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Vanguard's economic and market outlook 2018

22 November 2017 | Webinars

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The equity rally has been punching higher for nearly nine years. Do the fundamentals still support positive markets? Or will the mounting risks trigger a correction?

Joseph Davis is chief economist and head of investment strategy group for Vanguard, and Peter Westaway is chief economist and head of investment strategy for Vanguard Europe.

Leo Schulz, senior investment writer, speaks to Joe and Peter about Vanguard's economic and market outlook for 2018 and beyond.

This is an edited transcript of their conversation.

Leo Schulz: Rising risks to the status quo. For most investors, 2017 has been a pretty good year. The FTSE All Share is up over 13% in sterling over the past twelve months, the MSCI World Index is up 24%, emerging markets are up more than a third, those last figures both in US dollars. Bonds meanwhile have been broadly neutral. What's coming next, what are the risks to the status quo?

My name is Leo Schulz. I am extremely pleased to have with me today chief economist and head of investment strategy at Vanguard, Dr Joseph Davis, calling in live from Malvern in the US, and Dr Peter Westaway, chief economist and head of investment strategy here at Vanguard Europe. A very warm welcome to you both. If anybody on the line would like to ask questions to Joe or Peter, you should now be seeing a box in which you can type those questions and we'll pick them up as we go through the discussion.

The call will last roughly half an hour. As for the agenda for today, we'll look at the normalisation of policy, at the inflation paradox, investment returns, and then the major risks currently facing investors. So let's get started, Joe, let me start with you. Rising risks to the status quo is the title that you've given to Vanguard's 2018 economic and market outlook. Joe, in your view, in your words, could you describe to us what is the status quo?

Joe Davis: Thanks, Leo, and thanks everyone for calling in. The status quo is effectively the current trends we've witnessed in the global economy, not just since the global financial crisis, but potentially in place before the global financial crisis, [and the expectation] that they will continue to persist.

And for many reasons, that would seem reasonable, when we talk about the status quo, that it would be an environment where the global expansion continues, but the level of economic growth and the rate of economic growth would remain subdued.

So lower growth rates that we've all become accustomed to in Europe, in China, in the United States, that they would persist and then finally that in part because of that, inflation trends would remain stubbornly low.

And for a number of years, Vanguard has talked about these so-called secular forces that are driving lower expected economic growth and inflation, whether it be poor demographic patterns, somewhat sluggish productivity, a weak demand with respect of fiscal retrenchment, and supply forces with respect to the lack of credit, the vigour or credit expansion that we may have seen before the global financial crisis.

All of these we've talked about for several years, and it's only now I think they're becoming much more commonly accepted by certainly the economics community, the investment community at large. In fact, because they've been so commonly accepted, that is one of the reasons why we point to a risk of the status quo, because there's very little, in our mind, very little appreciation for some cyclical risks that are emerging now that the global expansion continues to age and continues at a fairly decent pace.

So the status quo is more of the same, but I think that we view that the risks, in particular that the financial markets are associating these long running trends - which should remain persistent - with the cyclical outlook for 2018, and we're pointing out to our readers, that those two may not equate next year.

Leo Schulz: And Peter, so those pointing to fairly subdued conditions, which have pertained since the financial crisis, what's the picture from a European perspective?

Peter Westaway: Well I think for both the UK and the euro area, they fit into that broad narrative, but of course there are some very important changes relative to the previous status quo for the UK. We're about to leave the European Union, or almost certain to, so how that plays out is casting enormous uncertainty in markets at the moment.

And then as far as Europe's concerned, or the euro area, political uncertainty has been the order of the day for the last few years, and if anything, things are looking a little bit more optimistic on that front. And so if anything we're a little bit more positive about Europe at the moment.

Leo Schulz: Joe, you talk about these relatively subdued conditions, but of course monetary policy, particularly in the US is tightening, QE is being wound down, rates are rising, what's your view on US interest rates, Joe?

Joe Davis: Well I think it matters on what part of the bond market we look at, you know. I am proud of the work we've done at Vanguard for the past several years, you know, going into even last year or earlier this year, we thought the Federal Reserve, it would be appropriate to raise rates, not because growth would accelerate, but rather the labour market would continue to tighten.

And the unemployment rate in the United States is near 4% and below any economist's estimate of what full employment is, or at least close to it, and we thought that they would begin tapering sooner than expected. I place that in context because we continue to feel, and if anything, have raised our expectations for Federal Reserve monetary tightening next year.

The US Treasury bond market expects at best two tightenings in 2018 following a rise in rates by the Fed in December, this month, which is all but certain. And we think again in part because of these rising risks to the status quo, we may see a cyclical, or have seen a cyclical low in inflation.

The unemployment rate in the United States will drop well below 4% likely this year, and so it would be appropriate for the Federal Reserve to be a little bit more aggressive in normalising policy. That may not lead to a market rise in long-term US interest rates, which if you look at say a benchmark ten-year Treasury yield in the United States, the yield is roughly 2.4% and we don't see a material change in long-term US interest rates for the foreseeable future.

I think we would need to see much more pronounced inflationary pressures, not just in the United States, but in Europe, in China. And we would need to see even a stronger cyclical resurgence in global growth as well as more aggressive monetary policy out of other parts of the world.

Again beyond the Federal Reserve, I think to see a marked rise in long-term interest rates, so certainly not our base case, but I think it's an environment where the biggest risk for the financial markets is the Federal Reserve is emboldened with a lower unemployment rate and a modest balance in inflation and wages to tighten and normalise policy a little bit more aggressively than the bond market expects.

Leo Schulz: When you say US unemployment falling below 4% this year Joe, I'm thinking you mean next year?

Joe Davis: Oh certainly next year, and it's 4.1% as we speak and for the first time since 1999, there are as many job openings in the United States this morning as there are unemployed Americans. So by almost any metric, the US labour market is fairly tight, and I think that's, our counsel to investors is that, and policymakers, I think there's a little too much focus on economic growth rates, say GDP, and a little bit more attention should be placed at this point in the business cycle, to unemployment rates, so roughly 80% of the world economy is at full employment by our calculations.

Leo Schulz: We'll come back to that in just a moment, but before we discuss that in a little bit more detail, Peter, the normalisation, the trend towards normalisation here in Europe...

Peter Westaway: Well even though we've just been talking about synchronised growth across the globe, it's less the case that the interest rate cycles are synchronised because the Fed continue to be probably a couple of years ahead of certainly Europe in their rate tightening.

So for the euro area, they are continuing to provide policy stimulus, they're buying more government bonds, albeit at a slower pace before, they've tapered their purchases from 60 billion euros a month down to 30 starting in January. That's expected to go on until September.

And as far as a rate hike's concerned, we're not really expecting anything like that until the middle of 2019 at the earliest, so really a very different situation in Europe. As far as the UK is concerned, that's a little bit more tricky to read because of course back in November, the Bank of England reversed their emergency rate cut, so they took interest rates back to 0.5%, which is where it was immediately before the UK referendum result.

But where interest rates go from now very much depends on how the Brexit negotiations play out and what's priced into markets currently, and we can see this on the chart that's up on the screen, is that really very gentle rate hikes probably two interest rate increases over the next two to three years, so really investors shouldn't be taking fright at the prospect of sudden high interest rates.

Of course that's only the average probability if the Brexit negotiations turned out very good. If suddenly expectations of growth picked up, then we could have faster rates, but I still think the main message is rates are going to be gradually rising.

Leo Schulz: Peter, if we could just stick with you for a moment, just as Joe was mentioning the employment or the unemployment conditions in the US at 4.1% unemployment, so the first I think one of the lowest rates since 1999, but in the UK we have one of the lowest unemployment rates since Harold Wilson was the prime minister in 1975. So really at a really cyclical low, and yet we're not seeing, is this having the effect that you would expect it to have?

Peter Westaway: No, I think it's fair to say that economists are a little bit puzzled about the way inflation is behaving here in the UK, but more globally, more broadly than that. I mean typically when unemployment falls or high GDP growth erodes their capacity, you would expect inflationary pressures to emerge, and wage inflation in particular to pick up.

And that relationship is often referred to as the Phillips curve, but what we've been seeing is despite these historically low unemployment rates, inflation has been generally very subdued. And some commentators have even talked about the death of the Phillips curve.

So for example if you look at the chart here, with the title the ‘low inflation puzzle', we can see UK unemployment the green line falling very sharply from its peak in 2012, so it's now around, just hovering above 4%.

And yet since 2015, we've had wage growth pretty much staying stable at around 2%, around the target, and that's really the puzzle. Now going back to our risk to the status quo, I think we would be being complacent if we thought that was always going to be the case, but there are a lot of economists scratching their heads about why it is that this relationship is so subdued.

Leo Schulz: So Joe, I don't know if you're scratching your head or not, but why do you think that relationship is as subdued as it is?

Joe Davis: Well you know, to Peter's point, there's been both head scratching as well as a lot of data crunching by the economist community over the past several years to explain this so-called puzzle. There is some strong evidence that there are a number of forces that explain patterns in inflation, perhaps not month-to-month or year-to-year, but certainly over a three or five year period, so-called trend inflation.

This would include not just the state of the business cycle in any local economy, so the unemployment rate in the UK or the United States, but the global conditions. And so globalisation, I think it's at the margin, led to somewhat lower inflation with the rise of China, so certainly, there's some evidence of that 1990s.

There's also the fact that commodity prices have, until very recently, have been in the doldrums globally, and so that has some flow-through effect to other measures of prices, and so that's set the precedent on inflation.

And then finally something that at Vanguard we've been able to document, that at least for some time, it may not be permanent, but there's an under-appreciated drag from the growing use of technology - think of computer and digital technology - on the prices that companies need to charge because computer chips and all of their cousins have lowered the production costs of firms.

And so I think when you put all of this together, you know, we've had a theme for several years that central banks by and large, would tend to struggle a bit in generating 2% inflation. Now again in the long run I think Peter and I and other economists would argue that a central bank in the very long run, if it's credible, can achieve any inflation target it wishes, and then it's a matter of calibration with respect to quantitative easing or interest rate cuts or hikes.

So again we do not believe that should unemployment rates continue to fall, that we will not have some point have some modest wage pressures. The laws of supply and demand at least in my mind, have not been eradicated from the labour market, but it has been a little bit more delayed than we would have thought two or three years ago in this context of lower trend inflation in general.

I mean to see a market rise in inflation globally I think it's a little bit tougher today than would have been the case say a generation ago, in part because a stable inflation expectation, at least for the time being the increased use of technology in the global economy.

Leo Schulz: What about the changes in the nature of employment, Joe? I was just looking this morning at some data around the US employment market. I think there's going to be maybe two million jobs will have been created in the US this year by the time we get to the end of this month and I think that's been the pattern now since 2011 - very little growth in wages.

Joe Davis: Yeah I mean we've documented there's a two-fold increase, it is one of these paradoxes: we have full employment yet low growth. We have what I would characterise globally technological disruption, and yet you have an environment where you haven't seen wage growth despite anecdotal reports of skilled labour shortages.

I think you can square all of these paradoxes by recognising that there are some structural impediments meaning I think we're going to have an environment of low unemployment rates in certain sectors, and yet rising measures of quite frankly income inequality in other components, given just the nature of what jobs are being demanded in the global economy at this time, and demands continue.

So I think, you know, when you look at, there's also a factor that is likely depressing average wage statistics, certainly in the United States, and that is the tendency over the last several years, given demographics, of younger workers entering the workforce just as older workers are starting to retire. And the average wage bill or salary of older workers tends to be roughly twice as high as younger workers, which makes a lot of sense given experience.

And so that, if you're somehow able to control for that, which you can, it would suggest that wages are starting to rise for the same person over the course of their career relative to two or three years ago, but it may take a little bit longer to see more significant wage pressures in the United States.

In our mind when you have the unemployment rate, which I mentioned, 4.1% today, when it starts to drop into the high to mid 3% level, we believe that in 2018, the so-called Phillips curve that Peter was referring to, this trade-off between wage rates and unemployment rates, that will start to re-emerge in 2018 if we're correct in the United States, which for several years has been in hibernation, for lack of a better term.

Leo Schulz: We just had a question asking whether we should be concerned that the link has broken, and I wonder Peter just in a very few words before we move on, if you can tell us has the reports of the death of the Phillips curve, have they been exaggerated?

Peter Westaway: I think they have been exaggerated for many of the reasons that Joe has just gone through. We can kind of explain why the relationship's less than it has been, but to repeat what Joe said, I don't think the laws of labour markets can suddenly be suspended.

It's still the case that as pressure in the labour market picks up, wage demands will become stronger, now in a world where labour was organised, there was much more trade union activity, our trade union membership then, that wage pressure can translate into wage increases much more readily.

Now in a world of Uberisation of labour markets, people working for themselves, self-employed, that channel is much less powerful, but it's still going to be there and so I think in the end, a combination of central banks drew a line on that traditional channel, plus sticking with a message that they will do whatever they need to, to get inflation to target, I think that's important.

But I think it's worrying if we start saying central banks have got no idea what they're doing, something else should be responsible for it, it's central banks' role.

Leo Schulz: Just before we go onto the next item, which is looking at investment returns, which in many ways sort of brings the conversation into focus, but just before we do that, Joe, could I trouble you for a few words on US tax reform, which is something which is current in the headlines this morning?

Joe Davis: Yes I mean, full disclosure, I was fairly sceptical that we would see tax reform at least in 2017, I know there were high hopes at this time last year with the presidential election results and President Trump winning the presidential office. I can tell you we are not assuming a substantial impact on the US economy given what looks likely the most likely outcome of the tax reform package.

I think from the corporate tax side, the lower rate, it's simplification of the structure, could lead to a modest uptake in capex or business investment, although I can give in this stage of the business cycle, we're going to see that anyway given the current labour market, which we talk about in our outlook.

But I think the economic impact that some hope we will see, I don't think it will translate into an economic growth environment. I think the financial markets have already discounted or are discounting significant acceleration.

So despite the fact that perhaps the risk to our economic outlook is at the margin, it could be a little bit better than expected, ironically at least for the US stock market, the risk again at the margin could be a little bit weaker than expected returns, in part because of some of the scenarios and anticipated benefit that the financial markets are trying to work through and anticipate.

And again we don't see it as a game-changer in terms of the cyclical outlook for the US economy, I don't think it will. It won't in any way undermine economic growth, but I think it would be at least in our mind it would be too aggressive to anticipate any significant acceleration in growth at least from the current house incentive packages of the corporate tax reforms.

Leo Schulz: So a bit of a note of caution there, Peter, just on fiscal policy, there's been some pressure in the UK on the Chancellor of the Exchequer, Philip Hammond, to draw back from austerity, is there a trend here towards a more accommodative fiscal policy?

Peter Westaway: I think there's an element of realism that's necessarily being introduced into fiscal policy in the UK, which is that the extreme fiscal austerity that was previously being planned simply wasn't feasible given the shock to the UK economy that Brexit has represented.

And indeed some type of mild loosening fiscal policy is probably warranted. So I think here the government haven't abandoned their desired aim of bringing down debt to GDP ratios, but they're being much more pragmatic about how quickly they'll do it, probably not until the mid-2020s will they get to a point where the deficit is down to zero, something that they were originally saying they wanted to do in 2015.

Leo Schulz: If we can sort of get back on topic and start to look at investment returns, Peter, could you just actually explain to us what it is we're looking at with this chart?

Peter Westaway: So this chart is known as a box whisker plot, and what it is designed to do, is give us an estimate of what expected asset returns are going to be over the next ten years. But we don't like to give our estimates in terms of point estimate, what we try to do is convey the uncertainty of those annualised returns over the next ten years.

So what we've got here is returns on UK bonds, global bonds excluding the UK, UK bonds, unhedged equities in the first instance. The area between the green and the blue, so the middle of those boxes – that's what our medium expected return is for each of those asset classes.

And then all of the lines are there to convey the uncertainty around that medium expectation. So the size of the box up and down gives 50% of our probability estimates, and then the long lines show us where the 5th to 95th percentile is, so it gives us a whole range of possible outcomes.

And in big picture terms, what comes out from that chart very clearly before we get to the detail, is that equity returns in general are much more uncertain than what we might expect from fixed income returns.

Leo Schulz: I thought the diamonds are showing the backward looking mean return.

Peter Westaway: That's right, so what that shows us is that historical average return that we actually enjoy from those different asset classes for a period from 1980 to 2016.

Leo Schulz: Joe, the returns that we're looking at on the chart are in sterling, does that roughly the same picture in dollars?

Joe Davis: Yeah unfortunately you get the same sort of picture wherever you sit in the world. I would also say to Peter's point that you know, one thing that we're very proud of is that our approach is fairly unique in the industry in terms of conveying an outlook and a probabilistic setting in a range of expected returns.

I think anyone who anticipates or provides an outlook in financial market returns has always had uncertainty in their head, and has a range of outcomes. We are just very explicit in our outlooks and we are saying two things. One is that initial conditions matter, whether it's a valuation of the stock market or the level of interest rates and risk premiums, to influence the size of those rectangles on the page.

But we also provide, we actually disclose what those ranges are and I think that's a more appropriate way to think about an outlook - to convey both the uncertainty, but also the relative confidence of various asset classes and expected returns.

And I can tell you that both the United States, across Europe and even in parts of Asia, our outlook since 2009, every year it went from a very, fairly bullish outlook on the long-term expected return perspective, and every year it's become slightly less optimistic and I'd say now more cautious certainly relative to history, in part because of the strong performance we have had, as well as just the low level of interest rates, inflation and the high level of valuations in some parts of the world, particularly in the United States. All of those are contributing to lower expected returns, in our minds, or at least the likelihood of that occurring over the next several years.

Leo Schulz: Peter, I think we're really interested to hear from you about UK returns, so particularly what we're seeing in that chart, but just one question that's on my mind that you might just bear in mind as you answer the question is returns have been pretty good this past twelve months or even these past several years, so I'm curious as to why we've had such a good time given the subdued conditions, and yet why your projections going forward are as low as they are?

Peter Westaway: Let me answer that part of your question first. I'd say there were two main reasons why we've had very strong returns. First, you can't get away from the fact that over the last six years or so, asset markets have been recovering from the huge falls that were experienced after the financial crisis, so there's been an element of catch-up associated with that.

But we've probably done most of that catching up by now and we've probably gone beyond catching up to actually moving forwards. And the second reason is that to an extent, market valuations around the world, certainly here in the UK, have definitely been buoyed up by very low interest rates and by the pressures of quantitative easing.

And remember, these were policies that were deliberately put in place by central banks to try and boost asset prices, to try and get people feeling more optimistic so that they would spend more, so that the economy would stay stimulated.

So in a way we're now going to be reaping the seeds that we sowed, as Joe said, we almost borrowed for the future and we're going to have to pay that back.

So if we look at this chart and go into more detail, I think the really striking result here is if you look at the two left-hand elements, which relate to bonds, both the UK and global bonds equity space, and what they show is that the expected inflation adjusted return on average is going to be zero, or 2% in nominal returns.

And that clearly compares to something like 5% real returns, 7% nominal returns over the past, so a really striking decline in returns on fixed income.

Turning to equities, clearly as we might expect, equities have stronger returns, we have an equity risk premium associated with that asset class, but even there the median expected return for UK equities and global equities, they are pretty similar, is around 2.5/3%, so probably 5% in nominal returns.

And that compares to something like 8/9% nominal returns in the past. So we have these very sharp changes compared to the past, and I said there were two main reasons for that, one is that as we've been discussing, valuations are very stretched, interest rates are very low for a start, so that's going to cause returns to be lower, but just genuinely assets have got a bit over-inflated.

But then second, and this is an important point too, even when asset valuations adjust themselves, in the long run we think that the underlying rate of return on financial assets, the real interest rate, is going to be lower than it has been in the past. And that's fundamentally because we think the global growth is going to be lower than it has been in the past, and that underpins all asset prices.

And unfortunately, very difficult for investors to avoid that, that asset return environment we now live in.

Leo Schulz: I should just point out that the returns that we're looking at here are obviously simulations of a ten-year annualised real returns as of September 2017, in this case in sterling, and these are not actual results, they are a forecast.

We are running over time, but what I would like to do is just quickly run through the major risks that we're currently facing, and again going back to our previous point, what we can see here from the FTSE All World Total Return Index, equity investors and indeed bond investors have been fairly well rewarded since the financial crisis, just if I could just again start with you, Peter, what would you see as in a few words, what are some of the key risks coming out of the UK and the European Union?

Peter Westaway: So for the UK, very obvious, it's Brexit, the trouble with Brexit is we still don't know how it's going to play out. We're talking about probabilities associated with either a no-deal Brexit, a hard Brexit, a soft Brexit, or even no Brexit at all, we think all of those four possibilities are still on the table. We think the most likely is either a hard Brexit or a no-deal Brexit, probably around 70% for that.

Whichever of those turns out, that's going to have very different implications for asset markets and the economy. On Europe, I think things are looking a little bit brighter than they have done in the past, this time last year there were a lot of political elections, political risks that could have turned out very badly, not least the French election, but in the event we got the election of a very pro-European radical new President Macron, and so if anything we think the risks to growth in Europe at the moment are on the upside rather than the downside.

Leo Schulz: Joe, just in a few words, what would be the two key risks that you might be looking at, at the present time from where you are?

Joe Davis: Well I think outside of a true low probability event potentially, but high impact with respect to North Korea and overarching geopolitical conflict, I think the two risks in our mind - one on the negative side would be the Chinese economy, not heading for a hard landing, we think those risks are still low, but a softness in economic activity first half of the year given their restrictive policies to date, I think we will see some of that.

We don't think it will get worse, it would be more contained, secondly would be the risks we talk about, the central tendency and Peter echoed it with respect to Europe, it would be a modest bounce in inflation, in part driven by higher labour markets, or tightening labour markets globally, so that's the most likely risk to the status quo view in our mind, it's something where we think the risks are rising at a higher than are currently reflected in the market.

It would be good news for the global economy, but we may just see a little bounce in volatility into markets, until markets would become a little bit more accustomed to it.

Leo Schulz: The status quo remains generally positive, though conditions are relatively subdued, labour markets are tightening but not yet pushing inflation out of any kind of control that central banks might have a hold on. How things will turn out in 2018 is still in the balance, but longer term investors are likely going to need to accept lower overall returns.

We had a number of questions, which unfortunately we don't have time to cover, but we will get back to those people individually. Should you care for a copy of the 2018 Vanguard economic and market outlook, please contact your usual representative, and equally if you would like a copy of the slides that have been used in today's webinar, contact your representative.

In the meantime there's a summary of the economic and market outlook on our website and a number of short video interviews with Peter and with our senior economist Alexis Gray, will also be available on our website as of next week.

I'll be back on January 16 when my guest will be Neil Cowell, head of UK intermediary sales, and again at 2pm, and our topic will be client engagement for financial advisers. Until then, our thanks to Joe Davis and Peter Westaway, and from everyone here at Vanguard, a very merry time to those celebrating Christmas, and to everyone else, a wonderful holiday. Thank you.

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Vanguard economic and market outlook for 2018 and beyond

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