Vanguard Perspectives®

Double-dip recession?

Introduction

Catherine Gordon: Hi. I'm Catherine Gordon. Joining me today are Joe Davis, Vanguard's chief economist, and Roger Aliaga-Díaz, a Vanguard senior economist who analyzes international markets. We're going to look at whether the global recovery can keep going throughout the rest of the year and beyond. Joe and Roger, thanks for being here today.

Joe Davis: Thank you, Catherine.

Roger Aliaga-Díaz: Thank you, Catherine.

Outlook for U.S. economy

Catherine Gordon: Joe, do you think the U.S. economy will continue to grow throughout the rest of the year or is there a threat that we'll see another recession?

Joe Davis: Well, there's certainly consternation among investors, among the markets, around the probability of a so-called double dip, which would be effectively another recession. So GDP growth or job growth, which has started to turn positive over the past several months, would actually revert and begin to contract. There is a palpable probability that we would have a double dip. We have research and analysis that estimates that probability around 20%. Now, 20% is fairly low overall, but nevertheless it's actually somewhat high given the early stage of recovery. We don't tend to see those sort of probabilities, at least historically.

When you look at the leading indicators, we still have more green than say, red or yellow, which would still suggest that the most likely outcome is a self-sustaining recovery. Albeit though, it will very likely be a muted recovery, so-called U-shape.

There's considerable progress being made, in part because of this U-shaped recovery. Consumers are continuing to pay down debt, so-called deleveraging, so things such as their financial obligation ratio or the percentage of household income that goes to debt payments has reduced or has fallen through time. And in part because that is expected to continue, it's one of the very reasons why more likely than not, the recovery, although it will be self-sustaining likely, will be uneven and, when you net out that volatility, will be fairly low or tepid, at least for the next year.

Outlook for global economy

Catherine Gordon: So, Roger, Joe covered what's going on in the U.S. economy. What are your thoughts about the global economy?

Roger Aliaga-Díaz: Well, at the global level, Catherine, we're seeing a more disparate, uneven recovery with emerging markets leading the way and Eurozone countries lagging behind. Now in spite of the recent volatility in European economies, we are still seeing the key drivers of the global recovery still working. We're still seeing a strong rebound in global trade that is boosting exports across the globe. We're still seeing emerging markets leading the recovery with countries like China, India, or Brazil projected to grow very strongly this year. However, clearly, the fiscal austerity programs being implemented in many European economies right now will amount to a large, negative shock to real spending in Europe.

Additionally, the weakness of the euro we're seeing may not help much in terms of exports since most of the European countries' exports stay inside Europe. So we wouldn't be surprised if the projected growth of about 1% for this year is soon revised downwards a bit.

Now the key question is, how much of a drag can this mean for the global recovery? And in this sense, in terms of the real economy, in terms of exports, the global exposure to Europe is not that critical. A slowdown in Europe could mean for countries like China or Brazil about 1 or 2 percentage points of lower growth on rates of growth that are already high. But the same or similar for the U.S., the exposure is not that critical.

We are seeing, of course, some contagion in terms of financial distress and uncertainty and we are concerned with potential problems in the banking system in Europe.

More stimulus or austerity?

Catherine Gordon: So I'm sure this was a topic of great discussion at the recent G20 get-together in Toronto, and we picked up on a fair amount of dissension within the group. With the United States on one hand, expressing concern about sustaining the current recovery, but then we had the European leaders on the other hand, saying that they're now more focused on reducing their deficits. Which priority do you think is more important, and why?

Joe Davis: You know, Catherine, we all talked about the deficit and how we as a country or we as a global community handle the fiscal deficit situation is the singular investment issue for the next decade. And it's this conflict between, in some camps, the feeling for greater fiscal support in the near term vs. the clear and obvious need for long-term fiscal austerity. And so, it's one of these rare moments in history, actually, when those cyclical factors are butting right up against the long-term secular ones. I think what in our mind is critical, and the United States—we have a short window on this—is to relay a credible plan for fiscal austerity.

That does not mean that we have to raise taxes and cut government spending as of this morning, but what you do need over the next few years is to relay a very credible plan to do so over a time period. Bottom line is, by our calculations, we need effectively $4 trillion shaved off the debt over the next decade. How we do that is going to be a great political and economic debate. It's already at a feverish pitch in some circles, and we will continue to see it. I think that's a good starting point, but we need to see credible progress.

So bottom line is we need to see a credible plan to ultimately do that, recognizing that to do it right now could be somewhat difficult and it could actually induce the very double dip that many are concerned about, which ultimately would be self-defeating because that would mean government outlays would then increase in the near term.

The role of capital markets

Catherine Gordon: So, if we look at this debate through the lens of the capital markets, how much influence do you think the capital markets have on government economic and fiscal policies, and do you think the bond market will essentially force more fiscal discipline?

Roger Aliaga-Díaz: Yes, certainly. We think the markets are basically forcing the hand of policymakers in terms of undertaking this belt-tightening that is highly unpopular but necessary to the rest of the key structural problems in the budget. And clearly, if not as a call for immediate action as Joe was mentioning, it's at least a way to bring into the public debate this important issue.

What will the Fed do?

Catherine Gordon: So we come back to the age-old question, which is, what do all these factors imply for the outlook and the Fed and where we think short-term interest rates will go from here? A number of market observers have noted  they expect the Fed to start raising rates in early 2011. Do you think that's reasonable?

Joe Davis: I think when we look at the risks in terms of the probability, and if the market is expecting the Federal Reserve to raise rates from close to zero by the middle of 2011, certainly then, in our minds, the risks are that the Fed is on hold for longer than expected. Now why would that be? The Fed, at the end of the day, has 2 primary objectives: inflation stability, full employment. We have actually neither right now because there is a threat of deflation in the near term, which means prices will fall on an absolute basis. I think it's still a tail risk, but nevertheless that is the primary risk, not high inflation, at least over the next 2 years.

And then, obviously, high unemployment, when we have unemployment rates close to 10%. And so, when you do the arithmetic, the odds are—it's not a given—but the odds are that the Fed is on hold longer than expected. And history generally shows that there is the tendency for the bond market and for futures markets to price in, so to speak, a Fed tightening cycle a little bit more prematurely than the Fed actually does.

And I think this, in my mind, goes back to one of the key tenets of Vanguard's investment philosophy, which is broad diversification. And we had analysis around fixed income diversification. I mean, if you polled many investors or many listeners 3 months ago, more often than not, most people thought that interest rates had to go up, and in fact, they fell.

And certainly I was in that camp. I thought rates would have risen by now. They have actually fallen, and significantly. So I think it's a testament to the difficulty in forecasting interest rates. It's also difficult, at least as a core holding of one's portfolio, to have that broad diversification so you do have exposure, whatever the future economic environment holds.

Catherine Gordon: Joe and Roger, as always, thanks for your time today.

Joe Davis: Thank you, Catherine.

Roger Aliaga-Díaz: Thank you.

Catherine Gordon: And thanks to all of you for joining us today. We hope that you'll join us again for Vanguard's analysis of economic trends.

Disclosures

All investments are subject to risk.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Foreign investing involves additional risks including currency fluctuations and political uncertainty.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

The performance data shown represent past performance, which is not a guarantee of future results.

Diversification does not ensure a profit or protect against a loss in a declining market.

U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations.

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