Qian Wang, Ph.D., is Vanguard’s Asia-Pacific chief economist and global head of the Vanguard Capital Markets Model team in the Investment Strategy Group. She is also a member of Vanguard’s Strategic Asset Allocation Committee and its Time-Varying Asset Allocation Subcommittee, which oversees and determines the asset allocation strategies of global multi-asset-class portfolios such as the Vanguard Target Retirement Funds. This podcast discusses the Vanguard economic and market outlook for 2024: A return to sound money.
Qian earned a Ph.D. in business administration from Stanford University, an M.A. in economics from Duke University, and a B.A. in international economics from Beijing University. Before joining Vanguard in 2014, Qian was director of research at a sovereign wealth fund based in Asia and the chief China economist and head of greater China macro research at J.P. Morgan.
This podcast is hosted by Rick Ferri, CFA, a long-time Boglehead and investment adviser. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.
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00:00:10 Rick Ferri
Welcome everyone to the 65th edition of Bogleheads® on Investing. This month, my special guest is Dr. Qian Wang. Dr. Wang is Vanguard’s Asia Pacific chief economist and global head of Vanguard’s Capital Markets Model. Today, we’ll be discussing current global economic conditions and Vanguard’s forecast for 2024 global financial market returns.
Hi everyone. My name is Rick Ferri, and I am the host of Bogleheads® on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, A nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net, where you will find a treasure trove of information including transcripts of these podcasts.
This month, my special guest is Dr. Qian Wang. Dr. Wang is Vanguard’s Asia Pacific chief economist and global head of Vanguard’s Capital Markets Model team. She’s also a member of Vanguard’s Strategic Asset Allocation Committee, which determines the asset allocation strategies of global multi-asset class portfolios such as Vanguard’s Target Date retirement funds. Dr. Wang earned her PhD in business administration from Stanford University, a Master of Arts in Economics from Duke University, and a Bachelor of Arts and International Economics from Beijing University. She has been at Vanguard since 2014.
Today, we’ll be discussing Vanguard’s economic and market outlook for 2024, a report that was recently published and is available to you online. So, with no further ado, let me introduce Dr. Qian Wang. Welcome to the podcast.
00:02:03 Dr. Qian Wang
Thank you, Rick, so much. First, I would say great job pronouncing my name, which is not easy. My name, Qian, has the same pronunciation in Chinese as money. So, Rick money is coming to your podcast today.
00:02:14 Rick Ferri
Well, there we go. We hope money comes to all of our listeners as well. Qian, you are on a very powerful team of Vanguard’s global economics and markets team. It consists of four PhD’s, and you are one, and Joe Davis is the global chief economist, and you are the Asia Pacific chief economist and the global head of Vanguard’s Capital Markets Model, which we’ll get into in a bit. But before we get into this report that you helped publish, I want to ask about your background. Tell us a little bit about yourself and how you ended up Vanguard.
00:02:56 Dr. Qian Wang
The true meaning of my name obviously is not money. It is actually a short name for my hometown. So, if you read Chinese, people can easily tell where I come from.
I remember back in the early 90s, China just started the market economy. Yet in college the teachers still taught us only Marxism, where only labor, not capital, creates value. And then I wondered, if capital doesn’t create value, then who is willing to make investments at all?
I remember in 1997, when I graduated from college, I traveled all the way to the US for my graduate study, first in the East Coast, Duke University, go Blue Devils, and then I came to the West Coast, Denver, for my PhD. So, after I graduated, I worked as a professor, an economist at a sovereign wealth fund, and then eventually when I came to Vanguard, I felt like I found the answer to a lot of my questions. So, great place to be.
00:03:56 Rick Ferri
Well, we’re certainly happy to have you, and every year we interview a different economist. We’ve had Joe Davis on a few years ago. Last year we had Ed Yardeni, and you are the noted economist this year. So again, thank you for joining us.
00:04:09 Dr. Qian Wang
00:04:10 Rick Ferri
I want to get into your report, which is the Vanguard Economic and Market Outlook for 2024. And the by line is “A Return to Sound Money.” So, before we get into the meat of the report, what do you mean by a return to sound money?
00:04:29 Dr. Qian Wang
By “sound money” we are talking about a persistent real interest rate. Basically, that means what we have seen. A nominal interest rate that is going to be higher than inflation. This actually in our view is the single best financial development over the past two decades. It really sets the foundation for solid risk-adjusted return for our long-term investors.
00:04:53 Rick Ferri
By that, do you mean just short-term like T-bills or you’re talking about 10-year Treasury? What do you mean by a real rate of return over the inflation rate?
00:05:04 Dr. Qian Wang
For all asset classes. We talk about a higher interest rate environment. Part of the reason is because we feel like the risk-free rate, which is determined by R-Star – the neutral rate, we can talk about that later – is higher. Now if you think about it, the risk-free rate is the foundation for all asset returns. You get the yield for long duration bonds; risk return plus term premium.
You get the yield for credit plus credit spread. Equity risk premium. You get the earnings yield. So, equity return. So, leaving the price change aside, then a higher risk-free rate means you get a higher expected rate for all asset classes. Isn’t that good?
00:05:47 Rick Ferri
I think it’s good to actually outperform the inflation rate because of course we haven’t factored in taxes yet. To outperform inflation is a good start.
00:05:56 Dr. Qian Wang
The central bank has been literally going to zero or in some places negative interest rates, and that raises a lot of concerns. Especially when investors also see a significant fiscal policy expansion. That raised a lot of concern about future inflation and also devaluation of fiat currency. I think that’s one of the reasons why cryptocurrency started to gain its popularity. So, now I think when central banks are exiting those ultra-accommodative monetary policies – that together with some kind of more prudent fiscal policy down the road – I think that will restore people’s confidence in the fiat currency. And to me that’s another way to interpret this “return to sound money”.
00:06:39 Rick Ferri
Well, it’s kind of interesting that you bring up cryptocurrencies in this. I never really thought about it. But you’re right.
The fear that monetary policy would cause a devaluation of the dollar, most people who are big followers of cryptocurrencies believe that this is needed in order to just have a stable currency. If the new policy long term is to have positive real rates, then that solves the problem. The budget deficit though. How does that work into all of that? How do you maintain real rates above inflation when we have such a large budget deficit, and it keeps growing?
00:07:16 Dr. Qian Wang
Yeah, totally. So, this is where when we say transition into a higher interest rate environment is the best financial development for the long-term. But I’m also saying that the transition could be very bumpy when everybody is adjusting to that higher interest rate environment where household saving will be more attractive. But for corporate, that also means when you make an investment, you’re going to be more prudent, and you need to allocate the resources to the most productive, profitable opportunities.
That also has very profound implications for government and fiscal policy. You could have a very vicious cycle between higher government budget deficits and also higher interest rates. That would raise a lot of concern about fiscal sustainability.
I think this is one of the questions a lot of people are asking at this moment. Now, one thing I would say is that Vanguard actually has quite some research there, trying to think about how much can the fiscal expansion go, down the road. One of the exercises we did is we tried to calculate the maximum sustainable debt burden for the US.
Because at this moment, the US federal government debt is about 100% of GDP. By the end of 2022. You could say wow, that’s high because people always have the 60% number in mind. That’s what the European Union said is the limit. But then you think about Japan. Japan has government debt at 260% of GDP, yet this government is still running.
00:08:51 Rick Ferri
But Japan has had negative interest rates forever.
00:08:55 Dr. Qian Wang
Exactly. So, the maximum sustainable debt burden is actually different across countries really depending on three things. One, the maximum primary balance the government is willing to or able to implement. Basically, the primary balance of payment. That means the difference between your revenue and spending, netting out the interest rate payment.
And then the second is interest rate. As you pointed out correctly. And the third is the country’s economic growth in the future. So, Japan, yes, that was sustainable because of low interest rates. But even for Japan, now we are talking about they’re going to lift up the interest rates down the road. So, this kind of higher interest rate, higher debt serving cost will bring fiscal sustainability into question.
We assume that if the US government is willing to run a primary budget surplus of 2%, and if we follow the CBO (Congress Budget Office) forecast of interest rate and economic growth down the road, then we estimate that maximum sustainable debt GDP ratio for the US is actually 225%.
00:10:06 Rick Ferri
Don’t give them any ideas, now. Come on.
00:10:08 Dr. Qian Wang
I know, I know.
00:10:09 Rick Ferri
I hope nobody in Washington, DC is listening to this.
00:10:12 Dr. Qian Wang
But the condition is that they need to run a fiscal surplus of 2%. Surplus. And guess what? We are going to do down the road? The CBO office is estimating projecting a deficit of greater than 3% of GDP in the coming decade. So, the government is going to significantly eat into this fiscal buffer over the coming years. And the fiscal space, the estimation, is based on some quite favorable projection of interest rates and economic growth.
What if we end up with another severe recession? Or what if the demographic trends worsen? Or what if the investors panic and interest rates rose more than expected? And then in that case the fiscal space will be much lower. So, to us, the rising debt has become an issue that must be tackled by this generation, not the next. So, that’s where we caution against the complacency.
00:11:10 Rick Ferri
And you mentioned a maximum taxation level and you had done this work on a report. And what did you come up with?
00:11:18 Dr. Qian Wang
Well, this is where we think the government, instead of running the 3% structural deficit, persistent, the fiscal deficit, they have to be more prudent with how much they spend and also what kind of tax revenue they collect. So, turning from over 3% deficit into a 2% surplus takes a lot of effort there. So, this is where we think either they may want to minimize unproductive spending, limiting contingent liability and make them more targeted, and also increase taxes where the revenues are low by international standards. That should be helpful. So, overall I think it’s very critical to maintain a prudent approach to the government finances down the road.
00:12:02 Rick Ferri
Well, we could get into this for hours, but we’re going to move on to the next level.
Now the Fed has two mandates. One is to limit inflation, and their target is 2%, and the other is to maintain low unemployment. In an era where there was a zero interest rate environment or negative real interest rate environment, it became really hard for the Fed to do anything to stimulate the economy. Do you feel as though this has been resolved because we have higher interest rates, that Fed policy may become more effective?
00:12:35 Dr. Qian Wang
So, thank you, Rick. I do think that the transition to a higher interest rate actually works well for central banks because in the case of economic downturn or a recession where you do have GDP contracting, labor market softening, unemployment rate rising, then the Fed has more room to cut interest rates to help the economy.
But I think at this time one thing we do want to highlight is that we are expecting an economic downturn or milder recession in the second half of 2024, and we do expect the Fed will cut interest rates – the Fed fund rate – probably starting in July. But one thing we do want to highlight is that we don’t think that will cut back to zero anytime soon this time. I think a very important part of that is indeed because the R-star neutral rate is higher.
00:13:24 Rick Ferri
Could you explain what R-star is?
00:13:27 Dr. Qian Wang
Yes, R-star is our equilibrium interest rate level that is consistent with stable growth, full employment, and 2% inflation. So that is the interest rate, theoretical interest rate level, that is neither stimulating nor restricting economic growth.
00:13:46 Rick Ferri
And what level is that do you believe?
00:13:48 Dr. Qian Wang
Yeah. One thing is that neutral rate is not observable. So, you can only infer that from how the economy is faring in the face of monetary policy tightening. So, one thing we would say is that, well, it was estimated that before the pandemic, after the GFC period it was estimated that the neutral rate is about 2.5% in nominal terms. 2% inflation plus 0.5% real rates.
00:14:19 Rick Ferri
And this is T-Bills, this is very short-term money.
00:14:22 Dr. Qian Wang
Yes, very short-term. The fact that after the pandemic in the last several years that the economy has fared so well in the face of aggressive monetary policy tightening, literally 500 basis point hike in less than two years, actually is telling us that the neutral rate, the equilibrium interest rate level, should be higher.
00:14:42 Rick Ferri
That it should be higher than 2.5% nominally, which if the Fed’s target is 2%, would mean 0.5%. So, you’re saying it actually should be higher than 0.5% real.
00:14:53 Dr. Qian Wang
Yes, I think. Then the next question is how much higher?
00:14:57 Rick Ferri
That would have been my next question, yes.
00:14:59 Dr. Qian Wang
So, this is where we actually have done our estimation model, econometrics model, to estimate what is exactly the level of the neutral rate at this moment. And our model shows us because of these demographic changes, because of this persistent structural fiscal deficit, and also because of higher productivity growth down the road, we do see that the neutral rate in the US nowadays is 100 basis points higher than what we have seen in the past.
We are actually expecting a 3.5% neutral rate in nominal terms at this moment.
00:15:37 Rick Ferri
So, a 3.5%, if the Fed gets inflation down to 2% and you could get 3.5% from a money market, and then you out about 10 years and you’re going to pick up 1% there as well. So, you’re at 4.5%. That’s going to compete against equities, will it not?
00:15:56 Dr. Qian Wang
Yeah, I mean totally. Rick, this is where we say at this moment one of the big messages from our paper is that the bond is back.
00:16:04 Rick Ferri
Bond is back.
00:16:06 Dr. Qian Wang
Yeah, bond is back. I think in the past decade when you have very low yields from the bond market, then essentially it’s a very tough time for our bond investors. Basically the only return you get is because of the price changes. For bonds, you have two components of return. One is the coupon income, and the other is price change. When your coupon income is very low or zero, then you actually suffer a lot from the volatility in price changes.
But down the road, what we have, the coupon income return is back. I think when you could have, let’s say 4.5% from this long duration bond return, the valuation is reasonable. That’s a decent return from your fixed income portfolio.
Now, on the other hand, you have equity valuation pretty stretched at this moment, especially in the US market. This is where we actually see the US equity market. The valuation is currently about 15% above our fair value estimate. So, given this very compressed equity risk premium, we would actually prefer to go into bonds, go into a fixed income portfolio, more in a balanced bond equity portfolio.
00:17:22 Rick Ferri
We’re going to get to the market model, but I wanted to continue to move on with the implications for a higher interest rate to consumers. If you go to buy a car, it’s going to cost more money. If you go to buy a house, mortgage rates are going to be high. And this is going to drain money from consumers. And so how does this new regime of higher real rates in the long term affect consumer spending?
00:17:53 Dr. Qian Wang
Higher rates obviously will make saving much more attractive for consumers, and I think they will also be more discrete in making borrowing decisions as housing and big-ticket items that are often financed with debt become more expensive.
So, I think this actually will bring consumers into a healthier situation, which is actually going to benefit the economy, make the economy more resilient in the longer term.
00:18:24 Rick Ferri
Because there would be propensity for people to save more and maybe spend a little less, your forecast for GDP growth or economic growth in the United States is still positive, but much lower than it’s been say even in the last 12 months.
00:18:43 Dr. Qian Wang
Yeah, Rick, this is where we differentiate our more long-term outlook with our more near-term outlook. When you think about why the economy has stayed so resilient in the face of over 500 basis points tightening by the Fed, consumption spending is one of the very important factors behind that.
Consumption has been holding up so well in 2023. There are several offsetting factors. Fiscal support – when you think about a lot of the fiscal support during the pandemic to the household and small businesses. Also, the fact that we cannot really spend that much during the pandemic and consumers end up with a lot of excess savings, and we haven’t seen that excess saving being exhausted at this moment. Well, we will soon, but not yet.
And then they also have very healthy balance sheets and leverage on the other side. Let’s compare now to 2008 during the GFC period. A lot of the consumer loans at this moment are fixed rate. Only 8% of consumer credit at this moment is based on variable rate compared to 40% in 2008. So, that actually shields them from the pain of paying of higher interest rates and also more excess saving on their balance sheet means that they don’t need to borrow that much at this moment.
Plus, the labor market is so tight, wage growth is pretty decent. So, all of those actually have supported consumer spending so far. Now in 2024 what we expect is that some of those offsetting factors will fade. So, we do have excess savings will largely be exhausted probably towards the middle of next year.
It has already exhausted for low-income cohorts of households. And then some of the fiscal support actually will fade. And then you also have the labor market that will start to cool. And also another reason, when you look at the business side, in the last several years we had a lot of industry that financed the industry policy from the government. Actually that supported a booming pace of investment in the infrastructural and also construction space. Those things are actually supporting the economic growth in the past 12 or 24 months.
But the pace could also slow down the road. This is why we are expecting the economic growth to slow, especially when monetary policy finally becomes more restrictive when inflation falls. So, in real terms, monetary policy will become more restrictive and start to bite. So, this is where we expect the economy to cool down, labor market to cool, and then the economy comes into a milder recession in the second-half.
00:21:31 Rick Ferri
I am 65 years old. I live in an over 55 community with a whole bunch of people around me who are in their late 50s, 60s, 70s.
People around here are spending money, but their homes have paid off. They’ve got money in the bank, they’ve got Social Security coming in. They’ve got 401(k)s that have a good amount of money in it. They’re spending money. So, these higher interest rates don’t affect certain demographics, and the boomers are a huge demographic.
I just see that this will continue for a while until my generation gets older and doesn’t go on as many vacations. How is that affecting the scenario that you just laid out?
00:22:13 Dr. Qian Wang
Rick, I think that’s one of the reasons we expected the recession to be a pretty mild one.
00:22:17 Rick Ferri
00:22:18 Dr. Qian Wang
The consumer fundamentals, actually the private sector fundamentals, are pretty resilient, pretty solid. I think this is where it’s very different from 2008 during the subprime crisis GFC when the consumer sector was so highly leveraged.
And then when you had the subprime crisis, this triggered a much deeper downturn led by the deleveraging of the private sector. Now I think when you look at what we have right now, especially in the consumer sector as we just mentioned, balance sheets look pretty solid.
And then the labor market. what we are expecting is that because of a structural labor shortage in this economy, even in a mild recession, we are not expecting the unemployment rate to shoot up significantly. In a typical recession the employment rate will shoot up to over 6%.
What do we expect? We’re expecting 4.8% – one percentage point higher than what we have today. This is higher than what the Fed is expecting, but still it’s not a big jump. I think overall those things coming together, that’s helped to explain why the economic downturn and economic recession will be rather mild. People will be more prudent when they spend, but they probably will continue to spend.
00:23:37 Rick Ferri
Well, let’s look outside the United States, the rest of the world. Are we leading the world, or are we in line with the world, or are we behind the rest of the world as far as the recovery from COVID?
00:23:50 Dr. Qian Wang
In the past several years, the US obviously has been leading the global economic recovery. I think that’s also one of the reasons why the US dollar has been so strong because the currency is like a horse race. It’s not just about how fast you run, but also how fast or slow the other horses run. This is what we call US exceptionalism. The US economy being strong and then that is where we are seeing the currency actually has been strong. But in 2024 what we are expecting is what we call the fading of the US exceptionalism.
In 2023, what do we have in terms of economic growth? It’s 2.5% to 3%, well above the trend growth that in our estimate is about 1.8%. So now you think about the US economy has been holding so well in 2023 to the very resilient private sector and also a lot of the offsetting factors. In fact, in our estimation, we think the US growth could have been 0% growth this year without those offsetting factors. But instead, this year what we see is about 2.5% to 3% growth.
But in 2024, what we expect is a slowdown in US economic growth. We are expecting only about 0.5% growth to 1% in 2024. And then the rest of the world, Europe will stay muted around 0.5% as well. And then emerging markets are actually going to hold up pretty well. In fact, I would say a mild recession from the US is probably the second best thing for emerging markets. A recession means the Fed will cut interest rates, and then a mild recession means the growth shock won’t be too big for emerging markets. So, with the US slowed down more evidently, this is what we call a fading of US exceptionalism. Probably the US is no longer leading the global recovery next year.
00:25:50 Rick Ferri
Interesting that you said when the Fed cuts, emerging markets benefit. Could you explain that a little bit more? How do the emerging markets benefit when our US fed cuts?
00:26:00 Dr. Qian Wang
When you think about the link between the emerging market economies and the US, the global financial condition actually will significantly influence the emerging markets. A lot of the emerging markets actually get U.S. dollar funding. They rely on the international capital flow.
So, when the US Fed starts to cut, the US dollar weakens, and risk appetite will start to turn more positive towards more risky assets, and that’s where money actually will flow back to emerging markets. This is where emerging market central banks also get more room to cut their own interest rate. So that’s where I would say they could actually benefit from a Fed cut.
00:26:46 Rick Ferri
You said that it’s been a muddled recovery in Europe for several years and it’s going to continue. What’s holding Europe back?
00:26:54 Dr. Qian Wang
There’s a lot of structural problems in Europe, but it is really about the monetary policy tightening. The monetary policy tightening is actually much more effective in Europe compared to the US because they don’t really have those offsetting factors. And also when you think about the monetary policy transmission channel in Europe, the European economy is much more reliant on bank credit. So, that is where banks can quickly adjust those interest rates. So that’s where higher interest rates actually bites into the European economy much faster than what we see in the US, and then that’s where we see the European economy is already flirting with a recession by the end of this year.
So, their economic growth was very muted in 2023, and also will continue to be muted in 2024. And plus they don’t have the fiscal policy buffer. This is very different from the US as well. Fiscal policy has been restrictive in 2023 and also in 2024 for Europe.
00:27:56 Rick Ferri
Well, let’s go to the other side of the world and speak to us about China. Our presidents just got together trying to bring in an era of better cooperation. It seems as though they need us, we need them. And so, let’s talk about our differences. That’s the way I see it. But you have much better insight. Could you tell us your views on what’s going on with China and the US and the relationship and also China’s economy?
00:28:26 Dr. Qian Wang
There’s a lot of uncertainty around the US/China relationship since the 2018 trade war. I think that’s also one of the reasons why domestic confidence, especially among businesspeople, is pretty low at this moment.
Now for the US/China relationship, I think one thing we have to understand, this is a structural issue that cannot be solved overnight or just by a meeting between the two presidents. I think there are two reasons for that. One is that between the two countries, there are so many discrepancies on many fundamental issues, right? Like the economic model, the role of the government, intellectual property protection, investment, and even many political or geopolitical issues.
And second, I think let’s say even China continues to make market reforms or even gets into political reform, I think the long-term competition between US and China is still unavoidable. From a historian’s perspective, there will always be competition and tension between a rising superpower and an existing superpower. That’s what people call the Thucydides Trap. I think the tension between the US and China, it will just continue in coming years and probably decade as well.
Now of course I would say the G7 realize that it may not be realistic or possible to entirely cut the economic ties with China, right? Given how much China is actually integrated in global trade, global economy, and increasingly nowadays in the global financial system.
So, I think that’s where they raise the concept. It’s not about decoupling from China. It’s de-risking. So that is the “3C” strategy. They’re going to collaborate in some areas, for example, climate change. They’re going to compete in certain areas like technology. And then they’re going to confront in some areas like human rights and geopolitical issues.
So, I think this will be the strategy down the road, and it’s not going to be surprising that this will have profound implications for the whole world. We are going to see a slower and also more fragmented globalization down the road. We don’t think it’s deglobalization, but the pace is going to be slower and more fragmented, and this actually will have negative implications on the resource allocation across the world. Think about capital, technology, and talent. So, I think this will be a hit on the productivity growth and economic growth everywhere for everybody.
00:31:09 Rick Ferri
Interesting. Can we talk about Japan? There seems to be a renaissance starting in Japan finally since basically the market collapsed and it was in 1990 and hasn’t been back since.
00:31:26 Dr. Qian Wang
Yeah. I think Japan has suffered three decades, right? It’s not just one lost decade. It’s lost three decades ever since the market collapsed. So, I think over the past 30 years the biggest problem for the Japan economy is actually lack of confidence. People don’t really see the future. Now, one of the things over the past three years, some people call it balance sheet recession. It’s basically deleveraging.
Both household and corporate, they are trying to clean up their balance sheets, reduce their leverage, their assets, and then because of this lack of confidence about the future outlook, then there is no incentive for people to spend, especially when there’s deflation and there’s no incentive for businesses to make investments. After all, demographics are one of the very important factors there. By the United Nation estimation, Japan’s population will be 40% lower by the end of the century.
If you don’t really see people, and we know that immigration policy in Japan has been more strict, then who are you going to invest for? You build up the factory, you produce those products. For whom?
A very important thing happened over the past 30 years. Two things. One, deleveraging for the private sector. That’s also why the Japanese government debt is so high. Because without private demand, it’s really the government public spending that’s holding up the economy. And second, the lack of confidence. So, coming to now, 30 years later, what do we have? One, the private sector balance sheet is pretty healthy at this moment. They have a lot of money to spend.
And second, the confidence has finally started to turn around because inflation is now up. People see inflation down the road. And there is a structural change in price setting and wage setting behavior. Wage growth is finally picking up because of the structural labor shortage. And then behind the scenes, the government has done a lot of reform trying to push for labor market reform, corporate governance reform.
So, I think at this moment, this kind of higher inflation after the pandemic was really just a trigger. When inflation is back, confidence is back, the private sector has money to spend. That’s where we think the Japanese economy will actually start to continue to grow down the road.
00:33:55 Rick Ferri
I just have one more country that I want to ask about because it’s been coming up so much in the news and it seems really interesting and that’s India. Can you tell us a little bit about the outlook for India?
00:34:07 Dr. Qian Wang
Yeah. From an economic perspective, we are indeed quite positive about India. This is a vast market with a very large population. It will resemble China a little bit, almost 30 or 40 years ago. And especially when the Modi government is actually starting to do a lot of structural reform, land reform, building up the infrastructure, financial reforms. So, this is where actually they are ready to leverage the significant potential of the economy.
In fact most recently you do see that India is benefiting from this global supply chain adjustment as well. They are actually getting more FDI – Foreign Direct Investment – building up factories. I think this is where India actually will benefit from this global supply chain adjustment and continue to unleash its growth potential down the road.
Now, I think the question for investors is again, the most important question, what is the price we are paying for that? Because sometimes what I see is that investors get too optimistic, and we know that structural reforms are not that easy. I think there’s a lot of encouraging progress in India, structural reforms, macro reforms. They do come up with a decent macro policy framework like monetary policy, fiscal discipline, a lot of them are very encouraging.
But structural reforms, especially when it involves vested interest groups, sometimes it takes much longer than people expected. So, I think that is where we would say yes on the economic front, we see a lot of potential. But on the equity side, I think on the investment side, I think investors should be careful about what price we are paying for that and what is priced in by the market.
00:35:59 Rick Ferri
Interesting. Let’s go ahead and get into the second part of this, which is valuation and actual investing. So, we’re going to take the economic side of everything that we talked about and we’re going to equate it back to expected returns from U.S. stocks, international, developed market stocks, emerging market stocks, bonds both in the US and internationally. And we’re just going to go through these asset classes. And again this is Vanguard’s view, based on your economic outlook.
And starting with the US stock market, I’m just using a very simple model of expected return, which would be three parts. Earnings growth, a dividend yield which would include some buybacks, and valuation change. So, using that as a backdrop for looking at the US stock market, you see lower returns going forward. And how would that break down among earnings growth, dividends, and change in valuation, which is price to earnings ratio.
00:37:03 Dr. Qian Wang
Yeah. When you look at the three components, I think what is driving lower returns in the US market, the one biggest thing I would say is indeed the valuation change. In fact, I would say what is really driving the outperformance of the US equity market in the past decade was really because of the significant valuation expansion. Now that I think it has something to do with the macro environment, a low interest rate, low growth environment.
And also the nature of the US equity market. As we know, the U.S. equity market was more tilting towards growth companies like IT technology companies where their cash flows usually happen much later in the future.
So in a low interest rate environment, the discount rate for future cash flow is pretty low. That gives you a higher price. And also in a low growth environment, growth is scarce, and then investors are willing to pay a higher price for growth. So, this actually explains the significant valuation expansion in the US market.
00:38:09 Rick Ferri
In particularly those mega cap eight stocks, whereas the rest of the market, the small cap, mid cap, really didn’t see that.
00:38:16 Dr. Qian Wang
No, I think it’s perfectly fine for investors to be forward-looking. You incorporate future news into today’s price, but sometimes investors just get too optimistic. And sometimes we get ahead of ourselves. So, I think at this moment what we see is that the US market is quite overvalued at this moment. We have a fair value estimation and we found that at this moment, the US equity market is about 15% above the fair value estimate.
We say, “trees do not grow to the sky.” It will have to eventually converge. Now, first it will converge to its fair value, and then even the fair value itself will start to decrease in a higher interest rate environment. So, this valuation normalization or contraction is one of the big reasons that we expect the expected return for the next decade will be much lower than what we have seen in the past decade.
You talk about the building blocks. Other than the valuation contraction, the other one obviously is also earnings growth. Earnings growth may be lower than what we have seen in the past. Now, I think a very important reason is because of the profit margin that will start to come down. Like the nearshoring, onshoring, when we focus the global supply chain adjustment focus more on resilience, security, in addition to efficiency, then that tells you there will be more cost involved. And then also the lower slower pace of globalization, more fragmented, also means that we may not be able to enjoy the low labor cost across the world in the best way. That also increases labor costs. And we know there is a structural labor shortage even domestically as well. So, this is where we actually see earnings growth will also be lower down the road.
00:40:11 Rick Ferri
And yet, when we look at the valuations of small cap stocks and mid cap stocks, the PEs – forward-looking PEs – are at the lowest they’ve been in decades. Do you see any improvement there?
00:40:25 Dr. Qian Wang
Yeah, I mean, Rick, I think that’s exactly what you said. Yes. Overall, it seems like the US equity market is overvalued, but not for everybody. If you think about the market performance this year, it was pretty much all because of the magnificent seven.
There could be opportunities actually. If you look into the market, what we see is that large cap and also growth companies are pretty overvalued. But on the other hand, we do see opportunities of value companies as well as small caps especially when we get into a higher interest rate environment and those companies will benefit more.
00:41:04 Rick Ferri
So, let’s go outside the US, we don’t have the high valuations, the PEs are almost half not. Not quite. But price to book, return on equity, everything showing foreign stocks look very much like mid-cap value companies. So, what is your outlook for expected returns from developed markets and then emerging markets?
00:41:26 Dr. Qian Wang
Right. So, when you look across the world, what we have seen is that non-US development market valuations are pretty reasonable. They didn’t really expand that much over the past decade. So, at this moment I would say they are actually reasonably valued and in some places even undervalued.
And then emerging markets are also undervalued in our view. So, this is where in terms of the outlook for the next 10 years, we actually expect international markets, that’s non-US markets, to outperform the US. Let me give you some numbers here. We actually expect about the annualized return in the coming decades of about 4.2% to 6.2% for the US market, but on the other hand, our expectation for non-US developed markets is about 7% to 9% per year over the next 10 years and 6.6% to 8.6% per year for emerging markets.
So, this is where we would encourage our investors to have a globally diversified portfolio.
00:42:27 Rick Ferri
And part of this is the currency change. You’re expecting the dollar to be softer, say, over the next several years, and this will boost up international stock returns because they trade in native currency. According to your report, about 1.1% or 1% as you’re expecting.
00:42:46 Dr. Qian Wang
Right. First, I would say the US dollar is also expensive. We also estimate that the US dollar is about 12% above our estimates of fair value. And the second thing is in the coming decade, we do think that there’s more headwinds to the US dollar than tailwinds because of the structural fiscal deficit and also because of the current account deficit as well. Those do not bode that well for U.S. dollar. So, we do expect the U.S. dollar to depreciate in the coming decade.
But Rick, one thing I would emphasize is that when we make those forecasts, it’s really for the long-term, right? So, the expected return, we are not saying that every year, you know, international markets will give 8% return. We’re saying that on an annualized basis this will be realized. It could be that in the near-term, especially if we get into a sharper economic downturn, investor risk appetite starts to decrease significantly and everybody flies to safe assets. But we are talking about when your investment horizon is actually much longer, then the fundamentals will reassert themselves and that is where we see the US dollar is heading towards depreciation.
And this is indeed one of the reasons we expect international equity to outperform in U.S. dollar terms.
00:44:08 Rick Ferri
So, before we get to your Vanguard Capital Markets Model where you provide guidance on percentages to each one of the asset classes, I just want to summarize what the report says and there are three parts. The first one is monetary policy will bear its teeth.
00:44:26 Dr. Qian Wang
Yep. I think this is where we all know that there is a long and variable lag of monetary policy transmission, and then we also had a lot of offsetting factors in 2023 that actually keep the economic growth pretty solid in 2023. However, in 2024, we expect those offsetting factors will fade and then monetary policy will become increasingly restrictive when inflation falls, so monetary policy will be more restrictive in real terms. And that actually will weigh on the economy, where we see the economy actually get into a mild recession in the second half of next year.
00:45:11 Rick Ferri
But we also see R-star, which is the neutral rate where it’s neither recessionary nor expansionary, that this number you believe is actually going to be moving higher and has moved higher and will stay higher. And you mentioned that you thought it would be about a real return of about 1.5% on short term money, which would be T-bills.
00:45:37 Dr. Qian Wang
Yes, this comes to monetary policy. What the Fed will do in response to that economic downturn. We think the Fed and global central banks will cut interest rates next year, but even if they cut, we don’t think we will get back to zero interest rate anytime soon. Zero rates are just yesterday’s news.
Beyond this business cycle, we believe we will settle into a higher interest rate environment. A very key important reason, as you just mentioned is because of the R-star, the equilibrium interest rate that is neither stimulating nor restricting economic growth is permanently higher. In the US., we estimate that neutral rate level is now 3.5%, 100 basis points higher than what we have seen in the past decade.
00:46:24 Rick Ferri
And so all this leads for investors to bonds are back. US stocks, not so much. But developed markets and particularly emerging markets look good.
00:46:35 Dr. Qian Wang
Yeah, I think it’s great news for our bond investors, not just that coupon income is back, but also at this more reasonable valuation and higher yield. The diversification benefit of bonds actually is coming back as well. With bonds actually bringing return, outlook being pretty attractive, and also because the equity market valuation is somewhat stretched especially in the US, we would actually number one, of course, continue to stay diversified, stay long-term. But on the other hand, I think they could actually come up with some more defensive portfolios. That is, we could overweight bonds and underweight equity a little bit. And then within the equity, we would also overweight international equity that includes emerging market as well as non-us developed market as well.
00:47:27 Rick Ferri
Well, let’s go ahead and get into that model. And the model is the Vanguard Capital Markets Model, which you chair the committee. This is your thing. And it’s in the report. So, you can look at it and has all the breakdown.
Not only just U.S. stocks, international stocks, but it gets into factors, you know, value versus growth. So, let’s go ahead and go through just the numbers really quickly. You compared it to a basic 60/40 portfolio, 60% stocks, 40% bonds where 36% of these stocks were US and 24% were international, which is the global split between US and international. And on the bonds you had 28% US and then international you had 12%. So that’s the benchmark that never changes, but your time varying asset allocation if you are going to be tactical – I know you maybe don’t like that word tactical, but I’m using it – if you were going to be tactical, it would look much different.
First of all, the stock and bond mix would be far less equity. I see here you have equities overall would be just over 40% and bonds or fixed income overall would be just shy of 60%. So, talk about that first and then we can get into the nitty gritty.
00:48:46 Dr. Qian Wang
I think the first thing Rick is that our time varying asset allocation model is different from a tactical asset allocation, because it’s long-term and also strategic in nature. So, when we say time varying, what do we mean? We mean we take the current market valuation into consideration because through our research we do find that starting valuation both for bond and equity is the most reliable predictor for the long-term expected return. Not for the short-term, for long-term.
So that is where we actually get more confident with this forecast when the time horizon gets longer and then we are still trying to maximize the risk-adjusted long-term return of the balanced portfolio. In this case we actually have a 10-year time horizon. I think this is a critical difference between us and a tactical asset allocation. We are not focusing on the performance in the short-term. And then I think coming to this how we allocate and make allocation, we look at the global 60/40. I think sometimes when people talk about global 60/40, is it really that exact number?
I doubt it. I think the 60/40 really symbolizes the concept of diversification. It’s a mix between bond and equity. When you have bond as a ballast to the portfolio when you are experiencing an equity downturn. So, I think it is really about that concept of diversification, but I think coming down the road, when we use the global 60/40 as a benchmark, so we say if we want to achieve the same expected return for global 60/40 in 10 years, and then we take the current valuation into consideration, what can we do?
And we found that if we go 59% fixed income and 41% equity, that’s still gives us the same expected return as global 60/40, but at a lower risk. So, essentially we end up with a higher risk-adjusted return.
00:50:44 Rick Ferri
- Very good. So, on the equity side, it’s interesting because rather than having total market equities, total US market being 60% and international being 40%, you are taking a heavier weighting towards value and a lesser weighting towards growth.
You are taking a larger weighting towards small cap. You are taking a quite an equal weighting between emerging markets and developed markets. These are some pretty radical shifts. I mean, you’re not ignoring US large cap growth, you’re not ignoring developed markets, but you’re really focusing on value, small cap, emerging markets, the ones where you see valuation.
00:51:31 Dr. Qian Wang
Yes, this is where we do see the value, the opportunity in the long term. A large part of that is because of the valuation that we just mentioned. We do see that relatively speaking, value, small cap, and also emerging markets and non-US developed markets are relatively more reasonably valued or even in some cases undervalued. So that is where we do see higher expected returns in the long term.
Now I think there are several things I do want to highlight. When we talk about valuation, valuation is the most reliable indicator for long-term expected return. But even so, I would say remember the keyword of long term. It doesn’t mean that immediately the valuation will converge, will contract, or increase. I would say valuation is never really a good timing tool for short-term developments. In fact, valuation can stay overvalued or undervalued for the very long term, especially if the macro environment, say interest rates, stay persistently lower for longer.
Or higher for longer, right? So, I think that’s one caveat. Don’t use that to predict value or small cap will immediately outperform next year or next month. So that’s one caveat.
00:52:50 Rick Ferri
I think that small cap value investors have learned that lesson over the last several years.
00:52:55 Dr. Qian Wang
Yeah. And the other thing I do want to say is that outperformance is not guaranteed. So, this comes back to our Vanguard Capital Markets Model. The VCM model operates in a probabilistic framework. When we predict about the future, it’s not just one scenario. We actually do 10,000 simulations. There could be 10,000 scenarios in the future and that gives you a probability distribution of the future. Everything is about probability.
So let me use the international versus US as an example. Back in 2015, we said, oh, there is a 65% chance for international markets to outperform in the next 10 years. And today the chance actually increased to 70%. So, you could always argue there is still a chance that the US continues to outperform over the next decade. But even if that happens, our analysis suggests that it will still be difficult for the US to outperform to the same degree as it did over the last decade because of the higher interest rate environment.
So, in the end this is where we still say we say we caution our US investor against a very strong home bias, or we caution against putting all your bets into one sector. Diversification is still the best preparation, and also stay long term for all kinds of possible outcomes in the future.
00:54:20 Rick Ferri
Let’s get to your fixed income asset allocation because here again, you’ve got almost 60% allocated to fixed income, of which a little bit more than half of that is allocated to the US fixed income markets. But a large majority of this, almost all of it is allocated to treasury bonds. And a very minor amount is allocated to the aggregate bond market, which would also have corporate bonds, mortgages, and so forth. So, you see a real undervaluation relative to credit risk and mortgage risk. You see intermediate term treasuries as the place to be.
00:55:00 Dr. Qian Wang
Yeah, that actually is based on our assessment of the valuation where we actually see the treasury is more fairly valued. On the other hand, I would say when you think about the credit spread, to us, at this moment is still somewhat pretty tight. The credit market may not have priced in a lot of the downside risk down the road, especially if we get into a recession and also in a higher interest rate environment than the profit margin of the company will also get squeezed. So, this is where we are a little bit cautious about the credit. We think on the Treasury side, that is where the valuation is pretty decent at this moment.
00:55:40 Rick Ferri
And you also think international bonds would deserve a higher allocation, being almost 50% of the fixed income is in international, whereas the 60/40 is far less than that. Now, is this hedged or non-hedged?
00:55:55 Dr. Qian Wang
Hedged. This is the difference between our equity investment and bond investment. Equity investment is unhedged. When you invest in the international market, that’s why we need to watch for the currency change. That will have an impact on the relative performance.
But on the other hand, the bond market, we do actually hatch the currency risk. To that extent, in the end, the US bond expected return and the return from the international bond market is actually very similar. We actually had the US bond return a nominal annualized 4.8% to 5.8% over the next decade and then it’s 4.7% to 5.7% from the international bond market. It’s not that different, but this is where I think we come to a very important concept about why we want to go international.
It’s more than just the return outlook. Both in the equity side and also the bond side. It’s because of the diversification benefit. We think about the rest of the world, they may not be perfectly aligned with the US market in terms of their business cycle, in terms of their policy cycle. So especially for emerging markets and even to a certain extent, China, the correlation there could be even lower.
Regardless of the outlook, bringing those into a diversified portfolio helps you to harvest those diversification benefits. Essentially that’s where you reach the same expected return, but with lower risk.
00:57:27 Rick Ferri
Well, that’s all the time we have. Thanks Qian, and it’s been a very interesting discussion. So, I want to thank you so much for being with us today.
00:57:34 Dr. Qian Wang
00:57:35 Rick Ferri
This concludes this episode of Bogleheads® on Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads® Wiki, Bogleheads® Twitter, listen live to Bogleheads® Live on Twitter Spaces, the Bogleheads® YouTube channel, Bogleheads® Facebook, Bogleheads® Reddit, join one of your local Bogleheads® chapters and get others to join. Thanks for listening.