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Bogleheads Speaker Series with Joe Davis and Maria Bruno

Post on: January 11, 2021 by Rick Ferri

The John C. Bogle Center for Financial Literacy is thrilled to present the third installment of the Bogleheads Speaker Series featuring Vanguard’s Joseph Davis and Maria Bruno.

Joe and Maria discuss the 2021 Vanguard Economic and Market Outlook and Vanguard’s views on global growth, inflation, the financial markets, and the implications for your portfolio.

Joe is the Global Chief Economist and Global Head of Vanguard Investment Strategy Group. Joe’s team develops asset allocation strategies and conducts research on the global economy, capital markets, and portfolio construction. Maria is the Head of U.S. Wealth Planning Research at Vanguard, leading a team responsible for research on a range of retirement, wealth planning, and portfolio construction topics.



Bogleheads® Speaker Series – Joseph Davis & Maria Bruno

Rick Ferri: Hello, my name is Rick Ferri and I’m the president of the John C. Bogle Center for Financial Literacy, a 501c3 non-profit organization that was created in 2012 by the founders of the Bogleheads organization with the assistance of Jack Bogle. The Center’s mission is to further financial education worldwide, promote those low fees and financial well-being, and to foster a sense of community amongst our all volunteer membership. And of course your tax deductible donation to the boglecenter.net is greatly appreciated. 

The idea for this online conference came about because of covid19. As many of you know we normally do an annual conference outside of Philadelphia but unfortunately we have not been able to do that in the last couple of years. For your planning purposes we plan to have a large conference in 2022. The location has yet to be identified but  please mark your calendars for the fall of 2022 for our first large and expanded Bogleheads conference.

In the meantime we have the Speakers Series and I wish to thank a lot of the bogleheads members who have helped put this together, particularly Mike Nolan of Vanguard who has tirelessly spent a lot of time with his committee  putting together this event. And we’ll also be working on the big event in 2022.

Today we’re happy to have our guests. Our former [podcast guest] Vanguard Joe Davis and Maria Bruno. Joe is the global chief economist and global head of Vanguard Investment Strategy Group and Maria is the head of the US Wealth Planning Research Group at Vanguard. Joe and Maria will discuss the 2021 Vanguard Economic and Market Outlook and Vanguard’s views on global growth, inflation, the financial markets, and the implications for your portfolio.

We wish to thank all of you who submitted questions for Joe and Maria. We hope you enjoy this presentation and tell others about it. Today’s event is being recorded. In a few days it will be available on boglecenter.net, and we will make a post on thebogoheads.org that it is available for viewing. Thanks again for joining us, and over to you Maria.

Maria Bruno: Thank you , Rick. It’s good to be here today. It’s unfortunate we weren’t able to be together in person in our fall conference, but it’s tremendous how we’re able to do this virtually. So kudos to the team for putting all this together. So Joe, we’re here together. As I was thinking, we’ve been working together on and off for about 15 years now, and this is the very first time the two of us have actually shared the stage together. It’s a virtual stage, but nevertheless the first time we’re together. So I’m looking forward to it. And no better audience to do this with than our bogleheads.

So with that in mind I think it’s only right for us to talk a little bit about Mr. Bogle. So you and I both had the opportunity to work with him and know Mr. Bogle. Tell us a little bit how he influenced you and your approach to investing.

Joe Davis: Sure, Maria. Again, thanks everyone in the bogleheads, making time. I hope this finds you healthy, you and your loved ones. And again Maria, I can’t believe it’s 15 years, never done this. Shame on us. For those in the audience, Maria and I go way back. I’ve known Maria since I’ve started here at Vanguard. 

And someone who touched me, ever since day one of Vanguard, was Jack Bogle. I do miss him considerably. I used to have the pleasure and the honor of having a lunch with Jack, probably about once every two or three months. We used to get together for lunch in the galley, which is our cafeteria–we called the Vanguard galley–and I always recall him having a little cup of soup, whether it’s minestrone or chicken noodle or whatever, and we would–there’s two things I would take back, well actually three–from those conversations.

One, Maria, one was that a tremendous leader, known in the industry, obviously leading Vanguard, yet he always found time to talk with individuals. He was in that sense selfless with his time. So that was wonderful attribute number one. 

Second, what I always enjoyed, talking about.Jack–was always impressed with his vast–he read widely, and so I was always a student of history,  but he certainly knew more history than I did. And so I think we hit it off in part because of that appreciation for history. Civil warfare to early business cycles in the United States. So he was widely read. And I think that was a tremendous asset for Jack because you would see that he would draw upon that in his speeches. He’s one of the few individuals- I’ve never met in the world who could talk about Shakespeare and financial theory within the same conversation. In fact he would make it actually very relevant. So he would expand those different disciplines. And something I always admire and I always tell my colleagues at Vanguard to aspire to.

And then the third. I watched from a distance when Jack was on stage, but you would see it in his readings, and so forth. But he did give me this coaching once, and that is he said, “You know when you do the strong research and you have a finding, particularly that’s in the aid and support of investors, do not be afraid to show conviction in that idea.” 

And so yeah, you would see that clearly from Jack. It led the industry for low-cost investing. In terms of our investment philosophy, he would not apologize, you know the song he would come across in the industry was strident, but I always–and that’s great that he demonstrated leadership. He would not bend in his conviction of his ideas, particularly when they were well grounded, as they always were and well researched.

So they were the three things Maria, I took back from Jack. I continued to  think about him on occasion and again when I passed through the statue–I’m on campus today–when I  passed through Jack’s statue those images come back to me with regularity. 

Maria Bruno: Yeah, your spot on. i think the one thing I would add too, is just really the focus on our clients, and we’re clients, right, we’re shareholders as well. And being a research team and doing the work that we do, unless we have key takeaways and how do you make it actionable, there’s very little relevance to what we do. So how do we take our learnings and how do we apply these to help investors improve their financial outcomes, improve their chance for investment success. So you know I continue to take that through the years.

Joe Davis: Right, I mean he’s been an inspiration for both of us. I love what you just said. I mean it’s like rigorous work, rigorous but relevant research, because it’s got to be practical, and if not–I mean it’s nice–but you know what, why should the shareholder help support the work that you and I do. That was always Jack’s north star, and something I’ve always aspired to be able to follow. But he set up a very strong path for all of us, and you know, you and I both, as part of the research at Vanguard, you know in many ways we’re trying to carry you his legacy in our small way. So he continues to serve as inspiration for us and for our crew.

Maria Bruno: Yes so I think that segues really well into how we’re going to spend the next hour. So Joe,  as we think about our economic outlook and what does Vanguard expect, and then do we take this and apply that into our own portfolios, and key messages for investors. So let’s start first with–so Vanguard published our 2021 economic outlook–and we think about the framework that we have for our near-term prospects, right. If we look at the recovery, highly contingent upon health outcomes and also consumer reluctance. So let’s talk a little bit about that in terms of where we’re heading as we’re starting the year, and as what we might expect throughout the year.

Joe Davis: Sure, Maria. So going back through, even replaying, these very challenging and traumatic events ever since the beginning of 2020.  I’m very proud of the team. We very quickly realized how significant–didn’t know exactly how the events of 2020 and even today would continue to unfold–we’re proud of the team really focusing on the framework that a healthy economy, or an impaired economy would begin. And then health, and so we very quickly, the first time in my career I had to very seriously think about health outcomes driving the economy around the world.

And so what we did is we applied the concerns around health, fear of catching the disease, the supply impacts, the inability to either go to school or to conduct business. And we applied a lot of data through that framework to say which sectors are going to be highly impaired because of social activity, so-called face-to-face activity, and that framework continues to serve us well.

I mean that told us that the global economy would suffer the deepest recession in world history. It would be short in the sense it would fall very profoundly. It would start to grow, and that the pace of recovery would largely be dictated by the path of the virus. And that has generally held out to be the case. It gave us, I think, a great deal of accuracy, or at least as best you can have given the uncertainties of the virus.

 So where do we stand today? It’s an environment where we look at the percentage of the world that has yet to achieve immunity to the virus, which is considerable, and that once you can have an estimate of the immunity gap, and how quickly that achieves herd immunity—so-called 70 or 80 percent of the world that becomes immune to the virus, the covid-19–that will then dictate the pace of the recovery, particularly with respect to social based activities. The thing about restaurants, hotels, travel which has suffered the vast majority of the slowdown, whether you’re looking at China, Europe, or the United States.

And so when we look at that, we look at our immunity gap as a factor of two variables. One is how effective is any vaccine. We all thought a vaccine would likely be developed that was certainly–as much as our hope– as our forecast. And secondly, what surprised us too, positively several months ago, was the efficacy of the vaccine. At least some of the two that are already approved for emergency use are well above the 60% threshold, which is deemed baseline. In fact it was well above even the childhood efficacy rate. So it’s roughly over 90%, somewhat higher. That plus the percentage of the population that actually takes the vaccine. You combine those two percentages and then you get a timeline of when we will quote-unquote get back to normal, or at least more normal activity. And so when we apply that framework it looks like certainly by the end of 2021 the largest economies in the world, the United States, China, Europe, will have achieved what’s so-called herd immunity, which means such a large percentage of the society has effectively  become immune that the spread of disease is much less rapid and it starts to dissipate.

And so that continues to be our framework. It means that growth for 2021, our theme was approaching the dawn. We’re not quite there yet, it’s going to be some unsettling next few weeks. We expected actually a retraction of activity. I think we saw for the jobs report the past Friday, we started to see lost jobs because some restaurants had to close. But as we proceed through 2021  we will see an acceleration of activity. Part of that is just recovering the losses from 2020,  but certainly 2021 should be a stronger year for the economy, and that was even before this additional fiscal stimulus  which will be enacted.

But it’s a positive economic outlook, but still we continue–just our hearts are out to those that continue to be affected by this virus both from the health side as well as for those that operate businesses which they’re still struggling right now because there’s still a decent amount of pain out there in certain sectors.

Maria Bruno: Okay, Joe. You mentioned acceleration. Let’s talk a little bit about trends. So you and your team have talked a lot throughout the pandemic about certain trends that we’ve seen accelerated. But then equally or important are trends that we’ve seen that haven’t been impacted, that we maybe would have expected from the pandemic. Can we talk a little bit about that in terms of what we might have seen, what we might expect to see.

Joe Davis: Sure. I mean I think we can bucket into three–we have three broad buckets in terms of how the world may have been affected, or we think will be affected, by covid-19. Again, I think it’s to underscore, I know covid-19 has impacted me profoundly on a personal level, and I would imagine others as well on the call today. I think our study of history, as well as our own personal experience, this has been a traumatic global experience that is shared by billions around the world.

So I think it is reasonable to expect some changes. I think one bucket of changes are trends that were already underway, that have been accelerated. So the move–and much of this has been discussed by others in the media and so forth, things that we’ve researched as well–the move to the increased digitization of the economy. Whether it’s media, financial services, others, that was already well underway. That’s only accelerated. We’ve seen this in the retail sector. Again, I think the future has been fast-forwarded to some extent. And so I think five years worth of phone call disruption.

Others call acceleration of certain business models that’s been compressed into roughly a year’s time, but that trend was underway already, and it’s something we’ve researched. I think you know we did a lot of work on the future of automation and what that may or may not mean to the labor market. The one thing at least I didn’t worry about in the past was the location of that work.

But look at that framework. I think another bucket, something that again I think you could argue was a trend that was going to occur anyway. But this has clearly been a step function, that is the move towards virtual work. As best as we can estimate, using all the data and our sense of the type of tasks that can be conducted remotely versus still the need for face-to-face interaction, Maria, we estimate roughly 15% of the occupations, or the jobs in the United States, for example, are just as effective on a permanent basis being conducted remotely, as they are in a, let me say an office.

But not all jobs are conducted in an office. Now that may not seem like a lot but that’s equivalent to the number of jobs in the 10 largest cities in the United States. So there’s going to be real estate implications for that. I think there are some things in some of the largest cities, although there’ll be some disruption there, without doubt, in commercial real estate.

And then I think there’s other trends that in one sense weren’t completely changed or unauthored by the current crisis. One that clearly has however, I think, is the likelihood that we’re going to see conditional stimulus. There is a reluctance in some economies to provide additional fiscal stimulus. Clearly we saw  central banks very aggressively taking interest rates to zero, even in some countries negative, to which they remain to this day.  I think that has been a pivot  from the past 20 or 30 years. I don’t think it will stop. That has some implications for the bond market, potentially for inflation which I think we could get to.

And then finally, some things that I think have been unaltered, believe it or not, with covid-19. I think some trends with respect to innovation and productivity, I think we were going to see this sort of innovation, whether we were working virtually or in person. And I think we could touch upon that with the vaccine, because I think that ties to the vaccine discovery.

And I think some tension’s quite critical between the United States and China. I think we were going to see continued tensions between two of the largest economies in the world with or without covid-19. So I have not seen anything that will decelerate some of those tensions and so I think that’s something that we’ll have to continue to monitor in the years ahead.

So I think there’s been, again, acceleration in some trends. Secondly pivots– fiscal is particularly a pivot–and then finally something I think would be unaltered, and that would be covid, the China tensions,  globalization is related to that as well. And then things around innovation. What we call the ideal model product.

Maria Bruno: Okay, good. All right I do want to move over to monetary and fiscal. Joe, I think that lends nicely into that, although we got right into it. And I forgot to do my job as a moderator to stress that we are taking questions. So we’ve got a few questions prior to the event. So we’ll weave those in, Joe.  But for those that are listening live, if you do have questions or want us to expand on anything just let us know, Michael is at the helm. They’re going through questions and he’ll be able to share any questions that we might be able to take live as well. So please don’t hesitate if you do.

So Joe, as we think about monetary and fiscal policies, we’ve seen a lot of stimulus activity. How much will it continue? What will be required to continue the road to recovery, in your thoughts.

Joe Davis: Well I mean, I think if policy by and large, Maria, will continue to remain very accommodative. I mean again, and to take a step back, and we have some of this in our annual outlook, as you mentioned, and referred to the combination of fiscal, monetary as well, but fiscal monetary  support that we saw in many economies, the US in particular in 2020, in part to address covid, was among the most significant we have seen probably since World War II. The Cares Act, which was well over two trillion dollars.

Pieces of legislation which we even—at Vanguard I spent a lot of time– even before some of those were enacted, just to give our thoughts from a macro perspective. In a bipartisan way that was a significant policy response and there are still areas that need to be addressed. I think the 900 billion dollars of additional  fiscal support, particularly for those that are unemployed, in part because the ability to work, particularly the restaurants and face-to-face intensive sectors, that will be helpful. They tend to skew lower income, which is really unfortunate.

I think going forward we will very likely see  increased tendency for fiscal spending and that may concern some given our debt levels. And we can talk more about that. Fiscal policy should be split into two components. One is really addressing  the near-term economic weakness and I think there’s still some impairment. If our forecast is right, the need for those measures will dissipate as we proceed through the course of this year.

I think monetary policy regardless will remain–interest rates, short-term interest by the Federal Reserve–will remain near zero for the foreseeable future. I think the early statement for raised rates is the year 2023, a little bit earlier than the bond market expects, but not materially different. Inflation is a wild card there.

And then the other component of fiscal which I would relate to longer term spending initiatives. Now many will focus on Social Security and medicare and medicaid. I think the one area that that regardless of your political leaning, I think you can make a very strong case for is infrastructure. There is the need for certain infrastructure spending, certainly in the United States particularly. If you travel by plane, train, or automobile you know the infrastructure needs. So I think we will see some of that in the coming year, and I think part of that could help. So I think we will see additional fiscal stimulus at some point.

I think the bond market will start to apply a little bit greater pressure, or a little bit higher interest rates. I think that process is just starting. And again, I am not saying we’re going to see a material rise in interest rates. But slightly higher than what they are currently today. I mean the 10-year treasury which is a benchmark interest rate in your trade, the yield in your treasury is roughly one percent. I mean it was two percent before covid-19.

 So I think we will march over the course of 2021, maybe not quite get there, but perhaps close to it. And I think, hopefully, it does so in an orderly way. If it was unorderly, I think the federal reserve would step into the markets and actually purchase some treasury bonds, because that would be counterintuitive, the market dislocations, it would be counterintuitive to be counter-productive to their objectives to stabilize the rise in interest rates. 

But as a bond investor, longer term, I’m hopeful for somewhat higher interest rates. I mean interest rates are negative after the rate of inflation. So I just hope that that rise is gradual and orderly, and not unorderly.

Maria Bruno: Yeah, Joe. and I do want to talk about that a little bit more as we get into the market outlook, because on the financial planning side, those are lots of the questions I get in terms of hey, what do we think we’re looking at in terms of  market returns, but also yields, and what does that mean for savers and spenders alike?

Yeah, okay. You had mentioned inflation earlier. Is that even a very real risk for us right now?  So if you think about who’s with us today, many bogleheads have seen different cycles of inflation under the Carter era where we’ve seen record high inflation rates in what you know in modern history, in modern times. But now we’re seeing very low inflation. And there’s other concerns that go along with that. How real is the risk of inflation, or what do we need to think about inflation, in the context of our portfolios.

Joe Davis: Yeah it’s a great question. Probably, as an investor, it’s one of the risks you always have on one’s radar screen. I mean anyone who particularly remembers, recalls the 1970s. Even for two or three years of rapid rise inflation can be, near-term, some pain on a balanced portfolio. So we all should take it seriously.

I would say three things with respect to inflation. One is just historical context. Inflation, believe it or not, is still fairly low. It doesn’t feel like that when I go to the grocery store. It feels like everything is up like 2 times, but in a broad basket of consumer prices, inflation is actually only roughly 1.5%. It’s below where most central banks want it to be. That’s one. So it has been generally the case for the past 20 years.

So that’s actually been a problem central banks have and that was actually our hypothesis, Maria, that central banks,  the economy, and the digital world would struggle to consistently generate 2% inflation. It’s one of the primary reasons why interest rates are as low as they are. Not the only one, but it’s one of the reasons it’s been somewhat lower than what is ideal, if you want to use those words. Secondly, the forecast is on a cyclical basis. It is very likely we will see a rise in inflation. Part of that is just the anticipated recovering the economy. That is a little bit healthy.

I mean we will see a recovery in the service sector if our forecast is right. And that means a little bit of firming, and you know things for air travel, hotels, and some social activity will return. There’ll be some long-term impairments in business travel and so forth. But domestic travel, if you look at China, is almost close back to pre-covid levels. Restaurants again, and so we will see that, and so we will see a firming in those areas and that will get us closer to the 2%.

And then third is the risk. For the first time since I’ve been at Vanguard, other than perhaps early 2000’s,  2006, we saw oil prices going to $100 a barrel, for the first time. Our team, Maria, sees a modest risk towards the upside in inflation. Not material, nowhere near the ‘70s. This notion that we will return to a high inflation world, I think underestimates some of the forces that have kept inflation at bay for a long period of time. Technology, globalization, and the Federal Reserve.  But that’s not to say that even with those forces you can’t have inflation a little bit higher than expected.

So I think fiscal policy is the wild card. This fiscal policy, increased fiscal spending, if it’s consistently aggressive over the coming three or four years. Does that start to raise everyone’s expected inflation rate? Maybe not 2%, maybe 2.5% or 3%. That’s the wild card. That’s what we have started to model. What we think about it would mean that interest rates would rise a little bit higher than we anticipate. But that’s the risk, but this is not a return–believe me it’s not–certainly in the next few years, a return to the 1970s.

And I am not complacent on it. I’m just telling you when you do all the math and you look at all that drives inflation–and that’s explaining, you know, understanding inflation is a very complex phenomenon–but when you apply all the variables that matter. You know we have an impaired labor market, we have also pent up demand, and we do all that calculus, it does say we’re going to have inflation start to rise. It should kind of crest roughly around 2%., maybe a little bit higher and then kind of settle in around 2%.

But if there’s a risk, it may go a little bit– at the end of this year–may recover a little bit more quickly  and that could take that, you know again we have the stable course in our investment portfolios. But that’s the one probable source of volatility this year. If the market’s temporarily down five or ten percent, I would say more likely than not it’s probably because we’re going to have a month or two where inflation perhaps comes a little bit higher than expected. We had that a few years ago. Eventually things will calm down, but  that’s probably the sort of–and we identify that in our risk report–sort of a source of attitude this year, that we should just be prepared for, and just try to look through it all.

Maria Bruno: Right, good. Okay another, and this is a common question, so 2020 was an election year. There’s lots of uncertainty that goes along with that. Now that as we move into 2021 and we have more–and it was just not the presidential election, but also with congress– as we have more clarity, as we’re heading into this year what do you think about the policy changes that might be proposed and then what we might need to keep an eye out on. Or your thoughts around any potential policy changes and implications throughout the year.

Joe Davis: Well again, I think  that actually is one of my biggest question marks as well, Maria, I mean right now the greater focus is on aiding the recovery. And the biggest thing is the quickest we can get to anything, any dollar spent for vaccine distribution, is you will make the recovery that much more quickly and have revenue stabilized.

That said, I think longer term we will see increased focus on tax rates to help fund some of the increased spending. Again, we had structural deficits under both political parties for the past five or ten years and so that was an issue. If you look at this the congressional budget office, which is a non-partisan agency, projecting higher debt levels for the next 30 or 40 years, it’s in large part because revenues fall short of expenditures by roughly three or four percent a year. And so that gap’s going to  have to close.

 I think we will see a number of things on the table with respect to the revenue side. I think particularly for higher income households it’s reasonable to expect that we will see modestly higher tax rates. But again, my personal view is there’s a whole cottage industry that tries to guess, and you feel more important. I do Maria–like how exactly should I trust, should I anticipate the tax rates–I would personally rather wait to see actually how they unfold rather than prognosticate on what form of tax rates we will see.

And then once I have that clarity, if that has some implications for my estate planning or my tax planning I do it with 100% more information, rather than trying to guess. I do know that regardless of that Vanguard will continue to underscore–and I think what will clearly endure–the importance of retirement savings, the importance of savings.

And I’d say the last point, which is not so much a tax policy perspective, it was everything you mentioned with respect to the headlines and the fact that all Vanguard investors, particularly those on the call, I think everyone’s long-term orientation to continue to remain invested, balanced, diversified, stay on the course.

You know, if there was ever going to be a year that was going to challenge that investment philosophy, 2020 and covid was going to be it. And if one had seen the headlines, I think many in March and April–I remember seeing the media, many were saying run for the hills. And look at the returns that we’ve seen this year. So again, I think it’s just a vindication. And I think everyone as a long-term investor should be pat on the back because the headlines were extremely troubling.

It was something I felt because the headlines impacted once not only professional life it all also impacted one’s personal life and family and friends. there was a lot of emotion to take into account, and I think everyone should really pat themselves on the back because that was not easy to do emotionally. Like kudos. And so again, it was just another underscore moment for the long-term orientation. And that’s always something I think that I know everyone on this call takes in mind.

But something I continue to remind family and friends even more so than the which are fair questions with respect to tax rates and so forth. Like first order principles, continuing to stay invested in the markets, I can be continuing to stay diversified. Okay, if that’s yes then I’m happy. Tax rates are going but let’s make sure that we take care of business first.

Maria Bruno: Yeah. No last year was hard, Joe. Yes, because I mean a lot of individuals are impacted by it not just personally but professionally as well. Unanticipated furloughs and things like that. And while some of the provisions in the Cares Act could help, I mean we have individuals who are really dealing with some significant financial challenges both near-term and long-term. So how do you actually unpack that and focus on the things that you need to know, as opposed to just reacting, and looking at this longer term.

In terms of the taxes you’re spot on. I’m starting to get more questions around that. Now in terms of, hey you know some of  the Biden proposal has some structural changes in it,  as well as with the estate taxation. But we don’t know exactly. It’s a proposal, we don’t know what or when or how. And if individuals are thinking through things, my suggestion there would be maybe hold off until we have some more clarity around this, or some certainty. But never really let the tax situation drive the fundamental decisions of investing. But they are certainly on our watch list this year. And as we get more clarity around that we’ll see more from Vanguard as well on that front too.

Joe Davis: Okay. That’s why it’s good to know Maria Bruno, at Vanguard not only because for my own, from my only questions I have, I mean Maria is my first call. Help me out here.

Maria Bruno: Well the thing is, if I don’t know the answer I know where to go, right. we’ve got strong teams with us, right. All right, So Joe, we think about the financial markets. So the market recovery that we had in 2020 was just as surprising as the decline was. Given where we were, where we are now, do you think the markets are fairly valued? What are your thoughts there? 

Joe Davis: Well everyone on the call, it’s Vanguard, you know I’m really proud of our framework. We  don’t talk about short-term market  ups and downs when we talk about our reasonable range of expected outcomes. For whether stock returns or bond returns we’re talking about a broad portfolio, say that total stock market, total bond market. And we look out for a long period of time, at least 10 years. And I’m proud of our forecast. I think it’s also reasonable to expect that those expected returns can vary through time. I mean we all know that as bond investments, right, the expected return on the bond portfolio today is naturally different from where it was in 1980. And so we just use that simple logic. But also recognize humility that this is the future we’re talking about ,so it’s all ranges of return. But it’s really grounded in  the latest academic research from finance, which we applied at Vanguard. So we’re both humble but also rigorous with respect to that.

That is context. I’d say our outlook, I’ve been fairly proud. I mean even though the course of 2020, Maria, we were actually–remember March and April, the free fall in the stock market–I remember one time, again we’re not market timers and we’re just saying, if anything, our market outlook had gotten more positive for the first time. It was a material upgrade in our long-term equity projections because we dropped below fair value as the market really sold off very aggressively.

And so we said we didn’t know the timing of it but again, closed one’s eyes, next five or ten years  expected returns on stocks are going to be higher than what we have incurred, the historical average. That came, so we certainly got the direction right, but the magnitude surprised me. I mean it was a very aggressive rise, most of which can be explained by the drop in interest rates, but not all of it.

 So how do you read that it means today, that we’re above these wide ranges of what we call fair value. Fair value for any asset is what is reasonably explained by say earnings for the stock, market earnings growth, the level of interest rates, because these are discounted cash flows in the futures for all, say publicly traded US companies. And so you generally have a wide fair value range, and most of the time the stock market is in that range.

Which means historical expected returns of eight or nine percent for planning purposes is reasonable, right. But every so often you deviate from those ranges. We deviated well above, we were way expensive in the late 1990s,which led to–you know, had we had our capital markets call, we would have had, look just expect lower expected returns in the next five or 10 years– not selling one’s investments, just for planning purposes expect low returns.

We sit here today. The outlook for the equity risk premium is still positive, somewhat lower than the historical average. The biggest reason why we expect lower returns, Maria, is not because the stock market itself. We still expect in the vast majority of cases, high probability, the next 10 years stocks will outperform fixed income. It’s just that the fixed income and money market returns are materially lower, and that’s because the level of interest rates, and particularly the Federal Reserve, right.

So that is the prime–so all the expected returns for all assets in one’s portfolio are modestly lower. It’s not because we’re bearish on the financial markets. It’s because of just the level of interest rates in money market funds. It’s not because of money markets because the Federal Reserve and the fed funds rate has implications for the bond premium. So  why should I have expected returns higher for a bond fund than a money market, or for a stock fund equity risk premium over bonds and money market. That the compression is more for everyone.

So that’s the primary implication. So we generally have shaved two or three, the model shape, two or three percentage points off the expected returns for all those portfolios on a five or ten year basis. But it’s not because the markets are grossly overvalued. They’re at the high end of the range. I have some concerns about some of the aggressive behavior, not by Vanguard investors, but the industry at large. The IPOs, some mega cap growth companies, really concentrated return.

So I think there’s definitely froth in parts of the market. Things even quite frankly like bitcoin. I see there’s a lot of, there’s some froth, one could argue, but it doesn’t mean the market is unsustainably high. It just means that we may see a little bit of a correction.

The one thing I think that is missed by many in the market is that even if we have modestly expected returns, say for US stock, let’s say in the four or five percent range over the next 10 years. That’s certainly lower than the historical average of nine or ten. Today roughly five percent if you own a raw basket securities. That certainly could outperform a very concentrated one.

You know growth stocks have outperformed value companies by the largest in US history ever recorded. And so if one is taking a broadly diversified approach, I think that may mitigate some of the risks of–some investors I think have become very concentrated. It has served them well in the past several years. My past is not necessarily prologue and so some investors could see actually lower expected returns than our central tendency because of those concentrated positions.

So that’s a broad brush, it’s not bearish, lower expected returns, but that’s in part because of what is going on in interest rates, in general, which I think is a natural expectation.

Maria Bruno: Okay, Joe. Actually I’m looking over here at my monitor because we’re actually getting some questions in as we go deeper into the financial markets. I think we’ve got a question that is interesting. And maybe just to briefly set the context, the underlying philosophy of a true boglehead is really to tune out the noise, particularly with the near term. Why are these projections, when we think about either the near term or the 10-year, important? And how do, when you think about it in longer term planning, the relevance of a say a one year or a 10 year outlook versus a longer term?

Joe Davis: Yeah. And one of the reasons that I appreciate the question, and Maria, you know that’s one of the reasons why even our outlook, we focus on 10-year numbers. I mean most of the industry including many of our competitors, in fact we’re not even in some media surveys because they’re one-year outlooks. We refused to participate in them. That means we’re not on TV as much. But so be it. Ten years is, I think, a relevant horizon. It’s a very long horizon but it’s a relevant horizon for planning. Now for some, if I’m 22 years old and saving for retirement it’s well beyond the planning cycle, I think the outlook is less relevant. But for many, they may have a 10 or 15 year planning horizon. And the cornerstone of asset allocation, which is the cornerstone of Vanguard’s investment philosophy, stay diversified, balanced. But one of the things that devising a portfolio, an asset allocation between stocks and bonds, that is predicated–and the foundation of that is based upon the expected returns. That’s the foundation of Vanguard’s philosophy.

So you have to have a reasonable expected return, and so if we don’t have this sort of outlook what  does one assume for a bond profiler. By previous comments, right Maria, should I assume historically? It would actually be fiduciary–it would not be responsible to say you’re going to get historical, like 6% or 7% returns, in fixed income if I’m saving for the next 10 years. That means that I’m not going to be successful. The odds of me, that would mean the probability of me being successful, whatever invested saving and spending strategy I have as a retiree, as a saver, is going to be miscalibrated.

And so we have a responsibility to say what are reasonable ranges of expected returns that one can then plug into the investment problem or the investment goal one is trying to achieve. It may not mean radical changes, but you know that right in even our advice units, and our calculators on our website–How much do I need to save for retirement? How much can I spend safely in my retirement?

That requires the expected returns being somewhat reasonable. Not perfectly accurate. No one has that, we don’t, no one has that. But certainly we have and we–expected returns do vary through time–and so we have a responsibility. So what is a reasonable range for that, sometimes a little bit higher than historical averages, sometimes they’re a little bit lower than historical averages. I think that’s important to lay that information out there so that investors can make as intelligent decisions, in their uncertainty as possible in this world.

And we’ve done that for 10 years. I’m very proud of it because our first outlook 10 years ago, there were many investors very concerned to invest at all given the financial crisis The low, this new normal.  And we were, our outlook was saying actually we’re going to have historical returns in the equity market, stay invested, stick to the plan. And that forecast was genuinely accurate. We didn’t get the ups and downs along the way, but we got the end point, and that’s important for planning purposes. And doing risk return trade-offs with one’s client.

Maria Bruno: Yeah. No, I agree, Joe. I get these questions a lot, particularly for retirees. And we can talk more about that. But when you’re doing long-term projections it’s fine to use a Monte Carlo simulation where you’re looking at different outcomes. But if you are looking at in the next one to three to five years, how much I should be spending from my portfolio, it would be imprudent not to think about what the initial conditions are. It’s risky to bank on higher type return expectations when the portfolio isn’t expected to produce that.

Joe Davis: Yeah I sat on some investment communities. I imagine you have many clients or you know counsel clients, right. Like for example, I’m a very conservative investor, but I’m trying to draw 4% from my portfolio over the next decade for spending. Or some institutions I serve on have a target of 4% spending. How should they allocate their portfolio?

Now it may be different, in fact it is different. My counsel versus 25 years ago–and it could have been 60/40 because of the bond return component– does not mean that bonds don’t have value. It just means a lower expected return  may mean they either cannot spend 4% from their portfolio. They have to save more. I mean that’s one certain viable path, or they’re going to have to–there’s no magic bullet–they’re going to take on more risk. Which means more equity like risk, perhaps 70/30, right.

Let’s talk about those trade-offs. Not one better than the other, and let’s just look at the comfort level with that. The pros and cons of that. And I think that’s the sort of conversation that these sort of ranges of returns allow investors to have. Again if one has a 100 year horizon or so, the initial conditions do not matter. But again, for some investors that’s appropriate. For many investors, anywhere from a horizon from five years to 15 or 20 years, then I think that’s where our sort of planning  projections can be helpful, right.

Maria Bruno: Right. So Joe, let’s get a little deeper with our  market outlook. So US equity returns, we’re looking at a projection real, not much unchanged from last year, anywhere around 3.7%  to 5.7%, I believe, in terms of the 10-year forecast for equities. Let’s talk about that, I guess, in a couple facets.

One, we would be remiss at a bogleheads event if we do not discuss US versus international So the projections are much more than the national forecast. So let’s talk a little bit about what’s causing that. What to expect? What to think about that in terms of diversification and asset allocation?

Joe Davis: Yeah and that’s one of those rich topics, Maria. You know Jack and I used to talk about–you know he was not as big of a fan, certainly as, or supporter of having non-US equity exposure–he wrote about it. I mean obviously the US market has  been the strongest performing equity market, among the highest in the world the past five or 10 years. It’s steadily outperformed non-US markets. But you know the past is not a prologue.

I mean without doubt the lowest volatility portfolio is a global portfolio. That does not mean that necessarily  the US will out or underperform–depends upon where the fundamentals are. We are expecting or projecting, more likely than not, that non-US equity markets will have somewhat higher expected returns going forward.

It’s not because of any sort of view on the US dollar. It’s primarily because of where valuations are. And if you look particularly in the US growth arena, valuations are at pretty high levels. I mean they’re close to late 1990s. So there is certainly some strong evidence historically that when you have these sorts of dislocations, or deviations I should say, that over time they tend to conditionally, they tend to converge. And so that is the primary reason why we anticipate non-US markets  to have higher equity returns than the US.

It doesn’t mean the US, it’s not a negative view on the US economy, it’s not a negative view on US earnings. It’s the fact that the prices that investors are already paying for US fundamentals is markedly higher than they are for European companies, Emerging Market companies, and Asian companies. And history shows  that where we currently sit, the risks are towards–it’s one sense, the price is being paid for the rest of the world’s growth is much cheaper today–and so if you have a long-term orientation, and certainly I adhere to this in many of our portfolios we provide clients, balanced portfolios have non-us exposure. 

And we can all debate what that optimal one is, but certainly having some non-US exposure is going to help on a return perspective. I think it’s prudent to have it even if one doesn’t expect part of the world to outperform the other, because it’s about modest volatility reduction on average.

But that is a component of our outlook. In fact most parts of the equity market globally, if they’re outside of US technology companies, are projected to modestly outperform. And we’re not picking on that sector. It’s just that those valuations are so extraordinary. That we have seen this before, but the times we’ve seen it before were the late 1920s and the late 1990s. 

I’m not saying that’s the one thing about today’s global equity market. We’ve seen a fantastic performance in the past five or six months. But it has not been broad-based. It isn’t like every single company has doubled in value. So that’s good news in the sense that being broadly diversified could help smooth out some of the underperformance of some companies that may have been starless. 

And I don’t know when that time is. I’m not picking on any one company. I’m just saying it’s unlikely that all of them are going to continue to grow to the moon. And so having the broad basket, I think you’ll see, if our forecast is right, companies that are more value oriented, particularly some outside the US, will play some catch up over the next several years. The timing, who knows, but over the course of the next five years it’s highly likely.

Maria Bruno: Yeah you beat me to that one, because we got that question before, Joe, around what are we going to get out of this value coma?

Joe Davis: It’s, yes, funny. I had the honor or the privilege to present to Vanguard’s board of directors, in December it was, on this topic. What’s going on between growth and value. We had a lot of our active managers in our Vanguard active funds, whether it’s like many of our active managers, some of us have a value sort of orientation. They tend to buy stocks that are lower in price to book. So today some of those value type companies are in the financial banking sector, energy companies, some tied to face-to-face services. Some of them have gotten absolutely hammered on a price relative to some large cap technology companies.

But the perception is that actually for the past 10 years growth companies on average have drastically outperformed value. So there’s some in the industry actually questioning the value philosophy, which is actually a cornerstone of everything from Vanguard’s generally active approach, and much academic research. So there’s a big debate about what my research I presented to Vanguard for directors was–that you can explain not all, but a lot of values underperformance in part because of the severe drop in inflation and interest rates. And so if we have a modest recovery, participating value companies will generally come back a little bit.

They may not completely recover all the relative on their performance. I mean the US growth index is up by 40%  over the US value index and that’s astronomical. That’s like five years worth of historical stock returns squished into one year on a relative basis. And  we’ve rarely ever seen that dichotomy. And then over and above the fundamentals, growth stocks have continued to outperform even when you control for things like secular change, and platform effects, and all these technology buzzwords.

So I’m not saying that this is the turning point when some of these value companies start to come back and contribute more to the equity market. It’s just that continued out performance is unlikely at least over a five-year basis. But again there’s a lot of active managers who have underperformed in part because of the value premium not really manifesting itself in the equity market. 

Maria Bruno: Okay. All right Joe. We’ve got a few minutes left. Time is fine. Let’s just real quick talk about two things. I want to touch upon one, we talked about the bond environment, low yields. What’s the message to investors, particularly retirees who are looking to try to eke out extra yield  either through credit or the yield curve? Briefly, what are your thoughts there?

Joe Davis: Well I’d say, I think again, the more that one tries to eke out the returns the more one is just  going to have to weather a month or two, or a quarter to–where the NAV [Net Asset Value] drops a little bit potentially because you’re just we’re going to have credit spreads that are approaching, whether it’s municipal spreads over treasuries, or corporate bond spreads over treasuries, that are approaching close to historical heights. 

Yeah the expected return on a corporate bond portfolio or municipal bond portfolio is certainly higher than treasuries because of the risk there. But that’s not a free lunch, and so that doesn’t mean don’t remove those, investors, it just means that you have a very low income commission as well as the proposed yield to maturity is fairly low historically. 

And so I think we all hope for a somewhat higher return from our bond portfolio. That means that we’re going to have to just look through a period too where you have a slight drop in the NAV. That’s the natural reset, right and you have less income cushion to absorb a modest rise in corporate spreads or municipal bond yields, particularly as the recovery continues. So again a healthy recovery means healthier bond returns for the five or ten or fifteen year period. And that’s what I’m hoping for. I mean if we’re here five years from now with the same interest rates, Maria, something has gone terribly wrong.

 And so, no, I don’t think anyone wishes that. So the converse though is okay. If I want higher expected returns, you know, no pain no gain. And I’m not talking about a lot of pain, I’m just talking about some fluctuations as we have a gradual rise in interest rates over the next several years. So that’s going to be a little bit different from the past. But I do know, particularly for conservative investors, that can be a little bit unnerving if they see the bond portfolio drop down in value for a little bit. Because the more conservative investments–hey I expect that from equities, I don’t expect that from fixed income.

Well the more they’re going to try to reach for yield, then particularly dabbling into high yield or emerging markets, yeah there’s a higher risk premium because of the greater volatility. So one, I just hope they don’t have expectations for money market like returns without any volatility, because we have a low income question, and so we just have to be mindful of that. I know I’m prepared for that. But we’re going to have to talk to ourselves, I think, before they occur. And I think it’ll generally be orderly. We won’t have a massive spike in interest rates.

Maria Bruno: Okay. All right, good. Thank you for that. And then last thing, but we did get this question in before, and I know you get this question a lot. Bitcoin.

Joe Davis: Well it’s not a currency. I think the market’s expecting it to be a future currency. I think it’s debatable. I don’t think, to be honest I don’t think many central governments will allow it to become legal tender. I’m particularly skeptical that China and the United States would allow bitcoin to usurp the US dollar. In Chinese, remember the bitcoin market is spitting in my face.

On that to be blunt, however it could very well become a collectible. I used to collect baseball cards. If you collected baseball cards other than Mickey Mantle baseball cards, well worth, I think over a million dollars in mint condition. So it’s not to say something that is in very finite supply, that is valued by a community, it cannot have utility value. And collectibles generally have that. You know, where my brother would say I could care less if I have that baseball card, that has utility for me.

Others it’s beanie babies or something else. I don’t mean to be dismissive of bitcoin. It could have value, but I think I’ve been shocked by its astronomical rise. The one thing that’s difficult with bitcoin, Maria, is that it’s very tough to argue what  the fundamental value is. I can tell you that the cost to mine the coin is lower than today’s price, and so that would suggest potentially it’s overvalued. But again, I don’t think it’ll ever become legal tender.

That does not mean, however, that could mean the price could go closer to zero. But it may mean it could still stay up well above zero, because it becomes a sort of–I say, come on, I think collectibles, the more you know there’s value, okay, but the other day it’s just a piece of fabric. But the Picasso painting is incredible value. I just don’t know. I mean is it a Picasso, is bitcoin a Picasso or is it the thousands of paintings that are produced every day that have hardly any value. I think that’s the question.

Maria Bruno: Okay, good. Thank you Joe for that. So all right. So of course we run out of time, but I do want to have a little fun because I think our boglehead friends are expecting a little fun too. So I want to surprise you with a quick lightning round of questions, and I mean quick, okay. So here we go. Joe, what’s the first media source that you go to in the morning when you log on?

Joe Davis: Barry Ritholtz.

Maria Bruno: Okay what’s the last book that you read?

Joe Davis: Life Agility.

Maria Bruno: Okay. So here’s a good one I came up with this morning. In case you’re wondering. Joe, so what would Joe the senior economist that you are today tell Joe the more junior economist that I met 15 years ago.

Joe Davis: Be more patient in one’s personal life.

Maria Bruno: Is your wife watching?

Joe Davis: I’m a very impatient person. That has positives and negatives to it.

Maria Bruno: Okay, all right, and lastly, myself, I’d say hope. Yeah. All right, thank you Joe. It’s been a pleasure sharing this virtual stage with you, and I thank the bogleheads as well for their interest and their time. So Rick, I’ll turn it back over to you.

Rick Ferri: Okay. Well thank you Maria and Joe for that great discussion. It’s always interesting to hear Vanguard’s perspective on what’s going on and particularly what might come forward. This presentation has been recorded and it will be available soon on boglecenter.net. And our next Boglehead Speaker Series live event will be next month and it will be a panel discussion from some of your favorite boglehead experts. So thank you everyone and we hope you have a safe and happy New Year. And see you next time.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant


Bogleheads Speaker Series

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