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Patience Needed in Lower-Return Environment

Christine Benz

Note: This video is the second of two parts with Vanguard's Joe Davis.

Christine Benz: Let's talk about Vanguard's forward-looking outlook for the U.S. economy over the next decade. I know you do it in bands. You don't sort of have a blanket growth target. But let's talk about where you are seeing the economy going in the decade ahead.

Joe Davis: Just to fix the audience's--what's average or expected. Most, including the Federal Reserve, expect the growth to be 1.5% to 2%. Now, that's roughly half of what it used to be. Some of that's demographics. I personally think demographics as a force, although it matters, is overrated. The biggest reason why individuals and most economists expect lower growth going forward because of lower productivity growth. 

We're not as bearish as that. We're slightly above the consensus longer term. We are doing deep research to see what potentially could lead to the next productivity wave. It matters because that drives everything from growth expectations to what central banks would call R-star which is an esoteric way of saying where neutral short-term interest rates are. But we are a little bit more optimistic than the consensus, but not in the next two years. I think that's a little bit longer term thing. But we are pairing that with valuations on the equity market which are still extended.

Benz: That's what I want to talk about, how this translates into investors who are thinking about their portfolios today, how this translates into how they might be positioning their portfolios, stocks relative to bonds. Let's start there.

Davis: Expected returns do matter to get a sense "on the efficient frontier" or this trade-off between, let's say, stocks or more aggressive investments and more conservative ones. It doesn't just have to be stocks and bonds. That's where valuations can come in. Because if we are looking out, like we believe one can do over the next 10 years, is that what is a reasonable range of expected returns, they are generally lower across the entire asset class distribution, bonds and stocks. Part of that is because of somewhat lower expected returns for cash, the risk-free rate. That's where valuations for the U.S. We are seeing expected returns for the U.S. market on a strategic basis being roughly 200 to 300 basis points lower than overseas markets. We are stressing, don't just focus on U.S. investments. Unfortunately, the risk/return trade-off, the expected returns in regard of any portfolio have fallen. And so, we characterize this as a lower-return environment. 

We don't think it's permanent, but it's going to last to the next business cycle. And so, it's going to be with us for several years. I apologize sometimes to investors, but hope shouldn't be a strategy. I think it would be hope, if we are hoping for these sorts of returns we've had either in the past decade or historical.

Benz: For investors who are getting close to retirement and they are looking at maybe a shortfall, it's their additional contributions that probably are going to have to make up the bulk of that …

Davis: It's going to be the savings clearly. Although, that's not palatable.

Benz: No, it's not fun.

Davis: I mean, if I'm listening to it, it's not fun. I think also the staying invested. I think there's going to be headlines--we had some in February--there's going to be headlines where one is going to, I feel them personally, one is going to want to withdraw from the market. All the more reason to stay invested in a lower-return environment. It's going to be patience and diligence that I think over the next five years are the emotions that we are going to have to harness to be successful because we are not going to have the tailwind of powerful low P/E ratios, high near-term interest rates that give us a boost to our portfolios. We're not going to have those tailwinds.

Benz: You touched on the international versus U.S. question. It sounds like you are suggesting maybe a little bit of relative undervaluation in foreign stocks. For investors who haven't looked at that, how about the value versus growth bifurcation where we've seen value stocks dramatically underperform?

Davis: Dramatically underperform. If one is comfortable taking some, I'd call it, active risk relative to their policy or portfolio--let's just say with 60% stocks, 40% bonds, Christine--if they are willing to tolerate periods of underperformance, that's at least a framework I would be looking through to say, if I'm going to tilt my portfolio. Personally, I'm one of those investors. What I tend to do is, say, what are valuations in the market on a smooth, long-term basis. That would tell me that I should be rebalancing my portfolio and even potentially putting new money into work, into overseas markets, into value, parts of the market that have underperformed. 

I know personally I will never get the timing right. It's a long-term, discretionary or automatically rebalancing to those parts of the market that have just underperformed. That's a nice disciplined approach. Any one year, it may not seem like it's paying off. But I do know from the research that over--and you've done some as well, Christine--over 10- or 15-, 20-year period you can add, I don't know, roughly 50 basis points in, I'd call it, rebalancing alpha. You could call it, slightly tilting one's portfolio. But one has to stick with it and be systematic in it.

Benz: Let's talk about bonds briefly, your interest-rate outlook and your outlook in turn for the bond market. And then I'd also like to talk about just quickly, if you could, the corporate--we hear things about corporate credit bubble that maybe that's the next looming crisis for all of us. Can you talk about those things?

Davis: The fixed-income market, the credit, high-grade corporate bonds, spreads are really tight. The high-yield market has had some strong performance. Working closely with our active fixed-income team, we do have concerns in some of the riskiest part of the market, parts of the high-yield market, I would call the lowest creditworthy components of the investment-grade, like, BBBs, we are seeing a continued reach for yield. We think in the next downturn, clearly, those parts of the market, as they have historically, will significantly underperform. I would just caution investors, if they are thinking about or tempted for that extra 50 basis points in stated yield, just eyes wide open. 

At least, I would suggest to my family and friends to say, look, how those assets have performed, I don't know, during 2008 or 2010. If one is comfortable with that, fine. But there's an asymmetric return profile for some of the riskier parts of the fixed-income market in the years ahead, because spreads have really compressed and the search for the yield has been really strong. Next year, we will be entering very likely a more restrictive Fed policy environment. The history shows that that's when those parts of the market may not perform as well as they have in the past.

Benz: How about high-quality bonds?

Davis: High-quality bonds, like, I'm not changing my--I'm investing. If they are underperforming, then I'm rebalancing into them, because I'm going to be very happy, much like 10 years ago, when I had them because I'm generally a more aggressive investor, just for me personally, I'm more of a 90-10 investor. I need ballast in that 10% for the 90% of the market. I look at my fixed income really to diversify that 90%. That's why theoretically that's a more efficient portfolio for me. I'm not worrying about eking out incremental yield in my 10% of portfolio. 

If I was in the opposite investor, I'd just say, if you are trying to generate more income and yield, the fixed-income part of the portfolio is not the only way one can do it. You can look at equities, and this thing about that stock/bond mix, if one needs to achieve a higher return objective.

Benz: Joe, always great to get your insights. Thank you so much for joining me today.

Davis: Thank you. Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for