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By Jeremy Glaser | 02-06-2018 01:00 PM

Vanguard: Market Just Blowing Off Steam

Vanguard's Joe Brennan says he still sees the economy as healthy and that investors should tune out short-term noise.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Joe Brennan, he's a principal and also the global head of equity indexing for Vanguard, to look at some of the market movements we've seen the last few days. 

Joe, thanks so much for joining me.

Joe Brennan: Thanks for having me, Jeremy.

Glaser: The first question is really around if this story that we've heard about potential for higher inflation and higher rates is really what's driving what's happening in the market or if there's other things going on.

Brennan: It's really hard to pinpoint a precise cause for the surge in volatility we've seen. Most likely what we're seeing is simply a blow off of steam in a market that has pretty stretched valuations and has experienced a period of low volatility for some time. There also may be some expectations being built in the market pointing to higher inflation concerns due to the positive economic news we've seen. This is all detailed in our year-end 2018 market economic outlook.

Glaser: Does anything that you've seen in the last few days really change your outlook, either for the economy or for corporate earnings or the way that you think about the world?

Brennan: Not really. We still think the economy is very healthy, and we see moderate growth for 2018. As we look forward, continued tightening in the labor market could lead to some upward pressure on inflation.

Glaser: When you look at your outlook for rates then, could that upward pressure on inflation lead to more than three increases this year or what's your take there?

Brennan: Predicting the precise path of rates is really hard. That being said, the Fed has been quite transparent about their intention to raise rates toward the 2% level by year end. If the market gets a whiff that the labor market may be tighter, and we could see increased inflationary expectations and pressures due to that, we could see the market adjust to a more aggressive Fed. We'd probably see some more volatility due to that.

Glaser: Higher rates would really have a big impact on the market there?

Brennan: It really depends on why rates are higher. If we saw higher rates due to higher inflation expectations and inflation premia being built into the market, that could cause some volatility, and perhaps both bond and equity markets would readjust to a new valuation regime. If we saw higher rates due to higher real interest rates, that would be coincident perhaps with stronger economic growth and earnings growth, which would actually bode well for stocks.

Glaser: Looking at valuations, where do you see them in the U.S. right now? Do you still see valuations as stretched even after the sell-off?

Brennan: We came into the year really noting how stretched equity valuations were, in that they were above what we consider fair value. Of course, going into the year through January, we saw equity continue to go up about 6%. We've erased those gains over the last few days and are about where we ended the year. So, right now, we would say valuations are still stretched in equities. Of course we have fairly low yields, so we caution investors over the return expectations for the next say five to 10 years, due to our starting point right now.

Glaser: Big picture then. What should be the big takeaway for investors after these couple of days?

Brennan: We always caution investors to not focus on the short-term noise in the markets, rather lean on the things you can control: keeping costs low, keeping diversification in your portfolio, having a long-term outlook, and rebalancing to your appropriate asset allocation. If the market volatility gives you an opportunity to rebalance, take that opportunity, but don't focus on the noise and the headlines.

Glaser: Joe, I really appreciate your take on the market today.

Brennan: Thank you very much.

Glaser: From Morningstar, I'm Jeremy Glaser. Thanks for joining us.

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