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By Christine Benz | 09-27-2010 11:23 AM

Vanguard's Davis: One in Three Chance of Double Dip

Odds of a double dip are elevated given the current stage of the business cycle, says Vanguard's chief economist, but the indicators are holding. Plus, Davis addresses positioning your portfolio for eventual inflation.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. What can investors expect from the economy and what implications does that have for how they position their portfolios.

Here to discuss these questions is Joe Davis. He is chief economist for Vanguard.

Joe, thanks for being here.

Joe Davis: Thank you, Christine.

Benz: So, Joe, I want to get back to something you wrote in June of this year. You were talking about the prospects for a double-dip recession, putting it at around 20% probability. Where do you stand on that forecast right now?

Davis: Well, unfortunately, that probability has risen over the past several months. Where we get those probabilities? Right now, that's estimated to be about one in three. We have proprietary economic indicators, actually 70 of them that we distill in terms of the outlook. So, you can interpret that one or two ways. One in three odds is somewhat elevated given the stage of the business cycle.

Benz: Yes.

Davis: But that said, our indicators are holding. And so, this tells me is that although growth will be very low and tepid for the next six months, that unless we have some profound shock, like we did three years ago, that slowly the turning point will come, and it'll be more of a conversation back to where we were several months ago, which is how strong will the recovery be, now whether or not we will have a recovery at all.

Benz: So, a related question, a lot of investors have been grappling with: this deflation-inflation question. Where do you come down on that question?

Davis: Well, I think, Christine, this is actually one of those rare times in U.S. history, where we actually have credible concerns over both. It just really depends on the horizon. So, what we said to clients for several years is that in the near term, it's more deflationary in nature, just given the amount of slack we have in this system, low velocity of money and other metrics. And it's something that now very importantly the Federal Reserve is recognizing as well.

So, the deflationary risks in my mind will be with us for at least another year or two. To be honest, I think, the fixed-income markets and the stock markets are already reflecting that reality.

When we start to look three, four years out, that's when, in our minds, the asymmetry risk to inflation start to change from one of more towards deflationary risk, towards higher-than-expected inflation. That's not the most likely outcome. We still maintain a 3% inflation rate is a reasonable central tendency, but over the course of five or 10 years, inflation risks will switch to the upside.

And that has very important implications potentially for how we discuss portfolios and portfolio construction and investment strategy.

Benz: Well, that's what I want to talk about. If I'm an investor, grappling with this mixed scenario, how does that translate into how I should think about positioning my portfolio with respect to inflation?

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