Webcast replay—Economy at a crossroads: What’s next?

Liz Muirhead: Hello, I’m Liz Muirhead from Vanguard’s Portfolio Solutions Team. Today I’m live from Vanguard Studio in beautiful Valley Forge, Pennsylvania. I’m delighted to be sitting down with Vanguard’s Global Chief Economist and Head of our Investment Strategy Group, Joe Davis, and our Global Head of Fixed Income, Sara Devereux. Joe, Sara, welcome.

 

Sara Devereux: Thanks.

 

Joe Davis: Thank you.

 

Sara Devereux: How are you?

 

Liz Muirhead: Great. Thank you.

We’ve asked these two experts to join us following the Fed’s much anticipated meeting that wrapped up yesterday. Joe and Sara are perfectly positioned to help us understand what the rate hike means for the economy and markets moving forward. Joe’s Investment Strategy Group serves as our in-house think tank and produces industry-leading research that shapes our viewpoints here at Vanguard, and Sara leads our deep and credentialed team of fixed income experts all around the globe.

Now, a few housekeeping items before we get started. First, many of you submitted questions during registration and we shaped today’s agenda based on your input.

Please submit additional questions during the broadcast and we’ll aim to address as many as time permits.

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Finally, be sure to check out the Resources icon on your screen for additional content. Now, let’s get down to it.

 

Joe Davis: She’s looking at me first.

 

Liz Muirhead: I am. Joe, we’re going to start with you. Back in January, the two of you spoke to our audience and you talked about inflation being projected to come down this year as supply-related constraints eased. But you also cautioned us that the demand side was going to be stickier. So, are we still on track for that 3% target you talked about at the end of the year, and how do we get there?

 

Joe Davis: I think so, Liz. I mean, obviously, we’ve had a deceleration in inflation. That 3% measure that you mentioned, that would certainly be true. We’re at 3% today for the CPI, but the core, what so-called economists call the core, excluding food and energy, is still higher than that. We’re closer to 4.5%, 5% range; and so still there’s a way to go. You heard Chairman Powell talk about that yesterday despite the important progress.

So, that’s been our thesis. You know, two of our primary theses of our annual outlook at the beginning of the year—and Sara and I talk about this a lot with her team—is one was inflation. The more it came down, that would be positive, but it would require some regressive Fed action. We’ve seen that second part too, and so now we have the Federal Reserve roughly 5.5%. So, only now are they starting to get above the rate of that trend inflation I mentioned.

So that should suggest two things. One is inflation will continue to come down but that the Federal Reserve will have to remain there for some time, which I think the market’s increasingly coming to that sort of view because of some of the stickiness in the labor market.

 

Liz Muirhead: Digging in on the labor market, you’ve talked about how tight the labor market is. Can you dive deeper into why that actually challenges inflation, and how has low employment played a role in the stickiness there?

 

Joe Davis: Sure, and, again, for workers, we want higher wage growth. That’s very positive for the economy and one of the reasons why the economy still has held up pretty well. But ultimately when you have strong wage pressures, all else equal, unless companies are going to reduce profit margins, they will try to pass on prices. And again, that depends; that doesn’t always happen.

You know, the run-up inflation we’ve had and some of the cooling down, that has not been driven solely by the labor market. Liz, you mentioned that it was supply chain; but we certainly diagnosed that a component of the inflation’s rise over the past year was wage, labor force-related, which some disagree. Increasingly, evidence is on our side.

And so what that says is two things. One is you’re going to very likely have to see continued cooling in the labor market if the Federal Reserve is going to ultimately hit their 2% target over the next 2 or 3 years. In fact, not just our research, others that are coming out since our research are starting to find similar projections that it may take two years to get inflation down to target.

Now again, it remains to be seen, but that says that it’s been good for growth; but it means that, you know, this notion that the Federal Reserve was going to be cutting rates any time soon, we certainly didn’t see high odds of that. In fact, now that’s, I think, increasingly very low odds.

 

Liz Muirhead: Sara, that dovetails into something I remember you saying back in January. You talked about the Fed needing to do a “hawkish hold.” So, you know, I think with everything we’ve seen so far this year, the resilience of the economy and after yesterday’s meeting, do you feel like now is the point where the Fed starts that hawkish hold, or is there more work left on the table?

 

Sara Devereux: So coming into 2023, the team had that view, right, that the Fed was going to slow the pace of hikes and would eventually reach a peak terminal rate of, I think we were at 5%.

 

Joe Davis: Yes, I think about 5%.

 

Sara Devereux: Then they would go into what we were calling hawkish hold. The hawkish hold meaning they were going to stay there, and they weren’t going to cut rates. That market was pricing cuts in the back-half of the year. We did not believe that would happen.

In addition, we kind of acknowledged there might be some risk to the upside if the economy was more resilient that they would need to do more. And that’s really what’s happened. The economy has shown more resilience than we expected, despite the bank stresses, despite the debt ceiling volatility. Right? So it’s taking a little bit more to cool things off. We’re now at, you know, the Fed went to 5.25, 5.50 yesterday. We think maybe 50/50 chance they go one more time this year. Then we will be at that hawkish hold. Again, I will reiterate the hawkish hold means we don’t think they’re going to cut rates anytime soon. We do not think they’re going to cut in the first half of next year.

Right, the market is pricing a cut. We don’t think that will happen, and we remain aware of a bias to the upside, that the economy still could have some steam, and the Fed may have more work to do.

So on that front, we’re staying really close to Joe and his team on what’s inflation going to do and what’s happening in the labor market.

 

Liz Muirhead: So, we may have ventured into restrictive territory recently, but the Fed’s work isn’t done. Joe, I’m going to take it back to you. I’ve heard you talk about how critical it is to be in restrictive territory to curb inflation and there’s been some debate about whether we were there earlier this year. How would you rate the Fed on that, and what are some of the factors, including your thoughts on the neutral rate that influence your view?

 

Joe Davis: Well, I think it’s certainly been a passing grade. I mean if you think just this time last year, you know, Fed had very low interest rates; and we had very generational high inflation. So to their credit, you know, some will criticize with the benefit of hindsight that they moved too late. I may have been one of those individuals at some point, full disclosure. But, nevertheless, central banking’s a really tough job, and they have moved very aggressively.

That said, you know, we continue to be of the mind that they are now restrictive, but only modestly so. And in fact, I think there’s really, there [are] three possibilities over the next 6 to 12 months because this gets to, Sara, your point. The economy’s been, certainly from our projections, on the higher end of this range. Right, growth has been stronger than expected.

There’s one of three reasons what may happen in the next 12 months. One is there [are] lags to the restrictiveness; and so we’re ultimately going to see a material slowdown, you know, a recession. Secondly is the Fed’s not that restrictive at all, and that’s where some of our research has shown that there probably is a somewhat higher, modestly higher mutual rate. But, we still acknowledge it’s part the lags. As the Federal Reserve move, there’s usually 12 to 18 months before you see a correction. And there’s a third possibility, and this is where some that are in the soft landing camp—I would actually call it the no landing camp are—and that is interest rates really don’t have any impact on the economy at all.

Now, that is potentially possible if you had offsets. So I’m being a little critical of the no landing camp, but it is possible you could have no slowdown at all. It, effectively, would have to be good luck on supply side. There’s government spending that’s been underestimated from some of the green energy buildout and so you get these offsets of service sector still elevated, manufacturing slowdown. You get this rolling sort of slowness.

So when you put all that together, Liz, I would say, listen, those first two reasons, which fully accord with history, would suggest that we have some weakness ahead. But, the Fed has not been restrictive enough for long enough to anticipate a material slowdown as we speak right now. But [that’s] why we’re also skeptical that we can have inflation come all the way down to 2% and stay there without any weakening in the labor market. It’s possible, but it would go against both theory and 100 years of market experience.

 

Liz Muirhead: That’s pretty compelling. So if I understand you correctly, it sounds like one reason that the economy may not have cooled as quickly as you had anticipated is because of this concept of a higher neutral rate and that it really is going to take a few years, perhaps, to get through that last mile, as I’ve heard you describe it, of inflation all the way down to that 2% target.

 

Joe Davis: Yes, and we updated just for—one, it’s a public service; and plus, we also have to know some sense. You know, neutral rate, this concept, it’s kind of like what the natural speed limit is. It’s the equivalent of, like, full employment. No one knows, ourselves included, what exactly that number is, but you think of it as a range.

And Sara, we talk about it with our team, it’s just more of a signpost, and that’s not the only signpost you look at. You can look at the fed funds rate relative to the rate of inflation. I think that’s an easier measure, something you don’t have to estimate, a model to detect.

But this other neutral rate concept, it’s important for no other reason than central banks use it as a barometer as well. So we updated the Federal Reserve’s own, you know, important methodology, which has been influential. And that analysis was updated several months ago. We updated it, in part, as a public service too, because that research shows that although there’s still this range to whatever this number is, it’s around, roughly 100 basis points higher than what it was before COVID, which means neutral is not in the low 2% range, which some in the Federal Reserve still believe it is. So it’s higher. It’s perhaps in the 3.5%.

Now the Federal Reserve, you just mentioned, they also, they’re 5.5%. So they’re definitely above that, but it’s not as wide as some think. But again, that’s only one of a number of inputs that we’ll look at. But it’s, I think, part of the reason why the slowdown hasn’t been as apparent. I think the more compelling one, though, is that they just haven’t been restrictive long enough coming out of a very deep shock and the rebound to the service economy, which has been tough to really pinpoint.

 

Liz Muirhead: No, that makes a ton of sense. And, you know, I think forecasting is always a challenging role to do. Your team is focused on trying to come up with what you think is the most likely outcome. But, Sara, your team actually has to allocate risks—

 

Sara Devereux: Yes.

 

Liz Muirhead: —in the portfolio around forecasts. So what is the range of outcomes that your team is assessing? Where do you see the risks to the upside and the downside, and what keeps your portfolio management team awake at night?

 

Sara Devereux: Oh, sure. Well, I would say, first of all, starting with the base case, we do think that the Fed has likely done enough, right, and enough to put us through what we would call a shallow recession, just enough to cool off the labor market and cool off inflation. So that’s our base case. But the risks do remain to the upside and that the Fed would need to do more.

Now, what does “more” mean? Right, more can mean holding at this restrictive level for longer. To Joe’s point, it might just take a little bit longer now that we are in restrictive territory, or it might mean that they have to resume hiking. So the Fed’s in a really tough spot, right, because long and variable lags, we’re focused on the labor market. That is a lagging indicator. It’s one of the last things to turn, and when it turns, it can turn quickly.

So that is at the heart of our shallow recession call. Like that’s a tough needle to thread for the Fed, so that brings me to what we think [is] the downside risk, which is that the Fed overshoots. Right, and that they drive us into a deeper recession. That’s one.

The second thing we talk about a lot is financial stability. You know, they moved rates a lot very quickly. We saw it with the bank stress. We saw it with the U.K. pensions. We’re always keeping our eyes open for potential financial instability. We’re also looking at other excesses that may have been created in the marketplace and the economy when rates were near zero. For example, private credit. For example, commercial real estate. These are pockets that we are keeping a very close eye on that could pose risks.

And, finally, geopolitical risk. We talk about it all the time. It remains front and center. So none of these risks that I’m highlighting are in our base case or we think they are going to happen necessarily. But when we’re constructing portfolios, we look at both the upside risk and the downside risk.

 

Joe Davis: I would just add, you know, just that it’s a privilege working with Sara and her leadership team. We update these probabilities as a group so you don’t get, you try not to get group think. So, you know, my economics team, it’s an input to the Senior Portfolio Management Team. But there [are] other things. Even if you have the right forecast, it may be priced by the market, Liz. It may not be. So we’re trying to look at the range of outcomes relative to the market’s implied range of outcomes. And when there’s a disconnect, that’s when the opportunities present themselves or to avoid risks. It’s a privilege to work.

But just so you know, it’s not just the base case as much as assessing, you know, where’s that distribution of risks? It’s always a fluid conversation that we have, but we try to remain disciplined to the framework and the analytical framework, but then applying judgment when you think that the historical record is not capturing everything that may be going on in the present cycle.

 

Liz Muirhead: Well, and it sounds like that collaboration is really beneficial for both teams, both in terms of the Portfolio Management Team and how you manage the portfolios and also the real-world feedback that you’re getting from that team on how they see the market digesting risks.

So, you know, Sara, let’s shift from the economy to the markets. Your mantra this year, and I’ve heard you say it a dozen times, is bonds are back. So can you explain what you mean and how should investors be thinking about incorporating bonds into their portfolios.

 

Sara Devereux: Sure, well, I’m pretty sure I’ve said it more than 12 times, a dozen times, but it has become my motto. But let me explain what I mean.

When I say, “Bonds are back,” I mean bonds are a really important part of a diversified portfolio. We went through over a decade where yields were near the zero lower bound. So some investors kind of gave up on the asset class or, you know, forgot about it, or moved away from it. So when I say bonds are back, it’s a call to action just to revisit bonds. If you haven’t looked at them in a while, look at them, consider putting them in your portfolio if you don’t have them in there now. 60/40 is back as well.

I’ll cite some reasons why they’re good to look at. One, valuations are attractive, and we’re seeing yields now that we haven’t seen in over a decade. Secondly, income. I say this too. The income is back in fixed income. That sounds really obvious because yields are higher, but what I’m talking about here is that income component of the cash flow. Clipping a healthy coupon really can stabilize and bolster your total rate of return because you don’t have to rely on price action. Prices don’t need to rally in bonds for you to have a good return. And the flip side is you have a cushion if prices sell off. You have a chip stack of that carry.

Then finally, diversification. Over the long term, bonds are a great diversifier to equities in your portfolio. But right now, yields are attractive, so you can get both good yield and that diversification benefit. So the bottom line is, what we’re saying is, you know, whether it’s ETFs or funds, index or active, consider putting bonds in your portfolio. That allocation decision is step number one.

Secondly, after step number one, step number two is which bonds to put in your portfolio. I’ll take a minute on that. In terms of portfolio strategy, you know, it depends on the individual investor, your risk tolerance, what else is in your portfolio, and your horizon. But, generally, what we’re looking at now is we believe that a recession may be on the horizon, right? And so typically bonds will rally, but not all bonds will rally. Deeper credit bonds can lag in that rally, so we have an up in quality tilt. For example, Treasuries, you had 4%, 5% yield in U.S. Treasuries last year. To get 4%, 5% yield, you had to go into high yield or private credit. So that’s a great starting point.

We also like other high quality spread products. We talk a lot about munis—very high quality, terrific fundamental value here. And agency mortgages—at this point in the cycle, they have convexity risk instead of credit risk, which means they could benefit from volatility declining.

Then when we go down into corporate credit, you know, we’re going to recommend a more selective approach. Right, you know, you don’t want to own every company when you’re going through a recession. Some will do better than others. You want to make sure you’re picking the right names to weather the storm. We say this a lot, that avoiding the losers is going to be as important as picking the winners. There’s a lot of yield to be had, but, you know, you want to work with an active manager. Our active team, actually, is incredible. They have exceptional skill at security selection, and we like to do that. You know, we’re happy to do that on the investor’s behalf.

 

Liz Muirhead: So valuations, income, and diversification are the reasons that bonds are back.

Now I heard you talk about recession a few times in that conversation. Joe, I’m going to take this back to you. You know, one of the thoughts behind tilting higher quality and leveraging fixed income in a portfolio is that a recession is coming. It feels like we’ve been talking about that for so long, so what are your thoughts? Is the soft landing story still a viability? You were kind of criticizing the no landing camp, so when is this recession coming; and what should it look like?

 

Joe Davis: I have to see it as a fair question. We talked, you know, six months ago, as in my comments would be very similar. And again, I think some in the market make it as if—and I think it’s tough for us as investors because you hear this—it’s either a 0 or 1 variable. And it implies either. If I say yes to your question, recession. That’s really bad for the markets. But if I say no, that’s really good for the markets. And both history as well as current conditions would say, you know, I think we all know it’s not that simple.

So to answer your question, there [are] some nuances in the market, and I think they are important. And that is, you know, our forecast has not materially changed. We don’t have GDP growth, and even in the beginning of the year, we do not have GDP growth contracting over the full year or any 12-month horizon. That sounds like not a recession. Actually, we’ve had a number of mild recessions where our GDP growth actually never fell for the year. 2001’s a great example.

But the unemployment rate rose, and if it rises over a modest, small level, 30 or 40 basis points—you mean we have modest job losses—and, therefore, the definition of when a recession takes hold. And so that remains our baseline. There has to be some tradeoff of modest labor, weakening labor demand. We do not see, as Sara mentioned, any wholesale recession because I think when some say recession, it’s like really deep. I’m not here to sugarcoat a significant slowdown. But that is still the baseline scenario, because we believe there [are] both lags as well as there [are] some tradeoff of higher rates and slowing down of the economy.

We could be wrong, and there is this, sort of, no landing. It’s just that’s going to be really tough still to do because when we continue to crunch the numbers, they would have to get the labor market imbalance, meaning vacancies, unemployment rate. Let’s say that ratio is effectively 1:1. We’re at 1.5. We were at 2. We’re at 1.5, which is actually still, other than the late ‘90s and the ‘60s, that is still the highest on record. And so it’s coming down, but we’re still imbalanced. So we’ve never fallen from here down to 1 and just hovered there. And so we’re just trying to use that, those sort of frameworks to be able to say, “Is it possible?” Yes, but it would have to be offset by something else where you get a little good luck on the supply side. So we still have a recession as a baseline, but I would stress, and that’s not changing the recent market environment.

Sara and I, we’ve been talking about this year, even with this forecast, there’s going to be a narrative through the market, even if we’re right, that through the summer, which we’re living right now, the soft landing was going to get really whole. And the final thing I will say is, since we’re on this subject, you know, we say the soft landing, at least I hear it talked about in the market, is really a no landing scenario.

The Federal Reserve was on tape yesterday saying they have a soft landing scenario, and they don’t have a recession. Just, with all due respect, that’s incorrect because they have an unemployment rate rising 100 basis points; and we have never had, in over 100 years, a rise of even modestly 100 basis points and not had job losses.

So, I hope the Federal Reserve is right and we avoid the recession. It’s just to have that and not to have deterioration in the labor market would be completely unprecedented. So again, this could be the first time, and it is different, but I just think we’re playing the odds, which is why we still have certainly well above 50%. We’re going to have that roughly 0% growth for the time. Maybe we’re a little too early, and it’s a little bit later next year because of Sara’s, you know, long and variable lags, but it’s something we will continue to monitor and work with Sara’s team, because you don’t want to stick to a view if it is wrong. That’s why we’re very data driven.

These sentiment swings in the market, I think, you know, can be tough. You can be swayed by that, and so you don’t want to stick to a view just because you’re stubborn to change it. But at the same time, we want to be very analytical in our approach because what are the assumptions we’ve made? What is the framework with which we came by those assumptions and those probabilities?

And now let’s reevaluate. If the data keeps coming in higher or weaker than expected, we should update our probabilities. But if not, while we’re on this subject, Liz, one can get swayed to the recent string of data points. And you see that in the market. The market’s forward-looking, but it also can overreact. And so I think we’re in—

Now, which one is it right now? I think it’s the latter, but again, we’ve got to just be intellectually honest and not stick to a view just because that’s what it was at the beginning of the year. I’m just saying when we crunch the numbers, we’re still at that view. But, you know, if we are wrong, we better justify why we were wrong and what are the numbers that are now coming well higher than expected?

 

Liz Muirhead: So, it sounds like perhaps you were early in terms of the call for a recession. But the strength of the labor market makes you believe a recession is still coming, even if maybe it was not until 2024?

 

Joe Davis: Yes, we see a recession. We need to see a cooling in the labor market. I mean, I think our baseline of the mild recession that Sara researched—I’m not afraid of using the word recession, but I want to underscore, like, what does that really mean? Because at least for me, when I hear recession, I hear, “Oh, significant job losses.” I mean, I still have the shadows of Global Financial Crisis, which was really deep.

This recession, if it is right along our baseline, is actually companies in general not firing workers. They’re actually pausing on hiring. That’s how you get very modest negative job numbers. You start to have unemployment rise, but it doesn’t skyrocket up. You know, so I’m not here to pick on—I’m just trying to paint what would that feel like? I still think that is slower earnings growth, a pause on hiring. You’re still having—the equity market probably wouldn’t like it for a time. I would be shocked. So it’s not pleasant, but it’s also—we’re not calling for, we’re not this super pessimistic view on the U.S. economy.

 

Liz Muirhead: Well, and historically, one of the leading indicators of a recession has been an inverted yield curve, which we’ve had for, I think, more than year now. So, Sara, taking it back to you, in a situation with an inverted yield curve, we’ve seen a lot of investors kind of hanging out where the rates are the highest, on the short end of the curve. What would you tell those investors?

 

Sara Devereux: Well, first of all, cash is really attractive, right? It is. We’ve seen a lot of flows into our Federal Money Market Fund, for example, and it’s no surprise with a yield over 5%2 (as of July 26, 2023).

You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

It is a great option if you have a very short investment horizon.

However, there are risks to hanging out in cash if you have a longer-term horizon. First of all, you’re exposing yourself to reinvestment risk. Right, and secondly, you’re giving up those diversification benefits. You know, if you go out and have a little bit of duration in bonds rally, you’re basically giving up that benefit.

So, I can understand why it might be tempting to like wait for, you know, try and time it exactly. When is the Fed going to be done? But let me first say, it’s really hard. Joe and I can attest to the fact that it’s very hard to call exactly when the Fed’s going to be done. But also, even if they have a bit further to go, right, the bulk of the hiking is behind us. Going from 0 to 5 is a lot different than going from 5.5 to 6.0, for example.

And secondly, you know, bonds now have that income component, that is that cushion. If you get in a little early and prices go down, you clip some coupon that that will pad against that. So, we’d advocate for building those resilient portfolios, going out the curve a bit to get that durable yield so you can get, lock in the yield and also benefit from diversification should we go through a recession if bonds rally.

 

Joe Davis: Well, we have to think about the same things, but you have to think about it from a different perspective in terms of dry powder, right? You’re usually fully invested, but you’ve liquidity. I mean maybe, you know, advisors, institutions have the same thing but I think your question is beyond cash management. Like this is money that in, I’ll say, normal times—

 

Sara Devereux: Long-term money.

 

Joe Davis: —would be fully invested in some sort of long-term investment program.

But it’s more of—I mean I can feel it. I mean, as a personal investor, right, it’s like, well, markets seem pretty frothy on the equity side. We have, you know, high cash income. But I think, you know, the only thing I go, just for what it’s worth, when I go through my head as a personal investor is, “Okay, Joe, if I’m going to do that, what is my deployment strategy?” because it is timing. Because it usually doesn’t feel good when I actually want to do it. Like, so, what is, thinking a bit ahead of time, what conditions am I going to need to see to put that money to work? And I don’t know what they are, right, but I think that’s something investors will want to think about.

So, I saw the reverse of that. You know, very, a few number of institutions did the reverse of that in 2008/2009. There was a retrenchment from the market. I mean it certainly could have even made some money. The question was when was that capital going to be redeployed; and if you recall 2009, ‘10, ‘11, the economy was not doing well by any stretch of the imagination. Yet the market started to improve. I think now it’s kind of like the inverse, and so cash can be very attractive. But it’s just thinking about, if one is thinking about that, what’s the deployment strategy, because you’re right. In the long run, cash is, at best, like a small, real-return strategy. So you’re giving up risk premia. It’s just going to be, like, how are you going to deploy that to your asset allocation?

 

Sara Devereux: Yes, we would say, “Time in the markets is better than timing the market.”

 

Liz Muirhead: I like that. Well, and I think we’ve talked about, too, that market timing is a low information ratio strategy.

 

Sara Devereux: Right.

 

Liz Muirhead: Right, that it’s very hard to execute. You have to be right on both sides.

 

So, maybe, thinking a little bit more about this potential for a recession, it’s historically been challenging for risk assets, but risk assets really haven’t been behaving like a recession is coming. So what are your thoughts on areas like corporates and high yield in this environment?

 

Sara Devereux: Sure. Wait, as Joe mentioned, the market has been doing, we’ve been calling it the “soft landing dance,” you know, but we think the music will stop. We will experience that shallow recession, but there is some time to benefit from parts of the corporate credit market. But it really goes to the heart of what we were talking about with bonds being a diversifier in your portfolio because when we go through a recession, typically stocks will sell off and bonds will rally. Right, but not all bonds are created equally. Some have more correlation to the equity market and so might not have as much of a diversification benefit, and that’s exactly what you’re talking about—the risk assets, the corporate credit, the high yield, etc.

And so right now with our view that a mild recession is coming, we are advocating that up in quality tilt as I’ve mentioned. But there is a lot of opportunity in credit if you’re selective and that’s where, really, our active managers come in. What we’re doing in our active portfolios right now, we are overweight investment grade. Right, we have a bias to noncyclicals over cyclicals, and we’re focused on, I would say, quality in terms of earning stability.

And then in high yield, we’re being even more selective. We look at every single company’s balance sheet. We’re looking for balance sheet stability. We’re looking at—we’re leaning into BBs over Bs and CCCs, and we’re also preferring bonds over loans because—especially those loan-only issuers. They tend to be floating rate, and so their cost is going higher, and that can cause some distress in that part of the market.

I think I’ll take a moment, actually, also, to say for high yield: The high-yield market of today is not the high-yield market of a decade ago. Its composition has changed. So, if you think about it, 2020, we had a default cycle. A lot of the bad names dropped out, right? Going back to 2014/2015, we had an energy crisis. Energy names fell out. A lot of the second liens fell out of the high-yield market, and really a lot of that riskier lending went to private credit.

Right, in fact, if you look at the high-yield composition now, the CCC part of the market used to be about 20%. It’s now only 10%. So I think this is something important to consider. We think the default cycle for high yield as an asset class, the default cycle is going to be more mild and lower than it’s been in the past, simply because of those compositional effects.

 

Liz Muirhead: Interesting. So high yield is actually higher quality now than private credit and higher quality perhaps than it used to be historically?

 

Sara Devereux: Yes.

 

Liz Muirhead: Fascinating. Well, maybe let’s take risk a little bit further out the spectrum and shift to equities.

So, you know, I don’t think any of us, those parts of the market, I don’t think any of us would have expected back in January that at this point in the year we’d be up. So, how has the run-up in stocks affected your team’s long-term outlook, Joe, and why is the market so optimistic?

 

Joe Davis: Well, I think on your first question, you know, we look—as the listeners and clients will know—we generally focus on the 10-year horizon. I think it’s long enough to have that long orientation. That’s where the predictability is the strongest in terms of our distribution of outcomes because we don’t have much insight on the near term. And it’s just—we disclose that in our research.

So, our outlook, if anything, for equities has come down very modestly since the turn of the year. But that was, for context, over the past year and a half that we mentioned in previous webcasts was our expected returns were going up. And it was in part because of the “bonds are back” dynamic that Sara talks about. A positive real yield was a reason why we were cautioning for low returns three years ago. It was the same reason as we started to have higher real yields that we were, because of higher cash rates expected. We were projecting two years ago over horizon that we were going to get higher expected returns for stocks because it’s an equity reverse premia over and above that dynamic.

And so what has happened is generally still it’s the same outlook as that short-term risk-free rate is boosting our long-term return projections. At the same time, we do have a little bit rich, equity-rich premium, that rate over and above Sara’s cash rate. So it’s one of these dynamics where our long-term outlook has not changed fundamentally. The dynamic has been positive. So in that sense, you’d say, “Well, the rally’s consistent with it.”

I think that’s pretty stretching it, right? I mean, I think this is a 10-year outlook. We have no idea what the next six months will be. The six months we have seen is within our distribution, but that tells you how wide it is, which is why we really focus on the 10-year from an orientation perspective. And so long story short, we have not seen a material change in that outlook. We would need to see, if fundamentals don’t change at all and we see another 10% or 20% up in equities, then you would be expecting from Vanguard a deterioration in our longer run expected return projections. Right now, the runup of stocks has been offset generally by the rise in the short-term interest rate.

So, yes, richer on equities but strong risk-free rate on cash. They generally netted out over the past six months when you look out over ten years. I think it really depends on where we go from here, but from a long-term investor perspective, it’s generally positive. As I said before, getting off the zero bound, you know, for the past two years, has been the single-best development, in my opinion, in the financial markets the past 20 years.

 

Liz Muirhead: Well, and I think if we look at what the markets have done, some of that runup has really been concentrated in a handful of stocks. So if we start to break the market down into value/growth or large/small, you know, we’ve seen large growth kind of take the lead again this year after value. You know, I think our long-term outlook, that 10-year outlook you talked about has been positive for value.

So how should investors be thinking about what’s happening near term versus that long-term view?

 

Joe Davis: Well, you know, as Sara said before, I think the narrower you get to the market, just two things: One is you’re taking on greater risk, and to be compensated, you hope that you really have skill or you have the support of a risk premium, which means, all else equal, they’ve generally been compensated for the risks you’ve borne.

Now all stocks are compensated as an index-like strategy, asset-class strategy. But within that, if anything, if you’re going to tilt, if you’re not going to own the entire market, history would show that you tend to orient toward value- based companies, so actually away from technology.

Now, you know, there’s a whole literature of why that is. Value companies may be a little bit riskier, so you’re bearing macro risk and/or investors overpay for growth. And so I think you come back to this environment. Just saying, if you’re going to concentrate on parts of the market, just be careful. You know, I mean 4% of the publicly traded companies over the past 50 to 80 years account for half of the equity risk premium.

 

Liz Muirhead: Wow.

 

Joe Davis: Four percent. So, I mean, that’s just fascinating. Now maybe some of the companies that are leading the charge this time are part of that 4% for the next 10 or 15 years, could be. So you can interpret that as a great opportunity. But also, I usually view that as be careful getting too concentrated because you can actually miss out on the very risk premium you’re hoping to capture. If you do it, just be mindful of the tracking errors you’re going to take, but it’s got froth to me. I mean it’s beyond, you know, the expected returns. You’re talking about valuation multiples that are going up significantly. AI would have to change the global economy by some valuation measures to such an extent that we’re talking about trend growth that’s double the current rate. That’s potentially possible in the next 25 years. I don’t think it’s going to happen in the next 18 months, and so I think there’s a little bit of froth in the market.

 

Liz Muirhead: No, that makes sense. You know, I know we’ve also talked about international stocks looking attractive. You know, what are some of the factors driving your outlook there; and why is our long-term view on international so strong?

 

Joe Davis: Well, it’s the same dynamic, Liz. And again, full disclosure is we, ourselves, to the own advice that I mentioned, right, my own perspective, the narrower we look at the market, the somewhat less precision we have. Right, and so if you’re looking at sectors versus the equity-risk premium, we’re pretty good on the equity-risk premium. At least we have been historically.

You start slicing the market, you know, the bands get wider. But that said, the logic of higher expected returns outside the U.S., it’s nearly all valuation. It’s not to do with currency. It’s not to do, really, with interest rate differentials, which are reflected, embedded in currency. It’s the valuation. I mean the vast majority of the outperformance of the U.S. markets over the past decade has been multiple expansion.

So, if we’re wrong and the U.S. market continues to outperform for the next decade, then that means the valuation disconnect just got larger again. So at some point there’s the law of gravity. But what happens for the next year remains to be seen.

 

Liz Muirhead: Maybe we can dig into a few different regions. I know that our viewers are very interested in our views on Europe, Japan, and emerging markets, particularly China. So what are some of our concerns around a recession and global interest rate normalization affecting the attractiveness of those regions?

 

Joe Davis: Well, you know, and I would try to separate—although the near-term economic projections certainly have a bearing on near-term economic fundamentals. Liz, but as you know from a valuation perspective, we try to worry more toward less on the economic forecast and more on the valuation perspective. That’ll drive most of our expected returns.

And why I say that is, you know, I’ve long said it. Vanguard, even our own research, we used to show ten years ago this chart, the correlation over longer periods of time, say 10, 15, 20 years, the correlation between GDP growth on one axis and stock returns on another axis, across countries the correlation is zero.

So, it’s not that growth doesn’t matter at all, it just means it’s the price paid for growth. So, you know, parts of the market, Europe has been cheaper going into the year. So has Japan. But they have lower expected growth than the United States on a trend basis. That’s already discounted, generally speaking, in the stock prices. That was the case three years ago. So where we go going forward, we’re generally formative relative to the U.S. We’re positive on the equity risk premium. It’s even stronger for the other developed markets. Emerging markets, generally it’s been more negative, but that’s starting to change a little bit because they have lagged so much. So, more to come on that, and they have the headwind emerging markets of China which I give Qian and the team who really diagnosed the fact that there was going to be continued weakness both cyclically as well as structurally from China. So maybe that’ll change, but right now that’s a headwind I think for emerging markets.

 

Liz Muirhead: Interesting. So, Sara, I want to get back to you. How does our view on international translate into the fixed income space, and can you talk about why investors benefit from having non-U.S. fixed income in their portfolios?

 

Sara Devereux: Sure. So I would say just generally from a portfolio construction aspect, we almost always want to have some international exposure, just because, just to put simply, it helps you diversify away from really U.S.- specific risks. So I’ll start with that.

The other thing we’ve been talking about this year, which is absolutely terrific for international fixed income, is that we had, gosh, $18 trillion in negative-yielding debt globally. We’re coming to the end of that era. It started in 2014. It peaked in 2020 at $18 trillion in negative-yielding debt. It’s down to about $2 trillion now, so that bodes well for global fixed income (source: Bloomberg).

You know, and then similarly in the U.S. market, valuations are really attractive. You look at Joe’s team and the VCMM outlook, yields are double what, expected 10-year returns are double what they were as recently as a year ago. And then, you know, finally I would say to some in our active teams, we talk a lot about dispersion and relative value. The more dispersion there is across sectors, corporate names, and countries, the more opportunity there is to monetize that relative value. We’re seeing that really a lot of opportunity in international markets in monetizing that dispersion right now.

 

Liz Muirhead: So, I heard you use the word “diversification,” and that word keeps coming up in our conversation today. You also talked about the 60/40 portfolio. So, I think with the environment and the way that it shifted, traditional asset allocation, portfolio diversification, and the 60/40 portfolio are back. But they’ve really gotten a bad rap over the course of the past year. Can you talk about why that happened? Why didn’t bonds behave the way that investors expected, and why do you think it’s different going forward?

 

Sara Devereux: Sure, so last year was a really tough year, right? It was also a very unusual year. The fed rate, we were coming off a global pandemic, very unusual circumstances in the background, first of all, the Fed raised rates at a record pace. We haven’t seen that rate of policy rate change since the 1980s, so there was really nowhere to hide.

Every asset class had negative performance last year, except for commodities and cash. The last time that we saw both stocks and bonds down more than 10% was in, I think, I want to say the 1800s. So, right.

 

Joe Davis: A long time ago.

 

Sara Devereux: Right, it was a long time ago. So, we experienced a tail event. Tail events happen. By definition, they are rare. So looking forward, we think we’re going to be in a much more normal environment.

You know, and then some other things, we’re off the zero lower bound, we’re past the peak in inflation, the Fed is nearing the end of its hiking cycle, flows have returned into fixed income, so things have really stabilized. So we really do believe in the 60/40 portfolio. I just want to emphasize it’s good for the long term. It doesn’t hold every minute of every day. It doesn’t hold every year. But over a long horizon, we really do believe that bonds are a good diversifier to equities.

 

Joe Davis: Yes, and the thing I would, again, to echo what Sara said, and I’ll channel the, play the advocate, some would say, “Oh, of course you’re going to say that, Vanguard, because you’re known for the 60/40.” And my team, Sara’s team, we’ve had a lot of these questions because last year was, it was jarring. But I’d say why we continue to believe—although it was very unusual—that’s in the historical record. We could have told you two years ago, if you had portrayed those events that, yes, that would be a tough near-term loss because you have unexpected inflation that drives down the discount rate. So it pushes stock prices down, interest rates up, and so bond prices fall. And so that has happened before, although it was a long time ago where it happened that vigorously. So, I’m not discounting that, but where my point is is that why the 60/40 is an enduring strategy, it’s that dynamic. What actually creates the pain also gives 60/40 a natural defense mechanism and that is the very rise in rates that is causing the trauma.

And so that, I mean, it’s unpleasant. Like, I didn’t enjoy that last year, but that very mechanism that is creating the pain gives the immunity to the portfolio longer term. So, again, could we see that again, Liz? Yes. You would have to repeat that inflation runup and the lack of policy response for a year. But again, even if that would occur, you would then have the natural defense mechanism that over [a] 5- or 10-year basis you more than break even despite the traumatic event you go through for that one-year period.

 

Liz Muirhead: I think if we stick with more of the academic views, one of the underpinning criticisms of the 60/40 portfolio last year was the rising correlation between stocks and bonds. So this longer term academic research that your team has done tells us about how common high correlation between stocks and bonds have been historically.

 

Joe Davis: Well, and that’s exactly that dynamic I was saying. That’s the trauma, the trauma of stocks and bond prices both going down as Sara mentioned, that’s the correlations going very high. Almost inevitably what drives that is unexpected, high inflation.

And so we have seen it. We use machine learning techniques that we could even say if the trend inflation’s going to be 4% or more, those correlations are going to go significantly up. But that very dynamic, it’s not a guarantee, but the very dynamic then likely introduces what, a monetary policy response, which pushes inflation down, which means then you get the 60/40 diversification again.

But again, that can take a little bit of time. I mean for those of us who remember the ‘70s, it was a few years and some policy mistakes from some central banks that led that to compound for a time. So I don’t say like, oh, it’s Pollyannaish or that there’s not some of that risk, but that’s where that dynamic occurs; and so correlations can go up. Generally, the correlation between stocks and bonds is very small and close to zero, maybe small positive if you have corporates in there.

But for the past 20 years, we’ve actually had negative correlations because it’s been a disinflationary trend. So if you say, “Okay, we won’t have as much disinflation; we’ll be bouncing around 2%, sometimes high, sometimes a little bit lower.” Then you’d say, “That’s where our central tendencies and capital markets models roughly 0.2 with a wide range to it.” But yes, we will generate those scenarios for clients to stress test their portfolios. But the machine learning analytics would point, if you have an inflation trend that’s sticky and higher than expected, you will get correlations that will bounce for a time. But then they ultimately, they do come down. They have a half-life to them because there’s a policy response. It’s the very rising interest rates which then becomes contractionary, which actually cools off the correlation, if that makes sense.

 

Liz Muirhead: So, high and unexpected inflation is what drove the correlations positive.

 

Joe Davis: Yes.

 

Liz Muirhead: And we’ve already heard and seen in the market data that inflation has come down dramatically, and the Fed continues to be committed to that policy response, that natural defense mechanism you talked about.

So, maybe another aspect of traditional portfolio construction is the concept of diversification. Joe, can you talk a little bit about why does diversification matter; and why is diversification not always about just low correlation?

 

Joe Davis: Well, again, I mean you can have a high correlation strategy that still leads to dramatically different returns in your portfolio. So I’ll use the extreme example that may resonate with some. Think of the case between U.S. stocks, for example, and non-U.S. equities. The correlations, historically, have been pretty high, 0.8, let’s say, even in a globalized world or even higher, 0.9. Some would say, “Well, I don’t need either U.S. stocks, or I don’t need non-U.S. stocks. Because the correlation’s so high, it’s like owning the same thing.”

But actually, it shows you can have correlations of two assets that are perfectly correlated, 99%, 100%. And they both go like this, and one has a positive return. One has a negative return. They’re perfectly correlated, and the gap of the return differentials is significant, I mean, 10, 20 percentage points in a year. Think of growth and value. The correlation between the Russell 1000 Growth and Russell 1000 Value is over 95%. Yet you have huge differentials and returns, and so that’s where I would say it’s not just, to your question, Liz, you hit it right on the head, it’s not just the correlations per se, but it’s the range of outcomes that you’re looking to achieve. Yes, certainly low correlation helps, but even if you have a high correlation world, you know, you’ve got to think about that in terms of what are you trying to achieve for your portfolio?

So, it’s more than just correlation is the simple [answer] to why diversification matters. Usually if you’re going really low diversification, there’s a tradeoff involved. So because you’re foregoing a risk premium exposure and either you’re attaching yourself to another risk premium, which has a different risk profile—but there’s usually a return give-up in that regard. If you’re comparing at least to U.S. equity or if you’re going up in expected return it’s probably—now you’re taking on different risk. You’re taking on liquidity risk. You get lower correlation, at least as it appears on paper. I’m not saying it’s a poor investment. You’re taking on idiosyncratic and liquidity risk, and so

there [are] tradeoffs of liquidity or, excuse me, risk premia in correlations that one wants to think about. It’s not [as] simple [as] saying low correlation’s good. It’s a tradeoff just like between stocks and bonds.

 

Liz Muirhead: Well, I think this is a good opportunity to shift to some of the questions that we’ve brought in from our audience. So, our first audience question broaches an interesting topic I heard you raise earlier and that’s AI. So generative AI is the new buzzword. Everybody is talking about it and its impact. So, Joe, first of all for you, how do you see applications like ChatGPT impacting us and our future?

 

Joe Davis: That’s a lot to unpack. It’s a fair and direct question, but there’s a lot to unpack, so let me try to bottom line it.

There’s a big debate as to how transformative will AI be, and will it be of the same magnitude as something as, say, electricity? It’s rare when technologies in the world impact the global economy. They become both ubiquitous and transformative. There’s a lot of technologies that are ubiquitous. I’ll say social media’s one—has not fundamentally changed the trajectory of economic growth. They have changed our personal lives, but it is, what is added, if anything, to economic growth, we could debate. It’s probably zero.

Electricity, on the other hand, is both ubiquitous and transformative. So what’s the difference? Electricity was both and thus changed the world because it changed the nature of work. So if AI’s going to be transformative, it’s going to be transformative because it changes the nature of the work and what tasks we as humans do versus what the machines do.

And so our preliminary research, and this is why we did the Future of Work paper, Liz, four years ago, is because I didn’t know what ChatGPT was going to be. We had no idea what that was, but we saw artificial intelligence; and our diagnosis then and our updated diagnosis today is the same. And that is it’s going to be more complementary to human labor than it is going to be, you know, a substitute for. Roughly, AI is going to effectively affect 70% of the tasks that human beings do, so that’s transformative. It’s going to be more complementary than substitute, so that tells us two things. Farther out, I’m saying 10 or 15 years out, it is very likely going to lead to materially higher productivity growth. It may not rise to the same extent as electricity. There’s still a lot to learn about it, and we saw this with electricity.

Electricity was around for 30 years before it really started to fundamentally change the global economy. So there’s what’s called implementation lags. Businesses have to figure out how to use it. We, as workers, have to figure out how to use it. So, a long-winded way of saying we’re in the early stages of this. I think there is more truth to it than fad, and it’s roughly 20% to 30% of the occupations will see material losses and jobs. And we disclosed that in our Future of Work four years ago.

Well, ergo, that means 70% of the occupations are going to benefit fundamentally. And so relative to five years ago, the concern five years ago was that we lived in a world of secular stagnation, which implies no disruption, which means no productivity growth. This, I think AI’s going to be the power tool for the knowledge economy.

It’s more complementary than substitute, but there is going to be disruption; and not everyone’s going to win in this. So that’s, bottom line, that’s our diagnosis. We’re in the early stages. It will not fundamentally change the economy in the next 12 to 18 months. It has the potential to be as transformative, almost as transformative as, say, electricity. But because it affects a wide swath of our tasks, the final diagnosis will depend upon how much more gen of AI improves in complementing the work that we do. Right now, it’s not complementary enough, but we’re still in the early stages of it.

 

Liz Muirhead: So maybe as a real-world test of the theory that you have there, Joe, Sara, how is AI transforming life for your portfolio management team?

 

Sara Devereux: Oh, great question. Well, first of all, technology and innovation are a critical part of our ability to deliver exceptional investment results at scale for our clients. So it’s something we’ve been focused on for a long time, and we have a lot of experiments and teams and innovation going on. But specifically to generative AI, we’re thrilled. We have a few experiments that we’re working on, and we’ve been building capabilities in a few areas.

I would cite, first, automation of sort of low value-add tasks is one thing where we’re using it. Secondly, creating enhanced insights, so data forecasting and using generative AI for predictive modeling, if you will.

And then finally, we use optimization in our portfolios as a way to sort of really optimize our risk parameters and generate those results that scale across funds. So, we’re thrilled to be, you know, on the breakthroughs. We absolutely, I love how you put that, that it’s like, you know, it augments the experience. It doesn’t substitute by any means, and it’s going to make our crew, you know, what they’re working on is going to be higher value-add activities and they’ll be able to effectively delegate lower value activities to generative AI.

 

Joe Davis: Yes, just when we looked at those, the future work and those tasks, why it has potential to be very positive, with disruption, Liz, is roughly 600 out of 800 occupations we looked at—there’s 800 in total—600 of them had the same, the most time spent on the same task. Cardiologists, financial analysts, teachers. You know what the task was? Accessing and processing information.

Now, when I’m processing information, it may be different from when Sara’s processing information. But I’m accessing, I’m trying to find medical records if I’m a nurse or cardiologist. That is where, if we can harness that, that’s the power tool that I’m mentioning. It’s Sara’s insights. Right, that’s processing, accessing information.

Now, there [are] some jobs where that’s the primary task and so those will automate away. But again, in the grand scheme of history, our problem the past 15 to 20 years has been—which is why we had the low-rate environment—is that we had no innovation in a material sense that was changing trend growth. So there’s potential to uplift trend growth. I don’t know, is it strong enough to offset some of the demographic headwinds we face? It could be, but that would have to be, it would have to get better than it is. And that’s the project we’re working on now. Like net- net, where do we come out, and that’s our active work process.

And I’d say for a business leader, what we’re trying to do is find use cases in a good, disciplined way to see where you can rein out value in a complementary way. My team’s doing this. Sara’s team’s doing it. We’re all doing it.

 

Liz Muirhead: So it sounds like the experience you have, Sara, and what you also anticipate there, Joe, is that, as a complement that improves the efficiency and experience for the portfolio management team. So it’s not replacing portfolio managers just yet anyway.

You just mentioned demographic change, Joe, and that actually goes back to another audience question that we got. How do you see other structural factors such as demographics and globalization impacting the economy and markets?

 

Joe Davis: Well, there [are] a number of ways. And I think probably the most tangible is what does it do for trend growth? So that could be earnings growth, and you net out the cycle. Right, so the next 10, 15 years, and it’s one of those, what we call at Vanguard, Sara, the mega trends, right? There [are] a number of them. Could be climate in terms of rising temperature. It’s debt levels, demographics is clearly one, and then nature of technology, hence AI.

Globalization or the lack thereof or retrenchment. So when you put them all together, demographics is an important one. And that’s where I think there is a horse race in the next 10 or 15 years in every economy in the world, between slowing demographics—which means, all else equal, we’re not going to have enough workers for all the work we have—and AI. And so some are saying we’re not going to have any jobs ahead, so it’s a horse race. Which one is it? Is it we’re not going to have enough jobs or we’re not going to have enough workers?

It looked like the debate was going to be, “Oh, we’re not going to have enough workers. We’re going to have this really low growth world.” This was the secular stagnation camp 10 or 15 years ago. We were modestly skeptical of that over a longer term basis, but we were banking on modestly higher productivity growth.

Now AI would suggest that it’s leaning in our favor, but it remains to [be seen] how much we go forward. So a long-winded way of saying demographics are a headwind to growth, but you also—that assumes that productivity doesn’t change. And we’ve been at a low end of productivity growth for the past 15 to 20 years. We’ve been there before throughout history, and so usually what changes is that this general-purpose technology, which is pervasive and transformative, and so that’s where AI, I think, could very well offset it. But it remains to be seen. It’s certainly not crazy to think that.

 

Liz Muirhead: Well, I think we’re almost out of time. I’d love to end the discussion up on a positive note. So can you each briefly share with our investors what you’re most excited about in this market? Sara, you want to start?

 

Sara Devereux: Sure. Should I say bonds are back one more time? I don’t know, it might be, it might be. I think I would broaden that. I think I’m really excited at our clients’ ability to build resilient portfolios and I think, you know, I think we have a differentiated approach here at Vanguard with regard to risk management. I think we can really help our clients do that, so I’m really excited about that opportunity.

 

Liz Muirhead: Wonderful. And Joe, what are you excited about?

 

Joe Davis: I would say that, this phrase I’ve used is return of sound money. Positive real rates across the spectrum. I mean savers were subsidizing those that had high debt. You know, we were debt deleveraging in the past 15 years. I was hoping secular stagnation was not in our future, you know, low, low bond returns, which ultimately bleeds even into equities and total returns over time. It’s been great to see the opposite and as I said before, I think it’s the best development we could have seen.

I think there’s permanence to it. I don’t think we’re going back. Maybe cyclically because someone has to cut rates, but it’s not going to be on—I think there’s some permanence to it, so that’s definitely good news.

And the power of compounding, I think, finally is back in the investor’s favor.

Liz Muirhead: Well, that seems like a fitting place to close this session. To our audience, thank you very much for your time.

 

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