Vanguard : Guarded, not bearish: Spotlight on Vanguard's economic and investment outlook

Stephen Steenkamer: Hello, and welcome to Vanguard's Investment Commentary Podcast Series. I'm Stephen Steenkamer. In this month's episode, which we're recording on December 17, 2015, we'll explore the 2016 edition of Vanguard's economic and investment outlook.

Joining me is Andrew Patterson, a senior analyst in Vanguard Investment Strategy Group and a lead author of the forecast. Andrew, thanks for being here.

Andrew Patterson: My pleasure, Stephen.

Stephen Steenkamer: The central bank of the United States, the Federal Reserve, recently raised its target for short-term interest rates. It was the Fed's first rate increase in nearly a decade, and it brought to a close a remarkable seven-year, post-crisis period in which short-term U.S. interest rates were essentially zero. How do you expect Fed policymakers to proceed?

Andrew Patterson: A lot of people look to the 2006 rate increases wherein you saw a 25-basis-point increase every single meeting, a march up to 5.25, and then they plateaued for some time. You're not going to see that this time around. The Fed is going to remain very data-dependent. You're likely to see a staggered, gradual increase in rates. We believe we'll see the fed funds rate, the policy rate, somewhere around 1%, 1.25% at the end of next year. And, in fact, we believe that it may be difficult for the Fed to get off that 1%, 1.5% range for some time after that. There's likely to be some sort of a pause.

After that, they're going to begin to assess the appropriateness of further unwinding quantitative easing. The Fed still has a $4.5 trillion balance sheet. It's $3.5 trillion larger than it was before. They're going to have to allow that to wind down at some point. So, In all likelihood, they're going to start to do that after they pause around 1%, 1.25%, take some time to assess the impacts of monetary policy.

Stephen Steenkamer: The beginning of Fed policy normalization would seem to be an encouraging sign for the U.S. economy. How do you expect the U.S. economy to perform in coming years?

Andrew Patterson: As was the case last year, we believe the U.S. economy will prove resilient, resilient to international weakness, resilient to structural pressures even within our own borders. We're expecting growth of around 2% to 2.5% next year; 3% was our view in previous years. We've since lowered that, because we believe there are structural issues facing the economy here in the U.S. You have demographic headwinds, you have an aging population, you have lower labor force participation, and the like; and those are likely to serve as a restraint on growth for the foreseeable future.

Stephen Steenkamer: What are Vanguard's expectations for the international economy in the coming years?

Andrew Patterson: A lot of questions to be answered internationally. Growth in China is likely to continue to slow. It came in in the most recent report somewhere around 6.8%, which we believe actual numbers are closer to low 6%, where they had been over the better part of the last decade, decade and a half, north of 10%. To a large extent this was expected as China transitions from an investment-driven model of growth wherein exports and investment in infrastructure, etc., tend to drive growth. They're moving toward a more developed-market type model of growth which depends, to a larger degree, on consumption. So you're seeing an emerging middle class in China. You're seeing them play a bigger role in growth within the country. And as that occurs, as it has occurred in some of their Asian trading partners who have taken the lead to becoming developed markets, you start to see growth slow. That low-hanging fruit of building railroads and highways, it tends to fade, and the consumer's importance tends to increase and growth usually slows as that occurs.

The other big question mark comes out of Europe. We saw a lot of benefits of QE early on. The quantitative easing policy there was announced in January, implemented in March. Early on you saw inflation, inflation expectations start to pick up a bit. Growth over the year has actually come back somewhat, particularly in the periphery, such that growth in Europe over the next 12 to 18 months will be somewhere in the 1.25%, 1.75% range, maybe 2% at a high level.

That said, inflation expectations have come back in somewhat, such that they have actually announced an expansion to their monetary policy, their quantitative easing policy, moving out the final date of asset purchases and also expanding the types of assets that could be purchased under the program. We believe, as the market did, that more is likely to be done going forward.

Stephen Steenkamer: Interest rate levels and changes in interest rates are very important to financial asset prices, especially bond prices. What are Vanguard's expectations for the bond market?

Andrew Patterson: In terms of fixed income returns, you're likely to see global fixed income somewhere in the 1.5% to 2.5% range-that based, in large part, on the low level of yields here in the U.S. and abroad. Gone are the days of the 5%, 6%, 7%, 8% returns that investors experienced in their fixed income portfolios since the 1980s, depending on the time period you're looking at, basically because we don't believe we're going back to those high levels of interest rates. The bond math just doesn't add up for you to get those types of returns in your fixed income market.

That's not to say that fixed income doesn't hold a place in a portfolio. That dynamic should still hold wherein you see a downturn in the equity market and maybe some positive or less negative fixed income returns. You're not going to get the same type of support that you had in the past from fixed income, but that doesn't mean they're not going to lend support from a diversification standpoint in your overall portfolio.

Stephen Steenkamer: Let's turn to stocks. As of mid-December, the year-to-date return of the broad U.S. stock market was near zero. The market struggles in 2015 followed six years in which double-digit gains were recorded five times. Is the bull market in U.S. stocks over?

Andrew Patterson: There has been a very long bull market in equities. There was a bit of a correction back in August. We don't necessarily believe that time is going to determine how much longer this bull market has to run. We believe valuations, when you look at them relative to interest rates and inflation and inflation expectations, they're more reasonable than some might think. Yes, they are elevated, although not to the extent that we believe a bear market is imminent.

In all likelihood, you'll see reasonable returns out of equities in the 6% to 8% range over the next ten years or so. That said, there is likely to be volatility over that period.

Stephen Steenkamer: Developed international and emerging stock markets generally have underperformed the U.S. stock market in recent years. Do you expect that relationship to change?

Andrew Patterson: So one of the byproducts of that underperformance, again, mathematical in nature, is really that you're seeing a discount emerge in terms of price/earnings ratios relative to the U.S. It's much more pronounced in emerging markets. That said, it's not necessarily without warrant. There are a lot of issues facing emerging markets today. Likely more questions than answers. One of those is how will emerging markets respond to increases in the federal funds rate? There are going to be winners and losers in that space. Some are going to be more prepared than others to withstand that.

Emerging markets, they are likely to outperform to some extent, but that's not to say that we're calling for an overweight to emerging markets, because there is likely to be considerable volatility in the emerging market space as these questions get answered over the coming months and years.

In terms of developed markets, they're trading at somewhat of a discount. In Europe, you're starting to see the benefits of extraordinarily easy monetary policy take hold. So you're starting to see a bit of a rebound in developed market stocks outside of the U.S. That's not to say that they're without risk, but the volatility there should be somewhat more muted than in emerging markets.

Stephen Steenkamer: You've talked about the prospects for the major asset classes. How does Vanguard think balanced investment strategies, those with some combinations of stocks and bonds, will fare in the coming decade?

Andrew Patterson: So in terms of balanced strategies, we believe that much like equities and fixed income, they're likely to be lower than they have been historically. We're unlikely to go back to the types of returns we experienced over the very, very long time period, back to 1926, even from the 1970s on. You're likely to see balanced portfolios outperform maybe the returns that we experienced over the last 15 years or so. But the probabilities that they're going to get you that 7%, 8%, 9% return, in the balanced portfolio space-for a 60% equities/40% bond portfolio-that investors may have become accustomed to over the last 20 or so years, the probability of experiencing those is low in our view.

Stephen Steenkamer: Many investor strategies are determined or at least heavily influenced by financial advisors. How might advisors create the most value for their clients in the coming years?

Andrew Patterson: I think the most important thing for advisors and their clients is to have these frank, necessary conversations and help clients to set reasonable expectations and to make difficult decisions-whether it's saving more, spending less now, spending less in retirement, maybe working longer. They are difficult conversations to have, but they're very, very necessary because investors who have become accustomed to the level of returns they've experienced since 1970, 1980, we're not likely going back there.

Stephen Steenkamer: Great. Andrew, thank you so much for being here.

Andrew Patterson: Thank you. My pleasure.

Stephen Steenkamer: For more information on Vanguard's economic and investment outlook, visit vanguard.com. You can also follow us on Twitter. And be sure to check back with us each month for a new installment of the Vanguard Investment Commentary Podcast series.

Thanks for listening.

Notes:

• All investments are subject to risk, including the possible loss of the money you invest. Investments issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
• Investments of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
• Past performance is no guarantee of future returns.
• Diversification does not ensure a profit or protect against a loss.
• The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions. We recommend that you consult a tax or financial advisor about your individual situation.
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