Dave Eldreth: As we start 2019, we’ve seen a decade of economic expansion following the global financial crisis. But concerns are growing that expansion may be ending and a recession could be on the horizon. On the heels of the longest government shutdown in U.S. history, what will the impact be for the markets and investors?
I’m Dave Eldreth, and welcome to Vanguard’s Investment Commentary podcast series. In this month’s episode, recorded on January 22, 2019, we’ll discuss Vanguard’s 2019 economic and market outlook with Josh Hirt, an economist with Vanguard Investment Strategy Group.
Josh, thanks for joining us today.
Josh Hirt: Thank you. Good to be here.
Dave Eldreth: Before we dive into the details of what the outlook says, could you explain the process for creating the research paper? And how can advisors use this to inform the portfolio decisions they’re making with their clients?
Josh Hirt: Sure. Well, really this is the culmination of our global economics team, both our U.S. team, our European team, and our Asia-Pacific team coming together with different sets of analysis and viewpoints and really thinking about, as we listen to investors and what’s happening in the marketplace, what are the key themes, what is our research saying, and how can we communicate that with the market? So I look at it as a very collaborative process from multiple regions across the globe.
And I guess our aim would be that we are looking at providing analytically based research that can give the advisor viewpoints, thought leadership on the economy, on the capital markets; and I would say really to use that to be able to set expectations with their clients and to be able to also shape their viewpoints of the economy and the markets as well.
Dave Eldreth: The way you construct the outlook paper is best-case scenario, worst-case scenario, and probabilities of each, right?
Josh Hirt: So I think that’s definitely an element that we’re always looking at in our analysis. One—in certain types of viewpoints, whether specifically if it’s the capital markets section if we’re looking at potential outcomes, as well as just from the economic fundamentals or the macro picture—we’re always trying to assess the situation and forward-looking as a probability distribution. One of the elements that sets apart how we approach many of the topics is that we know that the future is uncertain and that looking at them through, you know, a distributional framework, through a probability, the likelihood of the outcome is certainly something that we try to do in setting expectations.
Dave Eldreth: Okay. Now this year’s outlook is titled Down But Not Out. Could you highlight some of the themes, broadly, from the paper?
Josh Hirt: Sure. I think the main theme really comes from the name itself, Down But Not Out. And I think that as we looked at the global economy right now, that theme really struck a chord, not just from a global standpoint, but also from some key regions, the U.S. and China as well, in that we’re really seeing a period of perhaps peak economic expansion that is shifting down but not out. In other words, we don’t see a recession as our base-case scenario for the global economy or for any of those two specific regions.
Dave Eldreth: Now, since the paper came out, you’ve since revised a portion of that, correct?
Josh Hirt: [Since] this paper was really published in early December, we’ve seen a pretty unprecedented shift in the environment that’s in the market, some of the viewpoints that are in the market, and expectations by the market. Certainly, just equity volatility has been a component of that. But also, I would think just as largely, the contribution that a change in interest rate expectations have had by the market just really over the last month, a pretty dramatic shift, is very impactful.
So I would say that the biggest takeaway from what we’ve seen develop over the last month is that we really have found it difficult for the Fed to raise rates both times this year as we were previously expecting, so in March, at the end of their March meeting, and in June.
We really are finding it difficult for them to be able to raise rates in March given the market environment, given analysis that we’ve done on the impact of some of the volatility and the tightening of financial conditions and political uncertainty. We would just see the greatest likelihood of one interest rate rise coming in the June timeframe.
Dave Eldreth: Now, in that vein, are you watching other aspects of the economy, Brexit or the shutdown, that could alter those variables? Could they alter the outlook going forward?
Josh Hirt: [They] certainly have the potential to do so. As we sit here currently, we’re certainly monitoring both situations very closely. You know, the shutdown is one that is certainly hard to gauge political will, but what we can say now is that it certainly will have an impact on the economy, is having an impact on the economy. We’ll likely see this come through in the first- quarter growth numbers. We may see it even as soon as some of the labor market data that comes out next month. From our analysis, if we were to see a shutdown prolonged really just over another quarter or two, that in itself could be enough to actually drive the U.S. into a recession.
Dave Eldreth: You talk about the indirect effect. It’s really not just the 800,000 government workers that are not getting paid, right? I mean, there’s a ripple effect that goes out from that—vendors, contractors that work with the government, restaurants that government workers patronize on a regular basis. Could you talk a little bit about that?
Josh Hirt: Sure, that’s where you get into some of the difficulties in terms of analyzing it, just because, historically, you’ve had shorter shutdowns; and so you’re mostly looking at those direct impacts. You know, the direct impacts being the wages of the, in this case, the 800,000 federal government workers.
And as you get longer and longer in the duration of a shutdown, those second-order effects, the curbing of your spending patterns, the government contractors that are not getting paid and won’t get repaid, even when the shutdown were to be ended, those second-order effects are much more difficult to quantify. We certainly know that they are there. The risk is, is that the longer and longer that this would play out, that you would see those actually materialize.
Dave Eldreth: Okay, that’s interesting. Now, there’s a chart in the outlook that shows the stage of economic expansion for most major countries. Could you talk about that concept, and where does the United States fall in the spectrum?
Josh Hirt: Sure. Well, I think this really stems from us looking at some heightened sensitivity around recessions. So we went back, and we actually studied, since the ’60s across the globe, over 100 recessions to look for commonalities, drivers as such; and so part of that, a separate framework from that, was looking at where different economies are in the business cycle. And when we’re looking specifically at the U.S., [we’re] looking on a fundamental basis, so looking at things such as leverage in the economy both from consumers and from businesses. If we look at [the] labor markets’ so-called slack in the economy, if we look at inflation, really across a broad spectrum of indicators that we would follow, the U.S. is probably moving in the early stages of late-cycle-type behavior.
Now so when we wrote the paper about a month ago, the data we were looking at, at that point, we had really characterized the U.S. as just then moving into later-stage levels of the cycle. And we’re probably a bit more advanced in some respects, currently, but we would see that [as] sort of [our] current place, from the data that [we’re seeing] from the United States.
Dave Eldreth: Now the outlook discusses some of the various risks of the global economy and the markets. What risk is Vanguard most concerned about at this stage?
Josh Hirt: Yes. It’s a good question. I mean it’s something that in the outlook, we present a number of them. And I would say that there’s sort of this pull between the greatest risk in terms of severity as well as something that’s more highly probable. And where I’m going with this is thinking about both the trade scenario in the U.S. and China as well as central bank activity. I would really put these as two really key risks right now outside of what we’re seeing in regard to government shutdown, in regard to elements of Brexit. These would be two more longly held risks that we see sort of playing out throughout the year. You know, whereas China concerns us, the U.S.-China trade situation concerns us simply because of (A) the uncertainty that’s surrounding it, but also the potential severity of, if you were to have really major conflict or major disagreements between the world’s two largest economies. So certainly considerable risk there.
I would say something that is more front and center, from a U.S. perspective, we are in much more uncharted territory going forward than what we have been from a monetary policy standpoint over the last, really, ten years, but even more recently since the Fed started raising rates that the path forward is much more akin to walking a tightrope here. And so the risk of a mistake is significantly greater from that standpoint.
Dave Eldreth: Okay, now let’s talk about inflation for a moment. Past economic market outlooks have made the case that globalization and technology would make achieving 2% inflation in the U.S. and elsewhere difficult. Does that same opinion hold true?
Josh Hirt: From a structural aspect, we absolutely still see those as longer-term forces that are weighing on economies globally. More recently, though, we have seen a cyclical firming over the last year in inflation, which was consistent with our viewpoint that we actually would see this cyclical uptick. We’re now hovering right around 2%.
We see that really being the high water mark for inflation in terms of where we’re going for 2019.
One of the key aspects, and this is something that we wrote about in more length within the outlook, is just this relationship between wage gains and inflation. We find that the pass-through of those—whereas in prior decades it was more pronounced, really since we’ve gotten to a period of more stable inflation expectations in the early ’90s or so, as central banks began to target inflation—that inflation expectations are really the key component there in future inflation. And we just found that they’re much more well-anchored now than they were.
Dave Eldreth: Okay. Let’s switch gears for a second and talk about the markets. The U.S. equity market closed out 2018 with the worst December since the Great Depression. Given that, how likely is a bear market, and what do we expect overall for equity markets in 2019 and beyond, long-term?
Josh Hirt: Yes. So I mean just as a function of the movements that we saw toward the end of the year, it’s brought U.S. markets into almost more fair-value range through some of the metrics that we look through. And so just from that perspective, you’re seeing that the probability of a bear market or a significant downturn in the market has been reduced probably something closer to the historical norm, which would be around 20% or so. So you have seen valuations come back more in line.
As that translates into our view for longer-term equity returns, which is how we approach looking at markets, you’d find that that’s also marginally lifted rate expectations, even from when we published in the paper. So you’re probably seeing about an additional 100 basis points of expectations in terms of the equity markets, so centered at the median of that distribution being around the 5% mark. And so you have seen that this contraction of the market that we’ve just experienced has had the effect of, marginally for U.S. investors, raising some expected returns.
Dave Eldreth: Now in years past, our outlook has been more bullish on the U.S. market compared to international markets. And that seems to be flipped in this recent paper, correct?
Josh Hirt: Well, I think this has been a challenging conversation. I think [it’s] something for investors to really wrap their head[s] around, both the U.S. and the ex-U.S., you know, both the forward-looking outlook as well as just looking in the rear view, which we know it’s easy to do because you see a real divergence. And I would say that from just the numbers, what our model, what the forward-looking projections would show, taking initial conditions into consideration, that ex-U.S. markets do have a higher expected return, roughly around 200 basis points or so, than U.S. equity markets. So you see that from a fundamental basis.
Why I think it’s been challenging for investors and why this has been somewhat of a difficult conversation is that if you just look in the rear view, the U.S. has really outperformed ex-U.S. for really a long stretch of time here. You can go back for a decade and see a pretty significant outperformance there. And in many of those years, you were also seeing valuations that may have been favoring ex-U.S. markets.
U.S. equity have really outperformed most major asset classes over that ten-year period. So, we know that there’s going to be some cyclicality around this. And then that, as comparing all assets to that, if you’re looking just as an ex-U.S. investor, it might not be the best comparison simply from the standpoint that we know that there’s a great degree of divergence in market leaders and cyclicality if the U.S. has been really dominating from that standpoint for a number of years.
But I would just say that fundamentally, when we look at our capital market outlook, that we would still see more attractive valuations ex-U.S. and slightly more positive return expectations as well.
Dave Eldreth: It sounds like you’re making a strong case for global diversification within a portfolio.
Josh Hirt: Well, certainly. I think that it’s something that [we’ve] long [believed] because we’ve [been] through multiple cycles, as well as other asset classes. I would say that whereas this has been more of a challenging conversation on the equity side, if we take a look at the fixed income side, I think we’re seeing that play out extremely well from a diversification standpoint. If you look at ex-U.S. versus U.S. fixed income assets, you see that that story is much more aligned to what you would expect. We have different monetary policy regimes right now. The U.S. is doing something that’s different than other central banks as a result. You know, strictly U.S. fixed income, if you’re looking at maybe a broad market, is not performing as well as you might see some ex-U.S. fixed income assets, especially if they’re hedged. So if you’re hedging them back to the dollar, as we would advise for ex-U.S. assets, you’re seeing that diversification play out rather well.
So I do think, the point about diversification, we can fix it on the equity markets. I think if we look holistically at it, it’s something that really benefits investors well. But the other, maybe the final, point on that is that I’ll also conclude that we know that there’s a degree of home bias. It’s a very individual-centric decision around the degree of home bias. And so that’s something that really each advisor with their client or each investor needs to think through in terms of their own perspective on what degree of home bias is appropriate. So we know that there’s a range there.
Dave Eldreth: Okay. Now given the backdrop of the recent volatility in the equity markets, and coupled with the rising rate environment on the fixed income side, where should investors turn?
Josh Hirt: Yes, so I mean my first response would be that there isn’t anything that has meaningfully shifted our views for long-term asset allocation or for investors in terms of where to allocate. If you’re looking for the return generator in your portfolio, we would believe that to be equities. We still believe very firmly in the equity-risk premium.
And on the fixed income side, we haven’t seen a collapse in sort of the diversification properties of what that can mean for an investor’s portfolio, especially over longer-term periods of time.
And, in fact, from that standpoint, with higher interest rates, it tends to heighten the diversification properties of fixed income. So we would still see that as the ballast of your portfolio.
I think one dynamic that has changed a bit, and we really haven’t needed to have this conversation in probably a decade, is just now the viability of cash as an asset class. So to that extent, it may be something that is a potential positive. If investors have over-risked in their portfolio in looking for yield or return, because cash was essentially earning you nothing, it may be something that investors can now come back to and be more risk-aligned, from that standpoint. So that certainly is a changing dynamic, and asset allocation could really be a positive for investors.
Dave Eldreth: Okay, great, so you’ve provided a great summary of our economic and market outlook. We appreciate you joining us for this Vanguard Investment Commentary podcast and sharing your insights today.
Josh Hirt: Great, thank you for having me.
Dave Eldreth: To learn more about Vanguard’s thoughts on the markets, the economy, and other various financial planning topics, be sure to check out our website. And remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.