Vanguard's Davis: Get Ready for Lower Returns

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What can investors expect from the global economy as well as major asset classes like stocks and bonds? Joining me to share his insights is Joe Davis. He is Vanguard's chief economist. Joe, thank you so much for being here.

Joe Davis: Thank you, Christine. My pleasure.

Benz: Vanguard publishes an annual global economic outlook as well as its thoughts on where the equity and bond markets will be headed or what reasonable assumptions investors might make about them. Let's start by talking about the strength of the global economy. Let's take it major region by region, starting with the U.S.

Davis: I think as we went to begin the year, Christine, our outlook really hasn't changed, and we're getting ready for the new annual outlook toward the end of the year. And the global economy, in our mind, still can be characterized by bifurcation. So, our theme was one of resiliency for the U.S. economy going into beginning of the year, and that was most likely the very largest region of the world that would continue to grow above its modest trend. And I think the data to date has been very consistent with that. Other parts of the world are still lagging behind United States.

Benz: Let's talk about them. Let's talk about developed foreign markets, perhaps starting with Europe and also talking about Japan.

Davis: Clearly, conditions [in Europe] have improved relative to two or three years ago, but I still think it's safe to characterize Europe as one of stabilization at the margin. They are going to be hard-pressed to grow perhaps at a faster pace than what Japan has grown at over the past two decades. So, again, the worst is over, but nevertheless Europe still remains far from the sort of growth that we've seen. They still are in the midst of bank deleveraging. So, until we see stabilization in bank credit, which is probably at least a year off, it's [hard to imagine growth being] very strong at all in Europe.

Benz: And you still have very high unemployment in certain European markets as well?

Davis: Yes. And for Japan, again, I think we're starting to see nascent signs of modest growth. And that's a new development, something we talked about at the beginning of the year and something where, because the Bank of Japan has been able to drive inflation expectations positive at a low 1% to 2% range, that's a marked change from where they were two decades ago. Whereas I think in Europe, we'd characterize a deflationary bias in all of Europe. In Japan, we're seeing more modest inflationary expectations. So, that's been a big change. Nevertheless, if you look at both Europe and Japan, they are unlikely to be drivers of global growth going forward.

Benz: And how about emerging markets?

Davis: There, it's a mixed bag as well. So, again, our theme was a lot of pressure on the United States, and they've been up to the task thus far. China, it's a permanent slowdown to 7%. Longer term, this is very good news for global investors because what we have not seen the global economy do over the past five years since the global financial crisis is rebalance. And so, we are starting to see, in China, very marked pressure on structural reforms. That's very good. Nevertheless, we will see a significant housing slowdown, which will put some pressure on some of the bank credit and the increase in leverage that we've seen in China. So, we're not bears of China's economy over the next several quarters and years; but nevertheless, [we're unlikely] to see the sort of growth from emerging markets that we've been accustomed to.

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Benz: How about the other major emerging markets like Latin America?

Davis: I think it's a mixed bag. Brazil has obviously had some difficulties of late. When you look at the so-called BRICs [Brazil, Russia, India, and China], as they used to be called: Russia is obviously in recession. India, a little bit better signs of stabilization. But I think when you look at the emerging markets broadly, I think they will still have to come to grips with a China that is growing at a markedly lower growth rate than they were a decade ago. And I don't know if their growth models, so to speak, have become fully accustomed to that sort of lower growth rate.

Benz: Let's talk about the sort of inflation that people in the U.S. might be expecting over the next year or two.

Davis: Our theme for five years, Christine, is one where there was deflationary bias in the world, not inflationary bias. I think that still remains the case globally. I think in the United States we're pretty fairly well balanced, reported inflation around 2%. I think if we're going to see signs of higher future inflation, [Vanguard] has long been of the school that we will first see it in asset-price inflation. I don't think we can talk about that. But nevertheless, I think it's still reasonable to expect a modest 2% or so inflation going forward for United States.

Benz: And how does that affect, in your view, interest rates and fiscal policy going forward?

Davis: I think the real key--and we've done recent research on this, Christine--I think the key issue is whether or not one believes that the U.S. economy is fundamentally going to grow at a slower pace or it's going to be going back to the old days, which is unlikely. I think in either case, one can paint a picture where long-term interest rates are hard-pressed to go above 3%--either because one believes in secular stagnation, which means there is less slack, which means the Fed may have to raise rates a little bit in the earlier half of 2015 but will be hard-pressed to raise the rates above 2.5% to 3%. Or one is of the view that, long term, the economy can grow 3% or 4%, which means slack is huge, which means [the Fed] won't raise rates until 2016 before becoming more normalized. I think in either case one is looking at a fixed-income outlook where we're hard-pressed to see a market rise in long-term interest rates in the United States for the next two or three years.

Benz: So, I'd like to talk about how this all translates into your outlook for the equity and bond markets. You've touched a little bit on bonds. But let's take equity markets first. I think, on the surface at least, there is a lot to like about what you've just said: decent growth, modest inflation, interest rates not going to jump up quickly anytime soon. So, your outlook for equity markets, though, is pretty muted and coming down.

Davis: We are projecting in the next five or 10 years, Christine, probably the lowest range of expected returns for equities we've seen in the United States since at least 2005. The biggest reason is, despite the stronger economic outlook, the valuation component, price/earnings, price/book, those sorts of measures are also run up quite a bit. So, a much more important economic growth, per se, is the price paid for growth. And because of that, our expectations for equities are probably, say, in the mid to high single digits, at best, for the next several years. I think expecting more than that would place it outside of the historical reference point.

Benz: Do you see any pockets of opportunity within a market that doesn't look that exciting overall?

Davis: I think so. Generally speaking, risk premiums are going to become more attractive if they are not generating strong cash flow, have weak trailing returns, and generally have risk aversion in the marketplace. So, the only area of the equity market that I think is characteristic of that--and was the case beginning of the year--are areas such as emerging markets where economic growth expectations have been lowered; cash flows have been generally negative. And yet, I think their prospects for future equity investors are a little bit more formative than I think the markets may give them credit for. Other areas of the U.S. market: At the beginning of the year, we were concerned in pockets such as small cap, value, and dividend-paying strategies--all I think have tended to underperform this year. And they may still have some headwinds given where valuations are.

Benz: Shifting gears to fixed income: It sounds like you are not expecting any sort of immediate jump-up in interest rates, which should translate into perhaps modest but not bad returns for bonds.

Davis: I think the greatest risk in the fixed-income marketplace, Christine, is not interest-rate risk; it's more credit risk. And so, we've clearly seen investors--perhaps understandably so, given the low-rate environment--seeking higher returns and searching for yield. I think in part because of that, we're seeing risk premiums in areas such as investment-grade credit, clearly high yield, and other the parts of the fixed-income universe, those risk premiums have really compressed. So, I don't worry necessarily about a marked rise in rates and what that does to U.S. Treasuries. I'm more concerned about the excessive risk-taking that one could argue has taken place in some fringes of the fixed-income market.

Benz: That's certainly where we've seen a lot of asset flows going. Let's talk about Vanguard's thesis that investors should have globally diversified fixed-income portfolios but hedge that currency exposure. Do you still think that that's the way to go?

Davis: I think that's clearly a great starting point and, personally, I think that should be a reference portfolio for all fixed-income investors. If they want to take on currency risk, it's not something we believe that currency risk should be a compensated risk premium over a long period of time. Whether one can navigate currency markets, I think, remains to be seen. Nevertheless, there is clearly yield-curve diversification from having exposure to non-U.S. fixed-income assets, despite the low yields. So, regardless of the level of rates, it's the fact that yield curves are not perfectly correlated, which we've seen between Europe and the U.S. over the past two years, which I think still have some compelling--although still modest--diversification benefits.

Benz: So, the key idea is that you expect interest rates to move in different cycles globally. So, you're better off diversifying.

Davis: Different business cycles. Clearly, interest rates globally are correlated, but they are around 60%. So, I would say, Christine, theoretically as well as practically, the case for international diversification in fixed income, if you hedge currency risk, is the same [as the case for] international diversification on the equity side.

Benz: Joe, thank you so much for being here to share your insights.

Davis: Thank you, Christine.

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