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Vanguard's Davis: Equity Valuations Not Alarming Yet

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar. I am here at Morningstar's ETF Invest Conference, and I am joined by Joe Davis. He is chief economist at Vanguard.

Joe, thank you so much for being here.

Joe Davis: Thank you, Christine. Great to see you again.

Benz: Great to see you, too. You gave a terrific speech where you gave your outlook for growth in the economy as well as inflation. I'd like to start there: What is your forecast for economic growth?

Davis: I think in the near term, it's still one of caution. I mean, Christine, we've been one of having a longer-term cautiously optimistic view given some of the progress we've seen in the private sector. But if investors are looking out over the next six to 12 months, we're not seeing the sort of indications that we're going to see an acceleration outside of this 2% or so real GDP growth, a trend that we've been in.

We've seen improvement in investment, in some of the consumer-spending measures, and in the financial markets clearly. But it's the pall I think that overhangs sentiment which is still at a very low level given, I think, policy uncertainty quite frankly that is holding that back.

So I think a reasonable expectation is actually a little bit lower than where the Federal Reserve may be hoping at this present time. But if we could see greater clarity over the next month in terms of some of these initiatives, then I think that the Federal Reserve's outlook of a modest acceleration I think is actually appropriate. We're the closest we have been in six years to kind of getting out of this 2% to closer to 3% growth, but we're not there yet.

Benz: Obviously a big headwind or certainly a pall hanging over everything right now is the shutdown in Washington currently. How does that affect or not affect your outlook for growth?

Davis: It's a significant effect. In fact, we did a analysis and Bill McNabb, Vanguard's chairman, used a phrase at the beginning of the year, this "uncertainty tax," this concept that even the rise of policy uncertainty over and above normal conditions can act as a drag on business investment and, hence, economic activity. We saw this in the middle of 2011; we saw that in 2010 with Europe. We saw it last year, and I would anticipate that we will see it through the month of October. I would hope not, but I think it's likely that we will. So, I think there is the risk that the economic statistics disappoint for a little bit, before ultimately, what I would hope, we see the debt ceiling averted and we see a resolution take place.

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Benz: How about inflation? What's your forecast there?

Davis: It remains the same as it has been for three or four years, Christine. Yes, it pretty tight around 2%. I think one sense there were some that were concerned that, or viewed that, that inflation outlook several years ago quite frankly was complacent and that we're going to see runaway inflation.

We just still don’t see it yet. I think investors are going to look at one variable. They want to look at wage growth because that is by far more important in terms of assessing where inflation trends will go, rather than even break-even inflation or the unemployment rate. Right now, wage growth in U.S. is around 1.5%-2.0%, so it's tough to see core inflation from the Federal Reserve perspective breaking out in the near term.

Benz: How, in turn, does all of this translate into your outlook for interest rates?

Davis: Well, the bond market anticipates that the Federal Reserve is raising rates, not tapering before the end of this year, but raising rates sequentially in early 2015. I think at the margin, those are overly optimistic or overly aggressive assumptions. I think it's reasonable to expect that we will see tapering early in 2014, in part because of debt ceiling and some of those concerns.

Then also, I think the risk remains as it has been. The risk is that rates are on hold longer than expected. That's in part because the unemployment rate, I think, is lower and doesn't give a fair representation or accurate representation of the amount of slack in the labor market. I mean, 1 in 5 Americans that are employed are part-time. So, there is more slack than I think that stated unemployment rate of 7.3% perhaps lends itself to.

Benz: You didn't touch on this in your presentation, but I know you do forecasts there at Vanguard for asset class returns. First, let's start with what time period you are talking about, and then let's talk about your outlook for equities and bonds.

Davis: We generally look at a 10-year horizon. That's where we found it's a good mix in terms of where there is some predictability in equity market returns. It's a reasonable framework for also starting to think about strategic asset allocations. We look at fixed-income [assets]; they remain muted. We said at the beginning of the year there was elevated risk of loss, but yet they could provide a flight to quality in the event that equities really sold off. I think that's generally been the case throughout this year. So it's still one of muted return outlook.

For equities, those projections, Christine, have come down over the past two or three years. They're still in the high-single-digit range where that central tendency is in the 6%-9% range. But three years ago where valuations were, they were double-digit, where the skew was. So it's come down as valuations have deteriorated a little bit. It's not yet alarming to me. The odds are that investors over the next five or 10 years will be rewarded with a positive equity risk premium as they have the past five, but that size and that conviction has come down the margin, for no other reason, that stock prices over the past year, I think, have started to outpace earnings growth.

Benz: Is that a global forecast?

Davis: It's a global forecast. I think it's ironic. I think the one area where I believe that we're little bit more optimistic where investor trends are is actually in emerging markets. Three years ago we were among several firms, right, and Morningstar themselves, cautioning investors to not simply buy emerging markets [for the reason that] were expected to grow faster. [There was] a lot of analysis [why that was the case]. Ironically, as expectations for growth in China and other emerging markets come down, valuations have come down as well. And so at the margin we find ourselves cautioning investors not to completely abandon emerging markets since you have them as a diversified and return-producing role in a portfolio, but cash flows would tell you otherwise.

Benz: Yes, the optimism was running high and people were buying.

Davis: And they've significantly underperformed. I mean, it's been percentage points over the past three years. I think that's one area that we want to make sure they don't overreact too much to trailing returns.

Benz: In the presentation, you also touched on one potential pocket of froth or maybe even a bubble. Let's talk about what you think that might be.

Davis: I think those are investments that are solely oriented toward income-producing strategies. Again, we believe investors should take a total-return approach. But it's not just areas such as REITs, high-dividend-paying stocks, high-yield bonds, areas where I believe that, given [expectations that the low-interest-rate environment will] persist for some time, investors are gravitating to higher stated yields. I mean we're seeing everything to master limited partnerships and other areas of the financial-services sector, like bank loans. And we've done research on them. Again, I just hope investors do this with eyes wide open and know what they are getting into. They are generally taking much more just equity beta risk. And I think we saw that in May and June what could happen when we eventually do taper and start to even then raise short-term interest rates because on a relative basis, those income-oriented strategies I would expect can very well be the most significant underperformers.

Benz: Joe, always great to hear from you. Thank you for being here to share your insights.

Davis: Thank you, Christine. Thank you.

Benz: Thanks for watching. I'm Christine Benz for