Surveying the market and economic climate with Greg Davis
30 November 2018 | Markets and Economy
Gauging the investment and economic climate is often challenging, and these days many factors are combining to ratchet up the degree of difficulty. The global economy has been expanding and corporate profits continue to grow, but growth may be slowing, and an autumnal upswing in stock price volatility has underscored how quickly market conditions can change.
In the following interview, Vanguard Chief Investment Officer Greg Davis addresses investing and economic conditions, investor expectations and some of the ways technology is improving financial market efficiency and transparency.
The bull market in stocks that began in many parts of the world in early 2009 is nearly a decade old. Should investors adjust their expectations?
Greg Davis: Based on our fair-valuation metrics, we expect globally diversified stock portfolios to deliver annualised returns in the 3%–5% range over the next ten years.1 That's roughly one-third of their long-term historical average return. And it's roughly one-third of their annualised gains since the depths of the financial crisis a decade ago. So, yes, some investors probably are expecting too much from stocks.
Below our headline expectations for global stock portfolios, which assume sterling-denominated investments, are somewhat lower forecasts for the US market and somewhat higher forecasts for non-US markets. We're a little more optimistic about stocks outside the US because their valuations are lower.
The US Federal Reserve, the nation's central bank, has raised its target for short-term interest rates eight times in the last three years. What's changed in the US fixed income markets as the Fed has worked to normalise monetary policy?
Greg Davis: Longer-term bond yields began to rise in the middle of 2016, about six months after the Fed started its current cycle of rate hikes. But the curve has flattened a lot since then, as longer-term yields have climbed less than shorter-term yields. We believe one reason the increases in longer-term yields have been relatively muted is investor scepticism that the rate of US inflation is going to spend much time above the Fed's 2% target. One thing that rising yields, particularly short-term yields, have done is to make cash and US Treasuries more compelling investments – a real competing force relative to equities in certain cases.
How many more Federal Reserve rate hikes are likely?
Greg Davis: We're expecting one more rate hike this year, when the Fed meets on 18–19 December. It's almost certain to be another quarter-percentage-point increase, as all of the Fed's moves in the current cycle have been. If so, the target rate would rise from a range of 2.0%–2.25% to 2.25%–2.5%. We expect two more increases next year. By the time we get to the second half of 2019, we're likely to be in neutral policy territory, with a target rate of 2.75%–3.0%.
Central bankers in other countries are only beginning to lift their target interest rates from global financial crisis lows. How do you expect them to proceed?
Greg Davis: We expect the European Central Bank to leave rates alone until autumn of 2019, at which point it will begin to gradually normalise policy. The Bank of Japan seems unlikely to raise rates in 2019. Many of the emerging markets banks will be forced to tighten along with the Fed, although China is skirting the trend through further capital controls and modest yuan depreciation.
Your Fixed Income Group manages more than USD 1.2 trillion in bond and money market assets. What portfolio construction approach is the team emphasising?
When we think about our active fixed income portfolios, we've been trying to be a bit more defensive. Valuations for investment-grade and high-yield bonds aren't as attractive as they were over the last ten years. There's been a lot of spread compression – the differences between yields of lower-risk and higher-risk securities are not as large as they have been.
Given the late phase of the economic cycle and the risk of more restrictive Fed policy, US investment-grade and high-yield bonds could be negatively affected by rising corporate borrowing costs. So also could emerging markets bonds, as many are issued in US-dollar denominations or from countries with currencies pegged to the dollar. Of course, this doesn't mean investors should necessarily avoid these segments. We believe diversification is crucial to long-term investing success. I like a quote from investment researcher Peter Bernstein, who said that if you're not invested in something that makes you uncomfortable, you're not really diversified.
You mentioned expected stock returns over the coming decade. How are global bond markets apt to perform?
Greg Davis: In its 2019 Economic and Market Outlook, our Investment Strategy Group forecasts annualised global fixed income returns in the 1%–3% range in sterling terms, driven mostly by rising central bank policy rates and higher yields. Our estimates are higher than they were a year ago, when we anticipated 1%–2% returns. However, they remain muted compared to long-term historical returns of 5.4%.
If our new forecast proves accurate, globally diversified bond investors in many parts of the world should over time earn real returns – that is, returns above the rate of inflation. This assumes that central banks can succeed in keeping inflation in the range of 2%, which is more or less the goal in the US, Canada, Australia, Japan, the UK and the euro area.
There have been some recent signs of modestly slower economic growth around the world. How might slower growth affect the financial markets?
Greg Davis: The market effects of an economic slowdown, whenever the next one occurs, probably will depend on two factors – the speed and depth of the slowdown and the extent to which investors accurately anticipate those changes. Our Investment Strategy Group recently completed some interesting research on economic surprises and the returns of various asset classes. It found some correlation in the short term; the connection varied with the phase of the economic cycle. In the long term, on the other hand, it found that economic surprises don't really matter.2
What are the chances of a US recession in the next year or two?
Greg Davis: We don't see a US recession as our base case, but we believe the possibility has risen as the yield curve has flattened. At this point, the probability might be 20%–30% in 2019. Looking at 2020, the risk might rise to 30%–40%. The primary drivers of rising recession risk are higher interest rates and concerns about slowing global growth. Our estimates reflect a pair of models: a single-factor model based on the slope of the yield curve and a multifactor model that also incorporates other leading indicators, such as credit spreads, stock market returns and economic growth signals. The yield curve is sometimes dismissed as a recession warning signal, but our research suggests that it should not be ignored.3
The growth of indexing has been grabbing attention lately, with some speculating that its rise will lead to the next stock market downturn. Do you think there's any there, there?
Greg Davis: I don't know what will cause the next market correction, but it won't be indexing. I'm confident about that for several reasons. First, there's been no historical correlation between indexing and market downturns. The percentage of fund assets in index funds has grown steadily, while the market has fluctuated more or less randomly. Second, index mutual funds and exchange-traded funds, which mostly follow index strategies, are a small part of the overall markets. Among US stocks – easily the most heavily indexed asset class – index fund management accounts for less than 5% of the daily exchange-traded volume. And almost all of the trading in ETFs simply transfers ETF share ownership from one investor to another. Only about 10% of ETF trades cause buying and selling in the underlying securities that make up the funds. Finally, while some claim that index fund investors will rush to sell in the next downturn, exacerbating it, the opposite happened in 2000–2002 and 2008–2009. Investors sought out index funds, adding significantly to their holdings. It's not clear to me why the next downturn would see them behave much differently.
What do you think about crypto currencies like Bitcoin?
Greg Davis: We're not fans of Bitcoin and see it as a speculative bubble. We are very interested in blockchain, the technology that underlies the electronic currency, and what it can do to increase our efficiency and that of the financial markets. For example, we've partnered with benchmark provider CRSP and Symbiont, a blockchain firm, to automate intraday index data transmission through a blockchain network. That will increase transparency and decrease the risk of disruptions sometimes caused by manual processes. In turn, this will make capital markets cheaper, faster and more accurate for investors.
You've been Vanguard's CIO for about 18 months. If there were only one message you could share with clients and prospective clients, what would it be?
Greg Davis: That we're more than an indexing and low-cost leader. We've historically delivered successful actively managed funds as well. We're also determined to help investors everywhere – whether they're investing for themselves, their families, or institutions, directly or through financial advisers or consultants – make the best possible decisions. Our ability to do much more than index and deliver low costs is a natural outgrowth of our corporate stability and our client focus. Ultimately it reflects our mission – to take a stand for all investors, to treat them fairly and to give them the best chance for success. We're serious about it.
1 Ten-year period is 2019–2028. Source: Vanguard Economic and Market Outlook for 2019.
2 For additional information, see Vanguard's Global Macro Matters paper Here Today, Gone Tomorrow: The Impact of Economic Surprises on Asset Returns (2018).
3 For additional information, see Vanguard's Global Macro Matters paper Rising Rates, Flatter Curve: This Time Isn't Different, It Just May Take Longer (2018).
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