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

Christine Benz

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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Davis: Well, I mean, I think, one of the seminal discussions we will continue to have, all of us as an investment community over the next decade, is around inflation protection. So, I think, we have to be very clear with clients and articulate what do we mean by inflation hedging and the performance of various asset classes under a potentially higher inflationary world.

So for example, I think, there's some who view inflation hedge as some asset that moves month-to-month with inflation, that wouldn't necessarily be stocks, but yet in my mind and also for many investors what may matter over longer periods of time is an asset that can outgrow the rate of inflation and real rates of return, and that's obviously where clearly stocks have a more powerful outlook.

And it's going to be those sorts of conversations: TIPS and other asset classes that may move more one-to-one with inflation with actually trying to structure portfolio on a real return basis.

Benz: So, I would guess, though, you would say, don't wait until you see inflation to add inflation protection in your portfolio?

Davis: Again, even by looking where gold prices are, I think, even if assuming I'm right every year for the next 10 years, inflation never prints very highly. We'll still have a percentage of the population that will say you mark my words, inflation will be high, and so, so-called inflation risk premium will be high in the marketplace and that will continue to generate interest in conversations with clients. These are conversations we've really seen accelerate among the clients over the past several years.

Benz: So, you also wrote earlier this year that government debt levels are what you perceive to be the biggest macro risk. If I'm an investor thinking about that, how do I position my portfolio or how does that translate into portfolio construction?

Davis: Well, Christine, I think if you just look broadly; A, you want to be broadly diversified. So you want to own the world and for many investors that also means diversification across asset classes. So, for many investors, it's some combination of stocks and fixed income.

Now, in terms of how we address this situation, clearly, our fiscal situation on a long-term perspective is unsustainable, which means by that, to fix the situation over the next 20 years, we need to reduce government spending by about $10 trillion. Well, that's a lot of money. The good news is, over a dozen countries have actually gotten it right. So much so that economic growth after fiscal reform was stronger than before the reform began, but that will entitle some entitlement reform. That's the only way to really bend the curve in terms of debt to GDP.

So, how long we have one that matter? Probably about four or five years for a number of reasons, but again the good news there, too, is, if we don't handle this situation preemptively and by that I mean, we don't need to balance the budget in four or five years. We just need a credible plan to eventually do so over a 20-year horizon.

If we don't get it right preemptively, then the market will force our hand a little bit with higher interest rates in the future. And so that's the conversation we're already having with clients about the role of fixed income in a potentially rising rate environment.