Bogleheads on Investing with Joe Davis – Episode 17

Rick Ferri: Welcome to Bogleheads on Investing, podcast number 17. My guest this month is Joe Davis, Vanguard’s global chief economist, and our topic is Vanguard’s Economic and Market Outlook for 2020: the New Age of Uncertainty.

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Rick Ferri: My name is Rick Ferri, and I’m the host of Bogleheads on Investing. This podcast, as with all podcasts, are brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation. In this podcast we have Dr. Joe Davis, Vanguard’s global chief economist and head of Vanguard’s investment strategy group, whose research team is responsible for helping to oversee the firm’s investment methodologies and asset allocation strategies for both institutional and individual investors. 

In addition Joe is a member of the senior portfolio management team for Vanguard’s fixed income group. Today we’re going to be discussing a new report, Vanguard Global and Economic Market Outlook for 2020: the New Age of Uncertainty. The report is available online at Vanguard.com. With no further ado let’s bring in Dr. Joe Davis. Welcome Dr.

Joe Davis: Ha, thanks Rick. You can call me Joe, and, right, thanks for having me.

Rick Ferri: Well thank you so much for being on our show today Joe. We’re really fans of your work and you’ve given some fantastic presentations to the Bogleheads over the years. What I wanted to do today was get your team’s outlook on 2020. But before we start there, now who is Joe Davis? Can you give us a little background and some tidbits of your life and your bio.

Joe Davis: Sure. Well yeah, I actually grew up ten minutes from the Vanguard building I work in, outside here, outside of Philadelphia. I was attracted to Vanguard because I was an early investor in the early ’90s, and that’s thanks to my dad. He had the wisdom to show me how to start investing. I came out of graduate school with a PhD in economics. I was actually thinking I would end up on Wall Street in New York, but again my dad said, “Why don’t you apply to Vanguard?” So I did, and my resume found its hands into a group they were just starting. A group that I now have the great pleasure leading. A thought leadership group, effectively a research group, and that was seventeen years ago, Rick, and so it’s amazing. I count myself very lucky and fortunate to work with such a great company; and our group has grown from in those early days in 2000 to 2003 from fewer than ten crew members, now we’re over 65 and growing. And we’re in multiple countries, including Europe and Asia, so it’s an exciting group to be a part of, and I’d count myself fortunate.

Rick Ferri: One of the Bogleheads did ask who is the audience for the work that you’re doing because you know, as Bogleheads we’re basically following buy and hold strategies. You could do a lot of work and you make a lot of predictions about GDP growth, earnings growth. You actually put out market forecasts. And so, you know, how does a typical individual investor take that? Is it supposed to be actionable? Or who’s it for, and how should it be taken?

Joe Davis: Yes. I see three primary users or use cases for our annual publication. First is just, I think from any, is just an orient, or it helped provide investors with what a reasonable expected return for the portfolios or investment that they are already in. Right, this is not, and has never been, and never will be, supposed to be used as market timing calls and short-term prognostications, which I quite frankly see from many in the industry. This is to help inform you know what is a reasonable expected return on a portfolio, to help one to choose one’s goals. And before I came to Vanguard we did not have forward-looking expectations and so that’s been a big step forward for many, including internally in Vanguard.

Secondly, this is an input into the active management process. So for those investors that are perhaps in our actively managed bond funds, whether they’re taxable or they’re municipal, our economic outlook is an important ingredient. Because in those funds we are taking modest active risk, meaning trying to outperform a benchmark in a very risk controlled way and to try to do that, one of the many levers that the portfolio management team will pull will be a risk assessment of what the markets are pricing in from an interest rate, or say an economic growth outlook. And then how do we view the risk skewed relative to that sort of view in the marketplace. Again, all in the interest, in the objective, to try to modestly and incrementally add value for the shareholder in the funds.

Many times we view that as just as much not taking the excessive risk as it would be for trying to take more risk.I have a great example as even right now where I can feel and can sense in the market is becoming increasingly overly optimistic on growth. We see pockets of the financial markets where I would view as frothy risk-taking. And so for a long-term investor that is in these funds we are managing based upon our outlook to not be as aggressive as other funds may be. Which we believe in the long run will reward our investors in those funds.

And then the third would be for those that would retain Vanguard from an advice perspective because again, for certain investors who may have either a fixed spending goal– it may be an institution that has to generate a certain spending flow from their portfolio, or others know their variations and expected returns in the marketplace, again not in the one-year but in the next five or ten years, can then have implications for the asset allocation strategies that they would pursue. For some that have a very very long horizon, I would tell those investors that they should ignore all outlooks, including our own, if they have a very long horizon because the buy and hold, stay the course is very much appropriate.

But for years when I came to Vanguard I think what a common refrain would be, hey does Vanguard have an opinion on X or Y, and I think many, many investors want to stay the course but sometimes they also struggle with the headlines. And so one of the other primary objectives of this piece is to say yes, these are the probabilities that may occur in the future, whether it’s economic risk or financial market volatility. That we have thought about it and it’s reflected in our thinking and in the advice that we give clients.

Rick Ferri: So basically three ideas. Number one, your individual investors already have their portfolios set and their asset allocation and so it’s just sort of long-term estimates of expected return from bonds and equities so that they can do some planning. And the number two, it’s for your active funds so that they can maybe do some tailoring and potentially pick up some excess return or some alpha. And last you’re saying there are large institutional investors who actually buy your research or pay you to give this assessment. And those are the three areas where you find people use your report.

Joe Davis: Yeah, and some will just use it as an input into assessing the risk because at the end of the day we, all of us as investors, are making decisions on their uncertainty and in terms of our asset allocation, right. Even if we haven’t changed our asset allocation is still a decision whether implicit or explicit. And so, you know, the value that we hope to bring is to convey the range of ultimate outcomes particularly with respect to returns, and respectfully I think we do it in a very rigorous way. I mean we take some of the best techniques in academia, but we do it in a way where we convey, I believe, the market outlook as it should be, which is a range of outcomes. We’re not offering short-term point forecasts, you know we’re not, Vanguard doesn’t have an S&P 500 forecast for 2020.

I actually kind of laugh at those sort of outlooks and so I think if we can convey the range of outcomes and the rationale for why it is today versus, perhaps where it would have been ten years ago. You know, I think that can be of value. I’ll give you an example where it helps some investors, Rick, like ten years ago. You know our first annual outlook publication came out in the 2009 period which you can recall it was not a fun time in the markets and we had a great deal of clients wondering should they even be in equities at all. And this publication helped some in the sense that we said, listen, the economic environment for the next several years is going to be where I have elevated unemployment; it’s going to be fairly tepid growth, yet the outlook for the financial markets as best we can assess over the next five or ten years, believe it or not are actually the odds are tilted towards higher than average expected returns.

And if anything, we turned it out to be a little too low in our projections, our range, they came a little bit higher than expected. But I think that was helpful because behaviorally and emotionally at that time it felt as if oh you know I would even have friends and colleagues and my family that said listen and I feel like I really should get out of the market. And so even having that conversation, the rationale for why the expected returns are even higher, you could show that for some that are really mathematically inclined, you can show them with statistical rigor why historically there’s a reason to believe this. I think that had a service to investors.

This publication is not, not in any way intended to pick market tops and bottoms. We are really trying to inform investors that this is the range of expected returns and you could see in your portfolio.

Rick FerrI:  Now I think that your estimate of a globally diversified sixty percent stock forty percent bond portfolio you have a range of four to six, so call it the midpoint about five, seems to me to be very realistic. You know a good planning point. We have to have something to plan with. We have to have some number to use and I think that your numbers are as good as anything anybody could come up with. But the way to get to them though, in reading through your report, you start out by looking at, it seems, the business cycle. Could you explain about the business cycle and where do you think we are?

Joe Davis: Well we’re in one of the later stages of the business cycle in the sense of, you know, how long did this global expansion, which is going on more than eleven years and we expect it to continue into 2020 and why that matters as to where you are in the cycle, it has implications for two things. One is, historically at least when you’re in the late stages of any expansion two things tend to emerge. One is you tend to have the financial markets not only performing very well, which is good, but you tend to have financial markets outperforming the fundamentals and so in that environment investors can feel very good. But precisely because of how we approach the forward-looking return, expected future returns become more modest and so it’s important to identify where you are in that cycle at a high level because that does inform how one should be thinking about everything from rebalancing to the return estimates that they assume.

We estimate that the global economy will more likely than not continue to expand but growth will not accelerate, at least to the extent that at least parts of the stock market increasingly already anticipate, and so it will be one of these, somewhat of a paradox in 2020, is that we could have economic growth, you know, not be negative the expansion continue, and yet you could have the financial markets underperform for a time. And just to be prepared for that.

You know we do not see strong evidence of financial market bubbles which occurred late in the business cycle, say in 1998-1999 you could recall the Nasdaq dot.com. We don’t see the imbalances in other parts of the economy much like we saw on housing, certainly in late 2006 and early 2007.

There are though imbalances I think in the high level of corporate debt, high level of sovereign debt in some countries and we’ve had an extended period of very loose monetary conditions generated by central banks. So you know that’s what keeps us up at night a little bit, but I think at the end of the day it’s not the worst outlook. It’s just one I think we’re just trying to set lower but I still think reasonable- and they’re not bearish. It’s not a bearish outlook on either the world economy or the financial market.

Rick Ferri: I find it interesting that a year ago, after the Fed had increased rates three times last year but then the forecast was for three more rate increases in 2019. But in fact what we had was three rate decreases rather rapidly and in addition around the world monetary policymakers just have been decreasing. Is that a warning sign? 

Joe Davis: I mean, yeah, I mean one of our outlook last year, the theme of it was down but not out. And there was a boxing, you know, analogy, meaning the global economy was going to weaken significantly based upon the leading indicators which we track very closely internally at Vanguard, again used in the portfolio management process. And they weakened in China in early 2018; they weakened in the US in 2018 and so that foretold some point in 2019, roughly around the summer, that we were going to have what we called growth scares. And we published that in early 2019 that we were like, more likely than not going to see a slowdown growth which many did not at least anticipate as severity.  Now in part because of that slowdown our probability of recession almost approached 50%, which unnerved us a little bit because obviously if you have a recession the equity market historically has been down at least 20%.

The irony of it is that I think the Federal Reserve and some other central banks were observing and have similar models, as we do reckon. So I think that ultimately they reacted much more aggressively and so cut rates, I think which stabilized the situation. Quite frankly they reacted more strongly than I would have anticipated. I could have perhaps seen one cut because it was really just in the bond market, particularly the shape of the yield curve that was giving the most ominous sign of potential recession. But other indicators in the bulk of the economy, outside of manufacturing, as well as the equity market, were not displaying the same signals, which is why our probabilities never got above 50%. So it did surprise me how aggressively they reacted.

But then that was one of the reasons why the second half of the year the financial markets performed as well as they did. Now not the only reason, but that certainly was a primary catalyst.

Rick Ferri: We went from an inverted yield curve to now it’s getting to look almost more like a normal yield curve as longer-term rates continue to creep up here and short term rates come down. So there’s no longer an inverted yield curve. Now some people will say well that’s good that means no recession is coming.

Joe Davis: You know our probability of recession uses all the signals in the marketplace but we combine them in a way that’s actually more accurate, in general, than just the bond market alone or the stock market alone. It’s actually the power of a diversified set of signals, the power of diversification to diversify the portfolio, we use a diversified portfolio of signals, over a hundred in all, that you can use to assess what the risks are in the economy and it has improved, although we’re not completely out of the woods yet. One of the reasons why, although we don’t see a recession in 2020, there’s going to be uneven growth next year. And so I think the bond market is starting to come to the realization of that. The equity market quite frankly has priced in a much better economic outcome than I even think is reasonable. And so that’s why I still think in the near term we have to be prepared for some volatility.

Rick Ferri: I’ve been reading a lot about manufacturing, declines in manufacturing activity. In fact the Kansas City Fed recently announced that their district has had, I think it’s several months in a row now, of manufacturing decline. And globally there appears to continue to be this manufacturing decline, and how is that impacting your GDP growth estimates?

Joe Davis: It’s been a primary factor. It’s been a factor of why we foresaw significant global slowdown this year, you know, relative to 2018, which occurred in almost every market, one of the reasons that fed into the central banks switching course in various markets around the world and one of the reasons why we’re less bullish, so to speak, than I think many increasingly are for 2020.

You know there’s three reasons why the manufacturing sector in particular has been underperforming or in many parts of the world, including the United States contracting, meaning in recession. You know one was set in motion two or three years ago and that was there was a high level of inventories in the manufacturing sector and so there’s generally been in the past ten years, and three years sort of expansionary sort of tailwind to manufacturing, and then it slows down for a time and you can see that clearly in our signals. And you know we’re not completely done that but we’re still working through it and that’s why we’ve seen weakness across the manufacturing front. 

Secondly, it’s been in motion for ten years and that is the structural slowdown. Intentionally in China as they continue to try to rebalance and escape what many call the middle income trap, meaning they’ll become more developed, become more consumer based, and they’ve been successful to date. But the past days of even 6% growth, I think, are over and to that that has particularly impacted parts of the manufacturing sector. 

But the third one, in the end clearly the most cyclical one, has been the trade tension between US and China. We model that as best we can and it’s the high level of uncertainty. In fact, that’s the title bar of our publication issue, The New Age of Uncertainty that, why we call it that is that we believe that this recent significant rise in uncertainty is unlikely to unravel quickly that has led to slower than expected business investment. And that primarily hits, or certainly hits the manufacturing sector.

Rick Ferri: So one of the byproducts of this slowdown in manufacturing and global manufacturing are corporate profits. Now S&P earnings have been increasing in part because of tax cuts, in part because of buybacks. So we have this divergence between S&P earnings that are increasing and national profits based on GDP national accounts that have actually been declining. And a Wall Street Journal article recently brought this to light, I think a couple of weeks ago. Can you comment on that?

Joe Davis: Profit margins are still fairly robust when you look at the aggregate data. I mean they have weakened in a growth rate perspective, but thought I would say there’s two things going on. One is just a high level of profitability. It’s particularly impressive in the United States. It’s one of the reasons why I think the US has been among the stronger, or at least the more stable economic performers and equity market performers over the past several years. It’s just a high level of profitability. 

Now that the rate of increase has clearly slowed, part of that is just due to the economic environment, the weakness particularly we’ve seen overseas. There was a point in time this year which we estimate China was growing well below 5% perhaps as low as 3% or 4% which wasn’t reported in the statistics. We saw significant weakness in other emerging markets and in Europe. Germany and others, which again part of them are exposed to weakness in China.

And so, you know, we’ve seen a deceleration in that and then of course the equity market has continued to perform well, I think in part because corporate profitability then goes significantly negative when recession odds were being discussed. But I think for just other, just sentiment, sentimental reasons and so you’ve had this valuation, the P/E ratios have just widened further because earnings haven’t been keeping up to the same level of appreciation as prices.

And then as you noted, Rick, others that are more of a longer term, four or five years, the M&A activity, the buy back activity, you know, more so than the rate of natural investment and companies’ own growth prospects, something I would call sometimes “financial engineering” has been significant pace, you know, and then another another reason which is not often discussed and it won’t change quarter to quarter, but another reason are contributed to the high level of corporate profitability it is a little modestly concentrated in a handful of firms and part of that is, I think, the nature of the digital economy, what I would call network effects, and so very large companies may be able to maintain high profit margins or high profit levels, you know, whether growth is accelerating or decelerating. There’s longer-term issues and behaviors I think that can help to explain the high level of corporate profitability. But then there’s also the business cycle effect which tends to get most of the press attention.

Rick Ferri: Let’s move into the labor markets because I have a real question about this. You know I’m a baby boomer and I’ll be 62 next year and I see all of my compadres from high school and college getting ready to leave the labor force, you know, over the next year or two or three and if we get a lot of people leaving the labor force because they’re retiring how is that going to affect things like inflation, demand so forth?

Joe Davis: Yeah, I mean it’s an important issue. It’s you know I would put the aging of the workforce alone is just the slower rate of population growth we have in the US and in other countries versus say 10 or 20 years ago that that slower demographic forces have already had, I think, a clear imprint on a number of things. One is just what are the expectations for growth. What’s the natural run rate, right, so call it the average speed limit for any economy. You know we used to talk in the United States that a reasonable growth rate, for say, real GDP was 3%. You know in the nineties…

Rick Ferri: Were the good old days.

Joe Davis: The good old days. Now of course that was propped up by leverage, which we ended up paying the price for in terms of the housing market and in the global financial crisis. But yeah, the natural run rate for the US economy right now is slightly below 2%. One of the reasons for that is the aging of the workforce and the retirement population growth is not negative but it has clearly slowed, and so the potential growth rate of the economy is lower.

Now that does have an implication for inflation. You would say then if you have slower potential, let’s call it one-and-a-half GDP growth, and we’ve been growing in the United States roughly 2% the past four or five years, right. You would then expect inflation to rear its head sooner because even though you’re growing slower than historical averages you’re going above the speed limit right. So inflation is like a speeding ticket right. You only get that speeding ticket if you’re going above the speed limit. So I will compliment our team. We put our finger on this four or five years ago. That there’s been other forces that have been more than offsetting the inflationary pressures that you would think from less slack in the economy, which is really one way of saying regardless of your growth rate if you have fewer available workers you’re eventually going to see wage pressures and everything, right? But one of those forces is digital technology which has been a suppressant keeping prices down. You know it’s everything from online sales to just cheaper cost of manufacturing certain products and services and we were one of the first firms to actually quantify what that drag is. So what this means, yeah, I think the demographic imprint going forward, it’s one of the reasons, not the only one.

One of the reasons why interest rates are lower today in the United States and in Europe and in other parts of the world is because of slower population growth, and again it’s tied to lower expected economic growth, which has led to their lower interest rates. There’s a point with which it will reverse, when the global economy that’s roughly five years from now and again this is very slow moving, it won’t happen, you know, in one month, in any one year, but with an aging population over time that’ll mean that there will actually be a little bit less demand for very safe assets. 

And so which has been a significant boost to the fixed income markets as well as the lower rate of inflation. We had a research report on what are the investment implications of an aging world and a world with slower demographic patterns, and what we did conclude was that it is modestly inflationary. But those sort of headwinds don’t really come into play until roughly ten years from now. Demographics is a, there’s competing forces, there’s some things that can be positive to the financial markets, bonds or stocks from demographics. There’s other things that can be potentially negative, but these are slow-moving effects and so it’s important to say, you know, over what horizon may they matter and also to appreciate the other forces because demographics are far from the only one affecting an economy and financial market at any period of time.

Rick Ferri: I’m going to lump these next three questions into one. It has to do with your forecast for Fed cuts, number one, and secondly do we get to a point where rates are so low that we’re pushing on a string, another old saying on Wall Street. Has the Fed’s hammer been taken away, because interest rates get so low, and then, finally, what are the prospects for the US to hit negative interest rates like we see in a lot of the other developed markets.

Joe Davis: Let me take the last one first Rick. Yeah I think the odds of us seeing negative interest rates in the United States are very low, and much lower than other countries. I wouldn’t assign a probability to any outcome zero, that would be foolish. But I think there’s a number of reasons why we won’t see negative in the United States. I think one of the reasons is the importance of short-term funding markets including money market funds, which is really a strength and diversified source of funding for corporations and lending for short-term collateral.

And so there’s both technical as well as fundamental reasons why I think the Federal Reserve will be reluctant to test negative interest rates. And I am NOT a fan of negative interest rates. I’m more in the minority in my profession. I can’t prove this, but I think history will show that the modest negative interest rates we see in both Japan and in Europe are a mistake. And then we have not seen significant lift from either of those economies with negative interest rates.

Now again I’m not expecting a move from zero interest rates at negative 0.25 percent is going to lead to fundamental growth right that would be an unfair criticism but I think the risk of negative interest rates play and why I think we won’t ultimately see them in the US is that there is a risk that when a country sets negative interest rates you can actually lead some investors to start to believe that we’ll have deflation, meaning falling prices, or to lower their inflation expectations which is precisely the opposite outcome of the rationale for taking interest rates below zero to begin with. 

Rick Ferri: Yeah, unintended consequence.

Joe Davis: Unintended consequence. So I don’t have proof in that but I think there is now some, at least some doubt in some central banker’s mind and so I don’t think we’ll see it. I think in the next recession what we will very likely see though is the Federal Reserve cut interest rates to zero much more quickly than they may have done in the past, in large part because they don’t have as much room to cut and then secondly, although again it may only be modest effects but I think we will see potentially expansion of the balance sheet. And then thirdly what will gain much more discussion will be the pairing of monetary policy with fiscal policy in terms of stimulus. This will ultimately become a politically charged issue and my job is to assess the economic ramifications of this.

I do believe central bankers, generally speaking, are already pushing on a string. I don’t think the Federal Reserve should be pushing on the string. You know, they are trying to, at the end of the day, maintain full employment and to get inflation actually higher than where it is. So the risk is in our outlook and one of the reasons why we think the next move by them will likely be a cut and not a hike, even though I personally wouldn’t do it if I was on the Fed, is likely because they want to make sure that investors still believe will be positive inflation in the future and they want to continue the expansion as long as possible. And again those points are part of their mandate in charge, but we can all, I think, disagree about whether or not they should be cutting or not.

We debated that internally here at Vanguard, when I’ve sat in the middle of debates and I’ve actually argued from both sides — what surprises you as an economist I can use both hands — but by the other day also my job is to assess certainly for the portfolio management teams not what they should do but what ultimately the Federal Reserve and others will do because that has the bearing on the financial markets. And so, you know, I think the bar is high for the Federal Reserve to cut the rates in 2020. But yeah I think they’re more likely to cut them than they are to raise them if our assessment of where the economy may unfold and inflation may unfold this year is right.

Rick Ferri: It seems as though everyone hangs on every word the Fed says.

Joe Davis: You know I think this, I think the central banks get too much attention in the financial markets because they don’t control long-term interest rates and the stock market as much as I think people think they do. It seems like that the day of an announcement, but they really don’t influence it as much as they think. But I think the risk is they focus so much on preserving the expansion for so long that they may under appreciate some of the financial froth that is building in the system and so that’s what I worry about and that’s what I think one of the unintended consequences could be.

Rick Ferri: Let’s talk a little more about inflation.

Joe Davis: If we define inflation by the prices we pay for all the goods or services we purchase as consumers, in fact you know, that one of the most perplexing questions in economics and hence in the financial markets, Rick, is actually why inflation has been stubbornly so low for so long. Almost any central bank without exception in the world aims to have inflation averaged roughly two percent, and then they try to calibrate their short-term interest rates, which they clearly control, to try to hit that target, right, knowing that it’s a moving target and they’re trying to hit it. For all the golfers out there they’re a hundred yards from the hole, that’s where the inflation is on the green knowing that they’ll never get a hole-in-one but for close enough.

Rick Ferri: Could you explain why central bankers want inflation?

Joe Davis: Yeah, it’s actually a really good question. Why any inflation at all? The reason why, generally speaking, most economists would argue that you want a stable inflation rate that’s modest but positive is for two things. One is the belief that if you have a stable and expected inflation rate that it makes it easier for planning purposes, and so you’re more likely to have modestly higher investment, hiring, and then consumption. And there’s some truth to that, right, because if you can have a better foresight on the increases in prices and so forth that reduces uncertainty. We all know the higher uncertainty the lower, say, investment they’re spending, all else equal.

But the big reason why is because in any economy you have debt holders, right, so if you’re a consumer– many of the listeners out there myself included–well my highest debt right now is on the mortgage payment, which has a fixed term and it’s in six dollar amount. Why central bank’s want a positive inflation rate is if you had a consistently negative inflation rate, say negative three, negative four percent and you have a fixed debt level, that makes them paying back that debt that much harder because your income is falling by three or four percent, right.

I think what economists do a poor job in saying is when they say it’s bad to have deflation, what they should say, and what I should say, is that it’s bad to have wage deflation. Because if we see sales at the store and the TV one’s buying is 20% off, and so that, that’s not necessarily alarming. It’s alarming when you have all prices going down including the prices for our labor, meaning our wages or our income and our salaries going down.

That’s what happened in the early 1930s, which led to massive defaults particularly among farmers and many companies. It froze consumer spending because I don’t think anyone’s going to maintain their same level of consumption if their own income is not only falling but expected to fall further. And we’ve seen glimpses of how pernicious this can be, on and off, in Japan for the past twenty years. Right, because the bond market today, even in Japan in surveys, very few Japanese consumers expect inflation to be positive in the next five or ten years. And their wages don’t go up by a significant amount.

And so that’s where at the end of day when you hear the Federal Reserve is targeting 2% and everyone talks about the consumer price index, where that 2% came from all the way back from Milton Friedman, who won the Nobel Prize, even before that, it’s really around this fear of avoiding wage deflation, particularly that we saw during the Great Depression.

Rick Ferri: I recall when we had a negative inflation rate, just a very minor negative inflation rate a few years ago after the financial crisis. It was a big question on the minds of Social Security recipients whether they were going to cut my Social Security benefits. Which I think would have created riots in Washington DC.

Joe Davis: Yeah, but imagine an environment — that’s a great point Rick — imagine that then not just for those that are Social Security beneficiaries, imagine if everyone had the concern that their paycheck was going to fall.

Yeah we actually had this in the United States on and off in almost every economic crisis in the 19th century. Many workers’ wages were set by the day and so you had a lot of recessions —  this is long before the Federal Reserve was created, this is the 19th century where you had financial panics and so forth — and you would have unemployment rates go up by 10 or 20 percent in this very short time. And you’d have very deep, even if they were short, you’d have very deep downturns, a very volatile period. One of the reasons for that is you would have wages that were falling significantly for periods of time in many cities in the United States on the eastern seaboard. And I know that because that’s what I did my dissertation on, and so that is ingrained in central bank theory, which I think is it could be hopefully we don’t experience too much, but actually could be the irony of negative interest rates going forward is at the margin if that pushes down inflation expectations. That’s the very outcome that they’re trying to so hard to avoid.

Rick Ferri: Let’s get back to the global economy and talking about how this glut of manufacturing capacity overseas is affecting growth probably worldwide and also here in the United States and what is going on in Germany, what is going on in Japan, what’s going on in China, what’s going on in the UK and and talk about Brexit in this whole global package that I’m asking you to talk about. 

Joe Davis: The broadest stroke is that the global economy is still expanding but growth is uneven and it’s fragile right now. You know one of the underappreciated reasons we believe and we talk about in the outlook is the high level of policy uncertainty. Now again for those of our listeners there’s always uncertainty in the world and in life, but there’s times when policy uncertainty — you just mentioned one with Brexit. It’s Brexit. it’s US-China trade tensions. It is other trade tensions with other countries, between two countries all across the world. And then there’s actually increased political disagreement between and among political parties in almost every country around the world.

There is strong statistical evidence, including what we have done, that when you have those high levels of uncertainty, you will tend to see a lower investment than you would otherwise. Which I think makes intuitive sense and that’s one of the things that I think we see going on, that we see, we saw a drastic increase in policy uncertainty not just in the United States but we clearly saw it in China.

And one of the reasons for this cyclical slowdown that we’re still working through this year, Rick, and so that’s still working through the system. And you know Germany has a very high exposure too, through manufacturing, particularly to the China consumer, and it was the slowdown in the deterioration in private sector confidence in China, sometimes, which is not widely reported, which led to a significant slowdown there. Which I think will also increase the odds more recently that we saw phase one trade deal because I think, you know, Chinese policymakers were battling on several fronts. And so they were increasingly concerned that they were going to have growth much weaker than expected. And so they were, I think, a little bit more willing to at least have a phase one deal than what it would have been otherwise the case a few months prior.

So I hang some of it, not all of it, on uncertainty because it’s by these measures that we track, which are based upon news reports and other statistical measures, to measure and quantify uncertainty which can seem ephemeral and tough to put your hands on. They’re the highest that they’ve been in over 30 years. It’s not surprising that it is at least stunting or hampering some investment. It isn’t hampering the US consumer because he or she is still chugging along fairly well but it has been a reason why we’ve been mixed signals on the global economic front. 

Rick Ferri: So let me just go over quickly your forecast for US equities, non-US equities, and fixed income so we all have a general framework to work from before I get to the questions from the Bogleheads. Your expectations, or your forecast is over the next ten years for US equities to give nominally, that means with inflation included, 3.5% to 5.5% annualized. Non-US, you’re a little bit more optimistic, 6.5% to 8.5%. And I want to get back to that in a minute. And then fixed income 2% to 3%. Which means that a balanced portfolio of stocks and bonds 60/40, somewhere between 4% and 6%, and call the midpoint about 5%.

But let’s get back to the non-US 6.5% to 8.5%. Is that because valuations are lower? Is this by the way dollar adjusted, meaning is this in US dollars, so the dollar is going to contract?

Joe Davis: Yes. It’s in US dollars. There is a currency effect but the primary reason why the expected range of returns are better than the US is it’s your point, Rick, it is valuation based which is again another great reason you don’t need this reason for a globally diversified portfolio but certainly the US markets have just outperformed every other part of the world. In fact the S&P 500 index has arguably outperformed any investment, public or private, in any part of the world. It’s been that strong, which has been great, but it’s also why the expected returns are among the lowest.

So I’d say three broad points on our outlook for the financial markets. One is the principles of asset allocation will stand even in the lower return environment because over the next five to ten years it is much more likely than not that a diversified stock portfolio will outperform bonds and a diversified bond portfolio will outperform a money market.  Which is good to hear. Rarely would you see those expectations not be that. It would have to be in a bubble-like environment where you could actually reasonably generate other expectations. But we don’t have them.

Secondly is, yes a globally diversified portfolio should outperform the US over the next five or ten years. Finance theory tells us almost by definition that a diversified portfolio is quote-unquote more optimal than a US-only portfolio because you use diversified company risk across multiple markets, right, and you at least double the number of securities. So the global portfolio is always the most efficient one on the frontier.

Over the next five or ten years, that’s where valuation comes in and that should be a little bit more of a tailwind for the European, you know, other developed markets and even parts of the emerging markets. Now again the US has outperformed the non-US over the past several years. It’s more likely than not where valuations are that that will happen.

And so we use valuations in how we model, that’s the sort of the simulation engines behind the scene that we then show those results in the paper. We are the first to acknowledge we project ranges of returns because our models are good but they’re far from infallible and you know they have a, you know, error in them. But I can tell you our framework — we’ve published it in the academic community — our framework is generally twice as more accurate for long range forecasting, twice more accurate than either the historical average, which is what I think that most investors have generally used if you don’t have any other methods, you just use historical average; it’s twice more accurate than that, and twice more accurate than some of the popular ones that Bob Shiller made famous at Yale; part of the reason why he won the Nobel Prize.

So we use those valuation approaches to inform the investors of what those expected returns are, so they’re lower than historical average. You know we compare those returns versus, say, the average returns since 1980. I don’t think we need any mathematical framework, Rick, to tell us that the future returns will be lower than they were since 1980 because since 1980 you know we’ve had, I think, the best financial market performance in the United States that has ever been seen, and could very well ever be seen at least for the next hundred years.

Rick Ferri: Certainly in our lifetime. I mean it’s been a great run.

Joe Davis: Sometimes I don’t wish I would be back in 1982, but it was a great time. It didn’t feel like it at the time but we had double-digit interest rates and we had P/E ratios of below 10. I mean I think the ten-year Treasury was even higher than the P/E ratio. And since that time we, what we all know, interest rates have come down, the economy has expanded and valuation multiples have actually increased, and so what a great starting point that has effectively run its course. Which has led to double-digit average returns for not just all equity portfolios but even 80/20 portfolios and at times 60/40 portfolios.

So that doesn’t mean the outlook is somber. It’s just more of like going forward it’s a little, it’s certainly below the recent, it’s clearly below the recent historical average and that’s almost regardless of whether we have stronger or weaker economic growth this year coming.

Rick Ferri: Now I always look at the DuPont formula, if you recall from, you know, your days of study. You had, I mean, what are the three levers of return on equity. It is your operating leverage; it’s your financial leverage; and it’s your taxes. What that basically means is operating leverage is how much you actually get as a rate of return on the product that you’re selling, but financial leverage is a lowering of interest rates. As interest rates come down you get a bump in return on equity because your financing costs are low. And then as your taxes come down you get a bump in return on equity because your taxes are lower.

Well we can’t get too much lower on interest rates; we can’t get too much lower on corporate tax rates. I mean the only thing we have left is the operating leverage which is productivity through technology, and as we talked about before, population growth and that’s at least the population growth side is beginning to decline. So I look forward and I say well, where can the earnings growth come from over the next ten or fifteen years. It’s not going to come from your interest, lowering of interest rates, it’s not going to come from lowering tax rates; and you know baby boomers are retiring and we have slower population growth. So where does it come from?

Joe Davis: The one area that it could come from is the area that’s actually arguably the most important for long-term growth and that’s innovation. Economists call it productivity, but think of the rate of innovation, how much more efficient new products, services, business lines, right. It’s new technologies like the internet coming, that’s what I call pure oxygen. I mean that’s why innovation can be beautiful in the sense that you get higher operating leverage, meaning ROI. Natural right, it’s generally non-inflationary so it’s market friendly. That can lead to higher real rates, inflation adjusted rates, so that’s good for bond investors, right, because generally adds to the risk-free rate for all asset expected returns and then clearly that can be positive for equities and companies. So that’s one of the reasons why we have low growth– is yes its demographics– but the bigger disappointment has been productivity growth and that’s worldwide. Which is why some have argued this notion of stagnation.

Ultimately innovation, I strongly believe, will return and we have a report coming out in the next few weeks talking about the future of innovation, and based upon a lot of deep research we’ve done that’s encouraging. It probably won’t show up in 2020 but longer term I’m less pessimistic when I look out 10 years, than some. Now you know, knowing that the world has challenges to be sure.

You know I think on our more muted return outlook so ironically it’s there’s two broad things for this because I talked to two financial market reporters and you know they’re thinking about it from the active management side, or you know, they’ll say then, “Okay, well what’s the best asset class to invest in if it’s lower returns?” And which is not really the, I think, the right way to think about it.

I think what this is all the more reason for this to stay the course and staying fully invested. Because if it’s a low return environment that means that we have to have our money at work in our portfolio every day of the week, right, because returns are lumpy. It’s tough to know when the stock market will go up any day, week, or month.

And then secondly, that’s where the planning and focusing on the costs and just the diversification. I call those free lunches of the portfolio. They’re going to be that much more important.

Now, I know that your listeners appreciate this, but I think we’re going to have to, I think to be a service to others that are not, I would ask at least we turn up our volume on this a little because I think it may not be as important to someone of lower cost or diversification when you get, almost any portfolio gives you ten percent return, I think it matters much more to our friends and family if we’re talking about expected return of four or five percent because the margin for error is just lower.

So doesn’t mean we can’t overcome it. It’s the bond arithmetic that’s really going to, I think hurt, you know. Equity market’s not as shiny as it was, too, but that just means I think we should have to grit our teeth a little bit and focus on those fundamentals. When you talk to some, not on this podcast, Rick, but we talked to some, that doesn’t sound exciting right you go on the TV and you say, oh I’m just going to have to say a little bit more and stick to the fundamentals they look at you, it’s like, really, there’s not a there’s not a secret panacea on this?

Rick Ferri: When you don’t like the forecast you just go find a new economist.

Joe Davis: Well, there’s no silver bullets.

Rick Ferri: Do you have a recommended international stock allocation for your typical Boglehead investor?

Joe Davis: I would personally start any investor at 40% non-US equity exposure and this is something that we actually do in our advice units. It’s also the default non-US equity exposure in our target date funds. That is consistent across Vanguard. And so that’s where I would start.

It’s not a fully market cap, you know, the non-US market is a little bit higher percentage. But I think how I generally approach it is by following that 40%. You start there, and then if you have less comfort or more comfort deviating from that. But I think if you can start there that’s an important, because that really reduces the volatility of the portfolio. That’s the so-called quote unquote if there’s a sweet spot quote-unquote you have the lowest standard deviation in returns when you have that mix, you know, the returns differentials between the US and non-US years will bounce in a  year, they have and they will continue to but the volatility of that portfolio is generally lowest when when you’re at that point.

Rick Ferri: That area that you’re negative on is less quality or lower quality corporate bonds. I know that your research does influence some of the more active Vanguard funds. Are they going to be taking this and shifting — I know you can’t say that they will do it — but will they use this data to possibly shift out of an area where you’re not really hot on, which is the amount of triple B rated bonds that are in the corporate bond side.

Joe Davis: Yeah well you know it’s for those investors that have some of our actively managed bond funds, and again, our bond funds almost all that are managed internally by our fixed income groups. So I have the great pleasure of sitting on what we call the hub, but it’s a senior investment committee for the actively managed bond funds. I don’t chair that committee, that’s the head of the Global Head of Fixed-Income, John Hollyer, and there’s several of us on that committee.

And you know we take these sort of discussions that you and I are having today, Rick, and we take that into consideration of building the most viable, and what we think is an appropriate bond strategy for the investor in that fund. Now again those funds have hundreds of bonds and supported by a deep team of credit analysts and portfolio managers. Over time they add a lot of value by picking the right bond over another bond, what you would call idiosyncratic risk or alpha, right.

What we’re primarily trying to do is just make sure that the portfolio is optimally structured so that if we like corporate bonds, generally speaking, because the economy doesn’t look like it’ll fall in recession, we’re trying to pair that with interest rate diversification should we get weakness, and so we would generally be say long-duration. You’d actually be overweight treasuries if you’re overweight corporate bonds and so, yes, this is reflected but it’s not just solely like okay we think growth is higher we’ll take more risk; we do this in terms of how we assess the distribution of, say, economic growth or inflation. We always do it relative to what we assess the market is already anticipating, and that’s what I think is often lost by, at least when you watch certain shows, you read certain press reports. Because I think there’s this assumption that, I don’t know, higher growth or higher inflation means a direct, well once you do directly something to the portfolio what I think is lost sometimes is that the financial markets may be already pricing in a weaker or stronger than that scenario. And a great example right now is the stock market, which by our calculus is already assuming GDP for 2020 will be 3%, let alone two, and so if one so we’re bullish on the US economy we’re two, two and a half percent, that may not mean that in some of these active strategies that we would modestly take more risk. It’s all relative to what the market is already pricing in, so hopefully that’s helpful.

Rick Ferri: It is, thank you. Now one last question, because this seems to be an emerging issue when it has to do with climate change, ESG, this type of a strategy, are you seeing that having any effect on the market’s valuations, where people are putting their money?

Joe Davis: I’ve seen clearly interest from advisors, from some individual investors, some institutions in particular just on environmentally sensitive investing. You know ESG type strategies, or SRI strategies, Socially Responsible Investing. There’s clearly more interest. Right now I’d say more the interest is on what is it, because there’s different types of those approaches, right, you can either screen and not own certain securities versus maybe be more proactive and own certain companies outright. So we’re seeing more interest in that and we’ve obviously launched certain products that are consistent with those approaches. Time will tell how widespread they become in terms of invested in dollars. So I have heard the interest. I think the academic research community is starting to focus on it more than the economic space. So I’d say more to come on that, it’s something I could see us doing a little bit more deeper research going forward.

Rick FerrI: Joe it’s been a real pleasure to have you on the Bogleheads on InvestingPodcast. I hope we could maybe make this an annual event if you’re willing.

Joe Davis: Yeah, that would be great if you’ll have me. And for everyone Happy New Year and best of luck in 2020.

Rick Ferri: This concludes the 17th episode of Bogleheads on Investing. I’m your host Rick Ferri. Join us each month to hear a new special guest. In the meantime visit Bogleheads.org and the Bogleheads wiki, participate in the forum, and help others find the forum. Thanks for listening.

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