite outcome of the rationale for taking interest rates below zero to begin with.

Yeah, unattended consequences. Unattended consequences. So I don't have proof in that, but I think there is now at least some doubt in some central banker's mind. And so I don't think we'll see it. I think in the next recession, what we will very likely see, though, is the Federal Reserve cut interest rates to zero much more quickly than they may have done in the past, in large part because they don't have as much room to cut.

And then secondly, although, again, it may only be modest effects, but I think we will see potentially expansion of the balance sheet. And then thirdly, what will gain much more discussion will be the pairing of monetary policy with fiscal policy in terms of stimulus. This will ultimately become a politically charged issue, and my job is to assess the economic ramifications of this.

I do believe central bankers, generally speaking, are already pushing on a string. I don't think the Federal Reserve should be pushing on the string. They are trying to, at the end of the day, maintain full employment and to get inflation actually higher than where it is. So the risk is, in our outlook, and one of the reasons why we think the next move by the Fed will likely be a cut and not a hike, even though I personally wouldn't do it if I was on the Fed, is likely because they want to make sure that investors still believe there will be positive inflation in the future, and they want to continue the expansion as long as possible.

And again, those points are part of their mandate and charge, but we can all, I think, disagree about whether or not they should be cutting or not. We've debated that internally here at Vanguard. But I've sat in the middle of debates, and I've actually argued from both sides, which you probably-- would surprise you as an economist.

I use both hands, but at the end of the day, also my job is to assess, certainly for the portfolio management teams, not what they should do, but what ultimately the Federal Reserve and others will do, because that has the bearing on the financial markets. And so I think the bar is high for the Federal Reserve to cut the rates in 2020, but I think they're more likely to cut them than they are to raise them if our assessment of where the economy may unfold and inflation may unfold this year is right.

It seems as though everyone hangs on every word the Fed says. I think the central banks get too much attention in the financial markets, because they don't control long-term interest rates and the stock market as much as, I think, people think they do. It seems like that the day of an announcement, but they really don't influence it as much as they think.

But I think the risk is they focus so much on preserving the expansion for so long that they may under-appreciate some of the financial froth that is building in the system. And so that's what I worry about, and that's what I think one of the unintended consequences could be.

Let's talk a little more about inflation. And if we define inflation by the prices we pay for all the goods or services we purchase as consumers, in fact, one of the most perplexing questions in economics, and hence in the financial markets, Rick, is actually why inflation has been stubbornly so low for so long.

Almost any central bank without exception in the world aims to have inflation average roughly 2%, and then they try to calibrate their short-term interest rates, which they clearly control, to try to hit that target, knowing that it's a moving target, and they're trying to hit it. For all the golfers out there, they're 100 yards from the hole, right?

That's where they want inflation to be, on the green, knowing that they'll never get a hole in one, but close enough. Could you explain why do central bankers want inflation? Yeah, it's actually a really good question. Why any inflation at all? The reason why, generally speaking, most economists would argue that you want a stable inflation rate that's modest, but positive, is for two things.

One is the belief that if you have a stable and expected inflation rate, that it makes it easier for planning purposes. And so you're more likely to have modestly higher investment, hiring, and then consumption. And there's some truth to that, right? Because if you can have better foresight on the increases in prices and so forth, that reduces uncertainty.

We all know the higher uncertainty, the lower, say, investment or spending loss equal. But the big reason why is because in any economy, you have debt holders, right? So if you're a consumer, many of the listeners out there, myself included, my highest debt right now is the mortgage payment, which has a fixed term.

And it's in fixed dollar amount. Why central banks want a positive inflation rate is if you had a consistently negative inflation rate, say negative 3%, negative 4%, and you have a fixed debt level, that makes paying back that debt that much harder. Because your income is falling by 3% or 4%, right?

But I think what economists do a poor job in saying is when they say it's bad to have deflation, what they should say, and what I should say, is that it's bad to have wage deflation. Because if we see sales at the store, and that TV one's buying is 20% off, and so forth, that's not necessarily alarming.

It's alarming when you have all prices going down, including the prices for our labor, meaning our wages or our income, and our salaries going down. That's what happened in the early 1930s, which led to massive defaults, particularly among farmers and many companies. It froze consumer spending, because I don't think anyone's going to maintain their same level of consumption if their own income is not only falling, but expected to fall further.

And we've seen glimpses of how pernicious this can be on and off in Japan for the past 20 years, right? Because the bond market today, even in Japan in surveys, very few Japanese consumers expect inflation to be positive in the next five or 10 years. And their wages don't go up by a significant amount.

And so that's where, at the end of the day-- so behind, when you hear the Federal Reserve is targeting 2%, and everyone talks about the Consumer Price Index, where that 2% came from, all the way back from Milton Friedman, who won the Nobel Prize, and even before that, it's really around this fear of avoiding wage deflation, particularly that we saw during the Great Depression.

I recall when we had a negative inflation rate, just a very minor negative inflation rate a few years ago after the financial crisis. There was a big question on the minds of Social Security recipients were, are they going to cut my Social Security benefits, which I think would have created riots in Washington DC.

But imagine that-- and imagine that in an environment. That's a great point. Imagine that, then, not just for those that are Social Security beneficiaries. Imagine if everyone had the concern that their paycheck was going to fall. Yeah, we actually had this in the United States on and off in almost every economic crisis in the 19th century.

Many workers' wages were set by the day, and so you had a lot of recessions. This is long before the Federal Reserve was created. This is 19th century. You had financial panics and so forth, and you would have unemployment rates go up by 10% or 20%, and there's a very short time.

And you'd have very deep, even if they were short, you'd have very deep downturns, a very volatile period. One of the reasons for that is you would have wages that were falling significantly for periods of time in many cities in the United States, on the eastern seaboard. And I know that because that's why I did my dissertation on it.

And so that is ingrained in central bank theory, which I think could be-- hopefully, we don't experience too much, but it actually could be the irony of negative interest rates going forward, is that at that margin, if that pushes down inflation expectations, that's the very outcome that they're trying to-- so hard to avoid.

Let's get back to the global economy and talking about how this glut of manufacturing capacity overseas is affecting growth, probably worldwide and also here in the United States. And what is going on in Germany? What is going on in Japan? What's going on in China? What's going on in the UK?

And talk about Brexit and this whole global package that I'm asking you to talk about. The broadest stroke is that the global economy is still expanding, but growth is uneven, and it's fragile right now. One of the underappreciated reasons we believe and we talk about in The Outlook is the high level of policy uncertainty.

Now, again, for those listeners, there's always uncertainty in the world and in life. But there's times when policy uncertainty-- you just mentioned one with Brexit. It's Brexit. It's US-China trade tensions. It is other trade tensions with other countries, between two countries all across the world. And then there's actually increased political disagreement between and among political parties in almost every country around the world.

There is strong statistical evidence, including what we have done, that when you have those high levels of uncertainty, you will tend to see a lower investment than you would otherwise, which I think makes intuitive sense. And that's one of the things that I think we see going on, that we saw a drastic increase in policy uncertainty, not just in the United States, but we clearly saw it in China.

And one of the reasons for this cyclical slowdown that we're still working through this year, Rick, and so that's still working through the system. And Germany has a very high exposure to manufacturing, particularly to the China consumer. And it was the slowdown and the deterioration in private sector confidence in China, sometimes which is not widely reported, which led to a significant slowdown there, which I think also increased the odds more recently that we saw a phase one trade deal.

Because I think Chinese policymakers were battling on several fronts. And so they were increasingly concerned that they were going to have growth much weaker than expected. And so they were, I think, a little bit more willing to at least have a phase one deal than what it would have been otherwise the case a few months prior.

So I'd hang some of it, not all of it, on uncertainty. Because it's by these measures that we track, which are based upon news reports and other statistical measures to measure and quantify uncertainty, which can seem ephemeral and tough to put your hands on, they're the highest that they've been in over 30 years.

It's not surprising that it is at least stunting or hampering some investment. It isn't hampering the US consumer, because he or she is still chugging along fairly well. But it has been a reason why we've been mixed signals on the global economic front. So let me just go over quickly your forecast for US equities, non-US equities, and fixed income.

So we all have a general framework to work from before I get to the questions from the Bogle heads. Your expectations or your forecast is over the next 10 years for US equities to give nominally-- that means with inflation included-- 3.5% to 5.5% annualized. Non-US, you're a little bit more optimistic, 6.5% to 8.5%.

And I want to get back to that in a minute. And then fixed income, 2% to 3%, which means that a balanced portfolio of stocks and bonds, 60/40, somewhere between 4% and 6%, and call the midpoint about 5%. But let's get back to the non-US, 6.5% to 8.5%. Is that because valuations are lower?

Is this, by the way, dollar-adjusted, meaning is this in US dollars? So the dollar is going to contract? Yeah, it's in US dollars. There is a currency effect. But the primary reason why the expected range of returns are better than the US is, to your point, Rick, it is valuation-based, which is, again, another great reason.

You don't need this reason for a globally diversified portfolio. But certainly, the US markets have just outperformed every other part of the world. In fact, the S&P 500 index has arguably outperformed any investment, public or private, any part of the world. It's been that strong, which has been great.

But it's also why the expected returns are among the lowest. So I'd say three broad points on our outlook for the financial markets. One is the principles of asset allocation will stand, even in a lower return environment, because over the next 5 to 10 years, it is much more likely than not that a diversified stock portfolio will outperform bonds.

And a diversified bond portfolio will outperform a money market, which is good to hear. Rarely would you see those expectations not be that. It would have to be in a bubble-like environment, where you could actually reasonably generate other expectations. But we don't have them. Secondly is that a globally diversified portfolio should outperform the US over the next 5 or 10 years.

Finance theory tells us, almost by definition, that a globally diversified portfolio is, quote unquote, "more optimal" than a US-only portfolio, because you use diversified company risk across multiple markets, right? And you at least double the number of securities. So the global portfolio is always the most efficient one on the frontier.

Over the next 5 or 10 years, that's where a valuation comes in. And that should be a little bit more of a tailwind for the European, other developed markets, and even parts of the emerging markets. So now again, the US has outperformed the non-US over the past several years.

It's more likely than not, where valuations are, that that will happen. And so we use valuations in how we model. That's the sort of simulation engines behind the scene that we then show those results in the paper. We are the first to acknowledge, we project ranges of returns, because our models are good, but they're far from infallible, and they have error in them.

But I can tell you, our framework-- we've published it in the academic community-- our framework is generally twice as more accurate for long-range forecasting, twice more accurate than either the historical average, which is what I think that most investors have generally used. If you don't have any other method, you just use the historical average.

It's twice more accurate than that, and twice more accurate than some of the popular ones that Bob Shiller made famous at Yale, part of the reason why he won the Nobel Prize. So we use those valuation approaches to inform the investors of what those expected returns are. So they're lower than historical average.

We compare those returns versus, say, the average return since 1980. I don't think we need any mathematical framework, Rick, to tell us that the future returns will be lower than they were since 1980, because since 1980, we've had, I think, the best financial market performance in the United States that has ever been seen, and could very well ever be seen, at least for the next 100 years.

Certainly in our lifetime. I mean, it's been a great run. Sometimes I don't wish I would be back in 1980, 1982, but it was a great time. It didn't feel like it at the time, but we had double-digit interest rates, and we had P/E ratios of below 10. I mean, I think the 10-year treasury was even higher than the P/E ratio.

And since that time, we all know interest rates have come down. The economy has expanded, and valuation multiples have actually increased. And so what a great starting point that has effectively run its course, which has led to double-digit average returns for not just all equity portfolios, but even 80/20 portfolios, and at times, 60/40 portfolios.

So that doesn't mean the outlook is somber. It's just more of like going forward. It's a little bit-- it's certainly below the recent-- it's clearly below the recent historical average. And that's almost regardless of whether we have stronger or weaker economic growth this year coming. Yeah, I always look at the DuPont formula, if you recall from your days of study you had.

I mean, what are the three levers of return on equity? It is your operating leverage. It's your financial leverage. And it's your taxes. And what that basically means is operating leverage is how much you actually get as a rate of return on the product that you're selling. But financial leverage is lowering of interest rates.

As interest rates come down, you get a bump in return on equity because your financing costs are low. And then as your taxes come down, you get a bump in return on equity because your taxes are lower. Well, we can't get too much lower on interest rates. We can't get too much lower on corporate tax rates.

I mean, the only thing we have left is the operating leverage, which is productivity through technology. And as we talked about before, population growth-- and that's at least the population growth side-- is beginning to decline. So I look forward and I say, well, where can the earnings growth come from over the next 10 or 15 years?

It's not going to come from your lowering of interest rates. It's not going to come from lowering tax rates. And baby boomers are retiring. And we have slower population growth. So where does it come from? The one area that it could come from is the area that's actually arguably the most important for long-term growth.

And that's innovation. Economists call it productivity. But think of the rate of innovation. How much more efficient? New product, services, business lines, right? It's new technologies like the internet coming in. That's what I call pure oxygen. I mean, why innovation can be beautiful in that sense is that you get higher operating leverage, meaning ROI.

Natural, right? It's generally non-inflationary. So it's market-friendly. That can lead to higher inflation-adjusted rates. So that's good for bond investors, right? Because it generally adds to the risk-free rate for all asset expected returns. And then clearly that can be positive for equities and companies. So that's one of the reasons why we have low growth.

Yes, it's demographics. But the bigger disappointment has been productivity growth. And that's worldwide, which is why some have argued this notion of stagnation. Ultimately, innovation, I strongly believe, will return. And we have a report coming out in the next few weeks talking about the future of innovation based upon a lot of deep research we've done.

That's encouraging. It probably won't show up in 2020. But longer term, I'm less pessimistic when I look out 10 years than some, knowing that the world has challenges, to be sure. I think on our more muted return outlook, ironically, there's two broad things for this. Because I talk to financial market reporters.

And they're thinking about it from the active management side. Or they'll say, then, OK, well, what's the best asset class to invest in if it's lower returns? Which is not really, I think, the right way to think about it. I think what this is is all the more reason for this to stay the course and staying fully invested.

Because if it's a lower return environment, that means that we have to have our money at work in our portfolio every day of the week, right? Because returns are lumpy. And it's tough to know when the stock market will go up any day, week, or month. And then, secondly, that's where the planning and focusing on the costs and just the diversification-- I call those free lunches of the portfolio.

They're going to be that much more important. Now, I know that your listeners appreciate this. But I think we're going to have to-- I think to be a service to others that are not, I would ask, at least we turn up our volume on this a little bit. Because I think it may not be as important to someone of lower cost or diversification when you get a-- almost any portfolio gives you 10% return.

I think it matters much more to our friends and family if we're talking about expected returns of 4% or 5%. Because the margin for error is just lower. Much lower. So it doesn't mean we can't overcome it. It's the bond arithmetic that's really going to, I think, hurt equity markets not as shiny as it was, too.

But that just means I think we just have to grit our teeth a little bit and focus on those fundamentals. When you talk to some-- not on this podcast, Rick, but we talk to some, right? It doesn't sound as exciting, right? You go on the TV and you say, oh, you're just going to have to save a little bit more and stick to the fundamentals.

They look at you as like, really? There's not a secret panacea on this? When you don't like the forecast, you just go find a new economist. Yeah. Well, there's no silver bullet on that, right? There is no silver bullet. Do you have a recommended international stock allocation for your typical bogelhead investor?

I mean, I would personally start any investor at 40% non-US equity exposure. And this is something that we actually do in our advice units. It's also the default non-US equity exposure in our target date funds. That is consistent across Vanguard. And so that's where I would start. It's not a fully market cap.

The non-US market, it's a little bit higher percentage. But I think how I generally approach it is by following that 40%. You start there, and then if you have less comfort or more comfort, deviating from that. But I think if you can start there, that's an important-- and because that really reduces the volatility of the portfolio.

That's the so-called, quote, unquote, if there's a sweet spot, quote, unquote. You have the lowest standard deviation in returns when you have that mix. The returns differentials between the US and non-US will bounce around in a year. They have, and they will continue to. But the volatility of that portfolio is generally lowest when you're at that point.

An area that you're negative on is less quality or lower quality corporate bonds. I know that your research does influence some of the more active Vanguard funds. Are they going to be taking this and shifting? I know you can't say they will do it. But will they use this data to possibly shift out of an area where you're not really hot on, which is the amount of BBB-rated bonds that are in the corporate bond side?

Yeah, well, for those investors that have some of our actively managed bond funds-- and again, our bond funds, almost all of them are managed internally by our fixed income group. So I have the great pleasure of sitting on what we call the hub. But it's a senior investment committee for all the actively managed bond funds.

I don't chair that committee. That's the global head of fixed income, John Hollyer. And there are several of us on that committee. And we take these sort of discussions that you and I are having today, Rick, and we take that into consideration of building the most viable and what we think is appropriate bond strategy for the investor in that fund.

Now, again, those funds have hundreds of funds that's supported by a deep team of credit analysts and portfolio managers. Over time, they add a lot of value by picking the right bond over another bond, what we would call idiosyncratic risk or alpha. What we're primarily trying to do is just make sure that the portfolio is optimally structured so that if we like corporate bonds, generally speaking, because the economy doesn't look like it will fall in recession, we're trying to pair that with interest rate diversification should we get weakness.

And so we would generally be, say, long duration. You'd actually be overweight treasuries if you're overweight corporate bonds. And so, yes, this is reflected. But it's not just solely like, OK, we think growth is higher. We'll take more risk. We do this in terms of how we assess the distribution of, say, economic growth or inflation.

We always do it relative to what we assess the market is already anticipating. And that's what I think is often lost by, at least when you watch certain shows, you read certain press reports. Because I think there's this assumption that, I don't know, higher growth or higher inflation means a direct-- well, one should do directly something to the portfolio.

What I think is lost sometimes is that the financial markets may be already pricing in a weaker or stronger than that scenario. And a great example right now is the stock market, which by our calculus is already assuming GDP for 2020 will be 3%, let alone 2%. And so if one says, oh, we're bullish on the US economy, we're 2%, 2 and 1/2%, that may not mean that in some of these active strategies that we would modestly take more risk.

It's all relative to what the market is already pricing in. So hopefully that's helpful. It is. Thank you. One last question, because this seems to be an emerging issue when it has to do with climate change, ESG, this type of strategy. Are you seeing that having any effect on the markets' valuations, where people are putting their money?

I've seen clearly interest from advisors, from individual investors, some institutions in particular, just on environmentally sensitive investing, ESG-type strategies or SRI strategies, socially responsible investing. There's clearly more interest. Right now, I'd say more of the interest is on what is it, because there's different types of those approaches. You can either screen and not own certain securities versus maybe be more proactive and owns certain companies outright.

So we're seeing more interest in that. And we've obviously launched certain products that are consistent with those approaches. Time will tell how widespread they become in terms of investment dollars. So I have heard the interest. I think the academic research community is starting to focus on it more in the economic space.

So I'd say more to come on that. It's something I could see us doing a little bit more deeper research going forward. - Joe, it's been a real pleasure to have you on the "Bogleheads on Investing" podcast. I hope we could maybe make this an annual event. - That would be great, that would be great, if you'll have me, yeah.

- Oh, definitely. - Oh, and for everyone, happy new year and best of luck in 2020. - This concludes the 17th episode of "Bogleheads on Investing." I'm your host, Rick Ferry. Join us each month to hear a new special guest. In the meantime, visit bogleheads.org and the "Bogleheads" wiki.

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