Davis: Still Guarded on Stocks

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Joe Davis, Vanguard's global chief economist. We're going to look at some of the market turmoil and his take on it.

Joe, thanks so much for joining us.

Joe Davis: Thanks, Jeremy. Glad to be here.

Glaser: Let's start in China., which seems to be the proximate cause of what's really driving this market turmoil right now.

Do you think it's reasonable that a slowdown in China, or a perceived slowdown in China, is really going to have a major impact on the U.S. and European economies?

Davis: I think it has already had an impact. It's important for everyone to keep in mind that China has been slowing both deliberately, and perhaps more recently a little bit unexpectedly, for seven years. They've had an intentional slowdown that's been in the works.

But the indicators we look at have been pointing to growth at times of closer to 5%-6%, well below their 7% plan. I think it's reasonable to assign some of the headline and volatility to the weaker-than-expected numbers from China. But some of this should not be news to the market, quite frankly, because this has been a long-running slowdown in China for some time.

Glaser: If only a part of this can be attributed to China, what do you think are some of the other factors that are weighing right now?

Davis: There was a period of market complacency. Clearly, we've had this duality in the world between deflationary risk still pervasive (and, in our mind, it will continue to be so), and economic conditions are weak overseas, but the U.S. is fairly resilient. So you have this tension around the potential for Fed lift-off, then you weigh that with disappointing news outside of the U.S. on the economic front. I think it's natural we're seeing this bout of volatility on the backdrop of valuations, which in our mind, were stretched, particularly in the equity markets. We had a very guarded outlook for the financial markets going into the year. I would not have forecasted what happened last week and today, but it's also not surprising to see.

Glaser: You mentioned the Fed and the potential of a Fed rate hike. Do you think this kind of market volatility and worries about global growth, will that stop the Fed in September?

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Davis: I think those odds have increased materially. If you would have asked me a week or two ago, I think that the U.S. domestic conditions will clearly warrant a Fed gradually lifting off, … a still very, very tepid pace. We've been hard-pressed to see the Fed raising rates above 1% over the next two or three years, which is well below where I think the Fed is.

But the past week, the Fed will care about financial conditions, and you could make a strong argument that the U.S. dollar has effectively tightened policy for the Fed already. I think at the margin, risk may still be asymmetric, modestly to weaker than expected inflation, and inflation has been below the Fed's target for over three years, as you well know, Jeremy. So, I think this will lead them to pause, particularly since the U.S. is the only major developed market that is growing modestly above its low-return growth pace.

Glaser: If the Fed does wait, does that have any impact the real economy? Is it really going to make a big difference for growth?

Davis: I don't think so. It will be more of avoiding, at least in the market's perception, a policy mistake. I think 25, or even 50 basis points for that matter, is not going to materially impact most business consumers and lending decisions. But by stalling, should they pause, I think that would avoid the risk of the market at least perceiving the Fed being too aggressive. So in that sense, financial conditions would be somewhat more supportive.

But for the past two or three years, financial conditions have obviously deteriorated, but they are clearly coming from a very strong level, and it has been a really strong source of headwind for the U.S economy for the past two years.

Glaser: If you were concerned about stock valuations before the correction, post-correction do things look much more attractive, or is it just coming back to a fairly valued level?

Davis: When you look at it on a moving-average basis, which we tend to do, because we're going to have some of these periodic flare-ups, we're still guarded. We're not bearish by any means. We tend to look at a five- or 10-year period or more because any predictability of the near term is very low at best. But we still are somewhat guarded.

That said, I think some of the froth that we were seeing in parts of the equity market, it's harder to make that case today unless one is very bearish on global growth--and we're not. And if there's a history of markets perhaps overshooting, I think areas such as commodities and elsewhere …some of the froth in commodity prices are parallel to those we've seen in 2008-2009. Not all that is supply related.

So I think it's important not to get too bearish in the market environment, but we also will be cautious. Our guarded outlook that we had at the beginning of the year, this sort of environment that we're seeing may not be the end of it.

Glaser: How about in the fixed-income space? Any changes to your outlook there?

Davis: No. Ironically the few so-called risk premiums, at least historically, were at least close to averages with the shape of the yield curve. Yields are low but the yield curve was fairly steep on the Treasury side. That's obviously compressed a lot.

I think those that have more corporate-like exposure, clearly EM, they've been battered a little bit. Valuations in parts of the fixed-income market, at least relative to history, weren't as stretched as part of the U.S equity market at just the base rate, or the short rate, is so low, which really drives everything at an absolute level. I think you are going to have this high beta relationship, as we have had in the past, between equity market volatility and areas in the fixed-income market outside of U.S. Treasuries, and I don't see that changing in the near term.

Glaser: Joe, I certainly appreciate you taking the time to talk to us today.

Davis: Thank you, Jeremy. My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.