The outlook for 2014

Catherine Gordon: Hi, Im Catherine Gordon at Vanguard. Welcome to our program. Today well take a look at whats ahead for 2014. Joining us are Joe Davis, Vanguards chief economist, and Roger Aliaga-Daz, our senior economist. Joe and Roger, thanks for being here today. Joe Davis: Thank you, Catherine. Roger Aliaga-Daz: Thanks, Catherine. Catherine Gordon: In Vanguards latest Economic and Investment Outlook, which is now available on our website, we explain why we think the global economy could perform better than it has averaged over the past five years. Would you tell us why youre a little more optimistic today than youve been in recent years? Joe Davis: Sure. I think ultimately, its really a view of somewhat less drags and less downside risk to the global economy. This is not universal. It may not be for many emerging markets, but we look at the major developed markets of the world. U.S., Europe broadly, and Japan, our leading indicators, and they have for several months, are pointed to some modest building in upward momentum. I think its consistent with a financial crisis that, in the rearview mirror, is now several yearsover five years behind us. So, if we look at the U.S., again its one of potentially less fiscal drags in a period where time has healed, at the margin. So, the U.S. consumers will continue to need to pay down debt, but that pace is slowing. Thats somewhat positive for growth. U.S. corporate balance sheets remain extremely strong and with less policy uncertainty, we can see a modest pick-up in investment too. Then finally, government spending, which has been a significant constraint on real GDP [gross domestic product] at the federal, state, and local levelthat sort of headwind has also moderated. So when you add that up, its reasonable that the United States could grow 3%, perhaps even somewhat higher, in 2014. Thats something that we have not seen since 2006.

Meet the speakers

Catherine Gordon Moderator

Joe Davis, Ph.D. Chief Economist and Head Vanguard Investment Strategy Group

Roger Aliaga-Daz, Ph.D. Senior Economist

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Roger Aliaga-Daz: Ive seen something similar playing out in Europe too, in the U.K., even in some of the peripheral areas and economies. Again, as Joe points out, fiscal drag is still going on, but at a slower pace than before, and that alone can restore a few basis points back to the European economy and the U.S. economy. Now the other factor interestingly is over the last three years, emerging markets have been declining, have been kind of slowing down compared to what was expected. That has been giving a lower global growth year to year. This year, emerging markets seem to be in a lower but more stable growth environment. In that sense, they are not going to subtract more. We have the benefit of the positive effect from the other markets on top of that. Joe Davis: I think we also have to be cognizant of the secular, longer-term backdrop, which has some headwinds for the global economythe need to rebalance the economic growth model in China, high levels of government debt in the U.S. and Europe, and other regions of the world, high structural or high levels of unemployment in various segments of the world economy. So were really talking about a cyclical risk that is, at the minimum, more balanced than it has been in a long time. I think that in itself is very positive news. Catherine Gordon: I think its important to make that distinction. If we just turn to the stock market, I know Vanguard doesnt believe in making specific predictions about stock market performance, particularly over the short-term, but our outlook for 2014 does assess the factors that influence the markets. Can you tell us about what you see ahead for U.S. stocks? Roger Aliaga-Daz: Certainly we have to look at the key drivers of the stock market. One thing that we find over and over is that the key economic and fundamental drivers tell you very little of the short-term outlook. Some of them tell you more about the long-term outlook and fortunately, thats the investment horizon that is more important for many investors that save for a specific goal. One of these indicators that have some information for the long-term outlook for returns is valuations. Valuations right now, we can say, are a little bit on the higher end. Markets tend to be overvalued mildly, overvalued in various metrics. Statistically, or historically, that has correlated with near- to long-term returns that would be below normal, below average. Catherine Gordon: I think its safe to say that over the past at least year, 18 months, couple of years that, as much as people are interested in the stock market, theres been a lot of investor interest in the outlook for bonds and interest rates. Could you take a minute to comment on your outlook for interest rates, both here in the U.S., as well as around the world? Joe Davis: Sure, Catherine. I mean, the interest rates are clearly lower, though theyre higher than they have been, and thats one of the reasons why we saw losses on many bond portfolios in 2013, not a terrible surprise, given the general expectations we and others had of the modest rise in interest rates. I think, clearly, when an interest rate outlook ultimately depends primarily on the two key drivers of interest ratesinflation expectations, which I

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think across the world if anything, in some parts of the world, inflation is too low, but I think theyre generally stable. So I think if we see a pressure on interest rates, its going to be rising real or inflation-adjusted interest rates, which is tied to growth and hence central bank policy, which brings us to the big questionwhen will the Federal Reserve begin to raise interest rates? I think, for the first time in seven or eight years in our mind, the risk is that the Fed does not continue to push out when they may start to raise interest rates. Right now, the general expectation is the Federal Reserve will begin to raise interest rates toward the second half of 2015. For the first time in a long time, that risk is at least more balanced to that, whereas in the past, if you asked us, it was the risk of, well, at the margin, the Fed may be on hold longer than expected, and thats turned out to generally be the case. Its one where the bond market is expected to have somewhat higher interest rates going forward, given this modest economic growth, and its a good thing. Were hard-pressed to see a marked rise in interest rates through a marked rise in inflation, or a sharp rise in interest rates, at least in many developed markets. I think thats also reasonable. It would be a big surprise if that happened. And then finally, just an important point to keep in mind for investors is that the bond market itself expects a rising interest rate environment and its why long-term interest rates and intermediate bond portfolios have higher yields than short-term ones. Its one where we could see a rise in interest rates, but this exit strategy of central bank policy is a multiyear event and not something thats going to be squished into 2014. Catherine Gordon: So, as a result of the interest-rate rise that we did see in 2013, the U.S. bond market just finished its worst year in quite some time. And yet, for 2014 in our economic and market outlook, we show a little bit higher expected range of return from U.S. bonds over the next ten years. Can you tell us whats behind that assessment? Roger Aliaga-Daz: The key factor in setting our long-term expectations for long returns is initial yields, and what happened during the year is exactly that. Yields, as Joe points out, increased unexpectedly and by a significant amount. That explains the negative return in 2013. But at the same time, the positive side of the story if you will, is that for a longterm investor now youre starting from a higher level of yields. So, your return still would have capital losses from the rising rate environment. Rates are expected to increase as the economy improvesprobablybut at least youre starting from a higher level of yields, so you should expect a higher level of income to offset some part of these capital losses that are going to come over the years. As a result, the whole distribution of returns, if you will, has shifted to the right, with respect to the average, with a little bit higher return expectationsof course, with the caveat that they are lower than they historically have been simply because of the general level of rates.

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Joe Davis: So, its still a muted outlook, Catherine, but its a little bit better than before. Ironically, within segments of the bond market, if the U.S. is just an example, those areas that perhaps have had stronger interest from investorsparts of the corporate bond market [and] some other areas of the taxable market, where they had higher interest rate levels, particularly spreads [between] corporate bonds and treasuries and so forththeyve compressed. [And] the equity market has done very well. The relative return expectation differential between say, riskier bond portfolios and more conservative bond portfolios, that has actually narrowed. So, thats an important thing for investors to keep in mind, as well as if theyre potentially thinking about the structure of their bond portfolio. Catherine Gordon: I always like to ask this question. What are some of the risks out there this year that you think the market is overlooking? Roger Aliaga-Daz: To me, one risk that is important to watch for investors is actually the fact that growth could be strong. And the single indicator in which the Fed is basing its policies on, the unemployment rate, which by itself is not a complete description of the labor market and the weakness in the labor market. Specifically, the Fed is looking at the particular market, a particular number, but there are all types of other factors that can affect how much unemployment is in the economy like people going back, rejoining the labor force, that left before. Or the fact that simply, it may be possible that, going forward, its more difficult for U.S. workers to find jobs, given they have spent so much time outside of the labor force. So all the factors mean that, even if unemployment keeps declining, we may see inflation or pressures developing a little bit faster than what the Fed expects. So the Fed may need to rush into, basically, tightening to keep up with inflation. Its a risk of, contrary to slow growth, the risk of a little bit of inflation going beyond what the Fed wants, and the Fed trying to catch up with that trend. Joe Davis: I would say some of the things that perhaps may keep me up at night, and things we talk about in our annual outlook publication, Catherine, three that I think are talked about. But I think we should prepare for periods of uncertainty or volatility, concern around perhaps in Europe. Although weve seen significant progress, this is still a long haul, and I think we may have periods of doubt with respect to bank capitalization or progress on debt restructuring, and just debt levels. So I think that would be one. China, they are clearly targeting a lower growth rate and I think thats in many ways a good thing. But its a tough task to make sure the one can engineer that sort of outcome very placidly. And then finally, just the unwinding of these unprecedented stimulative measures of central banks around the world. I think were in good hands with those at the helm, but these are just uncharted territory.

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So there are the three that are, in my model, on the negative. On the positive side, I think its a little bit to Rogers point. Although were seeing signs of growth picking up, [and] history shows that once momentum builds, it can persist for some time, perhaps longer than some expect. Despite concerns that the U.S. and other developed markets may be in a period of secular stagnation, and years and years and years of very low growth, we could be in a period where, at least for several years, we actually have above-trend growth, a lower trend level, but a period that may catch more of the pessimists off guard. Catherine Gordon: Roger and Joe, thanks for your insights. And thanks to all of you for watching. We hope that youll join us again for our next discussion of economic trends around the world.

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