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Why Vanguard Is Less Pessimistic About Valuations

When viewed against the current rate environment, and not against historical averages, valuations look less alarming today, explains Vanguard economist Roger Aliaga-Diaz.

Benz: I'm wondering if you can talk about global market valuations, perhaps with an emphasis on the U.S., and then in turn talk about what they suggest in terms of future long-term performance from the U.S. and other major markets.

Aliaga-Diaz: That's a really good question. We tend to look at long-term return expectations, importantly to give investors a more or less good idea of what the portfolios can do for them in terms of future returns, in terms of recalibrating expectations. One thing that we factor in in forming those long-term return expectations is valuations, not just valuations, but also the level of risk-free rates. Regardless of where valuations are, the fact that risk-free rates, the Fed funds rate, and the short-term interest rates, are so low and expected to stay so low, relative to historical averages, that that alone would depress a little bit our return expectations across all asset classes. If you look at the famous long term dot of the Fed which is at 2.75 right now versus where the Fed used to take rates, more at 4, 4.5%. That 1 to 2 percentage point difference, that alone tells you how much lower the base risk-free rate over which returns are going to be built on. Also inflation, inflation being lower in the future than it has been in the past, that also shaves a little bit off nominal returns.