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Why Vanguard Is Less Pessimistic About Valuations

Christine Benz

Benz: I'm wondering if you can talk about global market valuations, perhaps with an emphasis on the U.S., and then in turn talk about what they suggest in terms of future long-term performance from the U.S. and other major markets.

Aliaga-Diaz: That's a really good question. We tend to look at long-term return expectations, importantly to give investors a more or less good idea of what the portfolios can do for them in terms of future returns, in terms of recalibrating expectations. One thing that we factor in in forming those long-term return expectations is valuations, not just valuations, but also the level of risk-free rates. Regardless of where valuations are, the fact that risk-free rates, the Fed funds rate, and the short-term interest rates, are so low and expected to stay so low, relative to historical averages, that that alone would depress a little bit our return expectations across all asset classes. If you look at the famous long term dot of the Fed which is at 2.75 right now versus where the Fed used to take rates, more at 4, 4.5%. That 1 to 2 percentage point difference, that alone tells you how much lower the base risk-free rate over which returns are going to be built on. Also inflation, inflation being lower in the future than it has been in the past, that also shaves a little bit off nominal returns.

Now we come to valuations. Valuations build on top of those two pillars of risk-free rate and inflation, and yes, in terms of the equity market, valuations are certainly edging on the high side. We are not that pessimistic about valuations as others in that, in spite of ratios such as the price/earnings ratios or Shiller CAPE ratios being in 95th percentile historically.

Benz: Exactly.

Aliaga-Diaz: Because we think that with those low rates we were talking about, earning yields for equities are also expected to be lower, which means that equities are running at a premium. Basically price/earnings ratios are normally expected to be higher, when rates are so low. We tend to compare price/earnings ratios in the market against the level of interest rates, not against historical average. And that tells us that markets are not as overvalued as you would think by comparing to historical P/Es. But certainly, are edging on the high end. Our return expectations for equity markets in the 5% to 6%, for example, for 10-year framework versus 8%-9% historical when you had all those things in.

Benz: Do you see any divergence in foreign markets relative to the U.S. in terms of future performance based on starting valuations and the other considerations?

Aliaga-Diaz: Yes. I mean, we saw that over the last five years the U.S. had about 300 to 400 basis points of advantage relative to other developed markets. We actually, based on valuations today, we may see the reverse actually happening going forward. Maybe not that magnitude but certainly the sign may flip. And that’s because of two aspects. One is valuations of the U.S. relative to all other developed markets and the second is currency. For U.S.-based investor, in dollars, the U.S. dollar is basically expected to normalize from current levels over a five- to 10-year period.

Benz: So, decline a bit?

Aliaga-Diaz: Decline a little bit. So, I am not trying to predict the dollar and currency, which is so difficult, but certainly on a five- to 10-year basis the fundamentals of the dollar such as the current account deficit, trade deficit, and also the fact that the rest of the world is going to catch up to the U.S., the U.S. has been growing faster, now it's the rest of the world's turn to actually start lifting up, and central banks around the world to actually start following the Fed, that the fundamentals point to a little bit of weakening toward the dollar. Once we have both things, initial valuations that are higher for U.S. relative to rest of the world and a dollar that is expected to normalize and to weaken a little bit, then that explains little bit the expected advantage of the other markets. It's really about diversification, because doing sharp movements in the portfolio could be clearly harmful. But this is something important to take into account and why it's so important to actually invest internationally.

Benz: How much is continued strength in the U.S. market dependent on some sort of change in tax policy, in your view?

Aliaga-Diaz: That's a factor. As an economist it's a very interesting theoretical argument of why tax reform matters. One thing to keep in mind, though, is that if the tax reform was announced today with all the details and we knew exactly what would be the effect on the economy, the way the market will digest that is with a one-time increase in prices. It will be even more of a windfall for current equity investors, not something that necessarily will lead to a change in allocation over the next 10 years or something like that. Even with that it's difficult in terms of economics to watch the net impact of the tax reform. Again, as I said from theoretical perspective clearly you are reducing the marginal tax on labor, so you expect more workers, or people working more hours. You are reducing the marginal tax on saving and investing, so we will expect more investing. You are reducing the global taxation of capital, and so on. So, all directionally, clearly that's a good thing.

Now when we go to the empirical observation to the historical data and estimations on the facts the net impact is not that clear. It seems that workers are not that responsive to taxes to decide whether to work or not. Companies look at many other aspects, not just taxes when it comes to investing, particularly the cost of capital or external conditions or currencies if they are investing internationally. Those aspects tend to blur a little bit the picture in terms of the net impact. Particularly if it is debt finance tax reform. You could argue that as interest rates increase leading to a higher cost of debt will be a little bit on an offset there on the economic benefits of the tax rate. Overall, it is positive for the economy to have more efficiencies and a simpler tax system. But in terms of equity markets there may be other things that move markets much more in any given day than the one-time announcement of the tax system.

Benz: OK, Roger, we have covered a lot of ground. Thank you so much for being here to discuss these topics.

Aliaga-Díaz: No, thank you. It's great to be here.