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Live webcast: Midyear economic update

July 08, 2013

Replay and transcript from a recent Vanguard webcast

A slow U.S. economy and stagnation abroad; federal debt and rising interest rates; corporate earnings and monetary policy: There's no shortage of issues that can roil the financial markets. In this live webcast aired June 20, 2013, Vanguard chief economist Joe Davis gives a timely assessment of the forces affecting the global economy and markets at the midpoint of the calendar.

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Rebecca Katz: Well, good afternoon to you and welcome to this live Vanguard webcast. I'm Rebecca Katz, and whether you're joining us on your computer, your smartphone, or your tablet, we're glad to have you here today. So this is the midpoint of the year, and we thought that it was a good time to take stock of the financial markets and the economy. And, actually, we think this is really good timing, because yesterday the head of the Federal Reserve, Ben Bernanke, spoke. Now, he didn't say anything too unexpected, yet the markets have reacted fairly negatively. So here to help us make sense of all of this is Vanguard's chief economist, Joe Davis. Joe, thanks for being here.

Joe Davis: Hi, Rebecca. Pleasure.

Rebecca Katz: We have a lot to talk about today.

Joe Davis: I think so. I think we do.

Rebecca KatzRebecca Katz: So, Joe, today I hope that we can cover global economic news and the outlook, recent market performance, especially stock and bond markets, and then prospects for rising interest rates. But we know that you have lots of questions and, as always, this webcast is about you and your questions. Many of you have sent some in advance. You can continue to send questions our way. You can even tweet them to us using #VGLive, and we have a tablet here; we can see them coming in. Normally, before we get started on questions, we ask our viewers a quick question, and on your screen you should see our first poll. What we would like to know is: "How likely are you to make changes to your portfolio based on market news or economic news like we heard yesterday?" Please, respond now, and in just a few moments we'll share those responses.

So, Joe, Ben Bernanke spoke, the markets have reacted; can you explain to us, really, what was the crux of the discussion yesterday and why this reaction? Is this bad news or good news?

Joe Davis: Well, certainly in our mind, it's good news longer term that the Federal Reserve is more seriously contemplating reducing how much they have been pursuing quantitative easing or expanding the size of their balance sheet. And the market has been just trying to ascertain for some time as to when that may slow down, the so-called QE3, as well as when they may terminate that plan. And Ben Bernanke yesterday not only did in a statement but, more importantly, in the press conference, in the Q&A, just provided—again, reaffirmed—that they are thinking about that more seriously than perhaps they would have been three or six months ago.

Now why they're doing so is because, certainly in our opinion, the market and the economy has less downside risks than perhaps it would have had at the beginning of the year. So, broadly speaking, this is good news, because the Federal Reserve is coming closer to the realization that the U.S. economy is stronger today than it was a year ago and so does not need the sort of "insurance," so to speak, of additional quantitative easing. So I would view this as good news for long-term investors, for you and I, and for the listeners at home and at work. But the market certainly is not thinking about that, at least today.

Rebecca Katz: But this was always structured as a temporary program, so I'm a little surprised at the reaction because, at some point, it had to taper off.

Joe DavisJoe Davis: Sure, sure, and again, I think part of what the bond market and financial markets are trying to think through, Rebecca, is what we hear—so-called tapering. So, again, it's this sort of question of when the Federal Reserve will slow the rate with which their balance sheet continues to expand by buying U.S. Treasury securities and buying mortgage-backed securities, right? Now, again, where I think the market is getting ahead of itself is the distance between when they may start to slow that rate of purchase and, ultimately, when they may raise the federal fund rate, which is still at zero. That second window is fairly long, more likely than not, and so I think the market is getting ahead of itself a little bit but, nevertheless, that's why I think we're seeing the sort of market volatility we're seeing.

Rebecca Katz: So just for some of us who may not've followed why the Fed was really doing this, so they were buying bonds, expanding their balance sheet and that was to keep rates low?

Joe Davis: Well, not just to keep short rates low. We all know that they're at zero, right? So the so-called zero bond. This so-called unconventional policy of purchasing a longer-maturity or longer-duration government securities was to lower the interest rate paid on longer-term asset prices and fixed-income securities. In other words, expanding the so-called "accommodation" that they would have loved to have done at the short end, but given that's zero, they couldn't do [it] any longer, so extended out just the whole Treasury yield curve, and why that, in their mind, was positive because they're lower—the ability to lower mortgage rates and to lower corporate borrowing rates and so forth. But, again, we—as a firm we've had some concerns that monetary policy may, quite frankly, have been working too well in the sense of investors globally perhaps taking on too much risk in some segments of the marketplace. So I'm certainly not surprised to see this sort of rise in volatility that we've seen over the past several days.

Rebecca Katz: Okay, and I do know we have some questions that are going to touch on different types or different areas, different asset classes, so maybe we'll come back to that. But in the meantime, we should have the results of our first poll in, so let's take a look. And we asked you how likely you were to make changes to your portfolio. Now being that this is a Vanguard audience, I could kind of predict what these responses are. And half of our audience said "not likely at all," about a little bit more than a third of the audience said "somewhat likely," and only about 10% of the audience actually said "very likely." So it's good to hear that most investors hear what the news is yesterday, seen the market reaction, and kind of take it with a bit of a grain of salt.

Joe Davis: Yes, I think that—again, what we've said for some time, what we firmly believe, is that a rising rate environment over time that is reflective of a healthier U.S. economy, healthier global economy, is emphatically good news. My concern—you and I did a webcast several years ago, Rebecca, and the concern was that would we wake up in the year 2014, in the year 2015, and interest rates hadn't risen at all, that would say that there was something actually much more fundamentally wrong with the U.S. economy, and the vigor and the resiliency that we hoped to see and that we're starting to see a little bit stronger growth than perhaps a year or two ago. So, again, longer term, a more natural rate of interest paid on various fixed income securities is healthy, but that will come with a volatile and at times some losses temporarily on some fixed income portfolios.

Rebecca Katz: You may have just calmed some of our viewers down about rising interest rates with your comments, but we'd like to ask our second polling question. Just because people aren't reacting, which is a good thing, doesn't mean people aren't concerned about some of this economic news. So we'd like to know which most concerns you: Is it the state of unemployment, rising interest rates, as Joe just talked about, or maybe the prospects for future inflation? So respond now and we'll come back with those results in just a few moments. So, Joe, we received an astonishing number of questions, they're still coming in, so I do think we should jump right into questions and maybe some of these issues will come out as we talk about them. Our first question is from Regina, and she's in Iowa, and she says, "Should I increase my stock asset allocation, even if slightly, and decrease my bond asset allocation during this time when interest rates are rising to cushion the blow to bond returns and potentially get better overall portfolio returns?" This is a common question. People are worried about interest rates going up, bond prices falling, and want to know what actions to take.

Joe Davis: Yes, it is by far the most popular question and understandably so. I think, for Regina, the important point to keep in mind is, ask that question and remove the phrase "in the event rates are rising." In other words, think about your portfolio construction, your asset allocation, regardless of where the markets may go, and thinking longer term in a sense of what's the sort of objective and balance between fixed income securities that, broadly speaking, tend to be less volatile than equity or stock securities from a broad benchmark. Think about that and how you want that to interact. Just the other day, it's ironic with Ben Bernanke's testimony, there's been considerable concerns of would bonds have some losses, but clearly the more volatile asset class and the asset class that had the more negative performance was clearly equity.

So equities clearly have larger risk and are expected to have larger risk over long periods of time, which is why they're expected to outperform bonds. So it gets specifically to the response of, if one is trying to have a higher rate of return over the next five, ten, or 15 years, there's no free lunch, and by our view and our investment philosophy, one has to take on more equity type of risk. But that also means that a day such as today, for instance, when the equity market is down, one has to look through that and be prepared for that sort of volatility. And again, I wouldn't necessarily say, "Okay, interest rates are expected to rise, so change my asset allocation." The bond market is already expecting a rise in rates, which is why long-term interest rates are higher today than short-term interest rates.

Rebecca Katz: And, frankly, you and I have been talking about rising interest rates now going on three years, I think, and we've talked about not timing in the stock market, but it seems like it's equally hard to do in the bond market.

Joe Davis: Yes, again, I think looking at a fixed income portfolio, clearly, if one is more risk-averse, one does not wish to see or hope to see greater volatility in the NAV of a certain bond holding than, all else equal, that would dictate or suggest a more conservative fixed income portfolio, such as a short-maturity bond from a corporate bond index fund or a municipal bond fund. And if they're trying to earn a higher income rate, then that historically has been associated with an intermediate-term or even a long-term bond portfolio. And so to try to move or navigate on a short-term basis based upon the evolution of interest rates is just active management, and that's a difficult challenge. And, at the margin, if one is inclined to think about that, I think there's also a possibility of contemplating our own actively managed funds, where we have professionals—and I know them personally—who are trying to navigate our portfolios to a potential rise in rate environment.

Rebecca Katz: Good point. So our next question is from Elizabeth, and she's in Monument, Colorado, and she asks, "Will the U.S. economy be able to grow, although ever so slowly, if Europe does not recover and if other global economies, such as Japan and China, falter?" So what are the impacts of those on us?

Joe Davis: Well, the United States has seen some weakness, particularly in the manufacturing sector and exports, related to all three of those areas, from the slowdown in China, which could actually be stronger than what some of the data suggest. Europe is still in recession and it does not show signs of bottoming at this present time. Japan has yet to show the vigor rebound that we have been hoping for. But that said, our view for some time has been that the U.S. could continue to expand in spite of volatility and disappointment throughout the rest of the world, because the U.S. still remains the predominate driver of growth globally. It does not mean that we are immune from a slowdown elsewhere but, at the end of the day, the U.S. still remains the most powerful engine in world economic activity and that has played out thus far. So the greatest developments we have seen and continue to see has been the rebound in the housing market, which we were hopeful for and anticipating. That, again, provides an additional level of shock resistance just to the U.S. economy. There again, there's going to be some—there's certainly some softness, and we're seeing that could very well prolong through part of the summer. But going back to the Federal Reserve, we share the same higher level of confidence of the U.S. economy recovering—continue to recover today, because the private sector is stronger today than it was just a year or two ago.

Rebecca Katz: So you normally talk about cautious optimism, and I guess in this case, you're more optimistic than cautious?

Joe Davis: Sure, I think so. Again, we're always going to have wiggles, so to speak, in the economic data flow, but we go back to what was one of the primary sources of the global financial crisis, and it was twofold. It was the housing market exuberance and overbuilding as well as extensive consumer leverage in the system. The consumer has liquidated and paid down a substantial amount of debt, well over $2 trillion, in the past four years. It's not been a pleasant process, but in part because of that and part because of low interest rates, which, of course, has hurt savers, it has helped those with that to help pay that down more quickly. So we're not through that process, but we would argue—I would argue—that we're at the point and have been at the point this year where we can have at least 2% real GDP growth as consumers continue to slowly get their balance sheets in order.

Rebecca Katz: Great. Well, we asked a polling question, we have the results in, so why don't we check in and see what are the greatest concerns on our viewers' minds? We asked whether it would be unemployment, rising interest rates, or the prospect of inflation, and, actually, it's fairly evenly divided here: 41% of viewers said "the unemployment rate" is concerning, 37% said "inflation," and 23% said "rising interest rates." But you may have had some effect on that because you view them as sort of positive. Does that surprise you at all? Is unemployment the most important thing?

Joe Davis: Well, the one that still continues to surprise me is the concern—I mean, I understand them, but the concerns around inflation, right? I know viewers for several years have said, with the Federal Reserve's actions and the global quantitative easing programs, that inflation was inevitable. We quite respectfully but conservatively continue to maintain and have maintained for some time that consumer price inflation was not necessarily going to run away and become the double-digit processes of the '70s and '80s. As the large part—because the primary driver of inflation trends over 3-, 5-, or 10-year periods—are the wage growth, the wages we all have, and the ability to spend in our pockets. So they're expanding, but at the same rate where measured inflation is, which is around 1% or 2%. If anything, the Federal Reserve is concerned at the margin that perhaps inflation is a little too low.

Now, that said, we at Vanguard have been more concerned at the margin with other forms of inflation, and that is some airs of frothiness in the financial market and some segments of the market, such as high-yield securities that we spoke about. We've blogged in the past about concerns, for example, of REITs, where investors searching for income, potentially purchasing securities based upon simply the stated yield, perhaps thinking more holistically with the portfolio. Again, this is industry-wide, not necessarily Vanguard, per se. So, in that, the Federal Reserve has actually more recently talked about those as potential marginal costs or risks to their quantitative easing program. I think another factor at the margin, why they're thinking about taking the foot off the accelerator a little bit, so that's been my area—our biggest area of concern.

Unemployment is still clearly—the Federal Reserve is still not seeing unemployment rate as low as they would wish, and we are seeing modest progress, but it will take at least another year very likely before the unemployment rate is at the level that the Federal Reserve has suggested they will start to raise interest rates.

Rebecca Katz: I see. Well, one of the other things that came out of Bernanke's announcement yesterday or one of the other reactions, I should say, is that the dollar strengthened. We have a question in from Tony, who's asking, "How do you see the U.S. dollar change relative to other currencies?" So we saw sort of a short-term blip, but longer term, how do you think about that?

Joe Davis: Yes, at least historically, over 1-, 3-, or 5-year periods, Rebecca, there tends to be an association between if a country is raising its nominal and real level of interest rate, which means either netting out the rate of inflation or not, but raising interest rates more so than other countries, you tend to see that country's currency appreciate. And so it's not necessarily surprising that the U.S. dollar may show some vigor. Again, how that plays out going forward now that the market is almost instantaneously pricing in slightly higher interest rates today than they were just two weeks ago, it's tough to say confidently that interests rates or, excuse me, exchange rates for the United States will then move markedly from the current pattern. If there's one concept that's potentially harder to predict than interest rates, it's actually currencies, because they are a function of relative interest rates. So you got real interest rates across various areas of the world economy, so you have to get those two factors right to get any currency pair more accurate. So I'm not surprised to see the relative strength, but what that implies for the next year or two, at Vanguard, we don't have a great deal of skill in being able to anticipate that.

Rebecca Katz: Well, maybe at least for summer vacations to Europe, some of us will benefit from slightly higher dollar rates.

Joe Davis: Well, the one thing with the U.S. contemplating more seriously the exit or slowdown of quantitative easing is that I think it is going to put the greatest pressure on those areas of the world, particularly certain emerging markets that have pegged their currency to ours. So by de facto, they have been importing, so to speak, our sort of very accommodative monetary policy, which for some regions of the world, were not in as severe economic straights as we were, so that's created some other imbalances in other parts of the world, in parts of Asia and in parts of, say, Latin America. And, so, those economies are having to grapple with it, and that may force them to perhaps make changes in either their pegged rate or their currency regime. Most reassured, that's actually broader good news, again, because they have to rebalance their risk to their economy, but that's also a reason why I think, at the margin, we're seeing greater volatility over the past several weeks and months in emerging markets, whether it's their debt markets or their equity markets.

Rebecca Katz: Is the struggle there that when the dollar strengthens and therefore their currency strengthens, it makes it more expensive for them to do export?

Joe Davis: I think there's a number of factors. One, it's been at the margin, so one hypothesis is that with global easy money, so to speak—we had a recent webcast on this topic—that those areas of the world that really benefit from that, from world exports and from global activity (i.e., emerging markets and the ability to service capital), were going to be potentially under pressure if you becomes somewhat more restrictive in the developed world. We're also seeing, again you mentioned China before, some slowdown there, and so that's, I think, just adding some additional concern to areas of the world that for several years have been a strong beneficiary of global capital. So it's not surprising to see just periodic setbacks, and this is one, again, one of the reason of, say, international diversification. And for years, we've said that emerging markets can have a nice diversifying role in an equity portfolio, and it's not because those are countries that are supposed to grow faster, it's because their business cycle is not perfectly correlated with ours, and I think we're seeing that play out this year.

Rebecca Katz: A moment ago you said that Vanguard's bigger concern was actually that inflation maybe wasn't high enough. So we have a question in from Sam, who asks why—I think what you were hinting at is we were worried about deflation—and Sam is asking, "Why is deflation such a big concern for the economy?"

Joe Davis: Well, again, it's for several years why deflation is, generally speaking, worse than just a modest level of inflation; it's that true, broad-based deflation means absolute wages falling; it's what the dynamic we had in the housing market in 2008, '09, and '10, with falling home prices applied on a broad scale; and what that does, particularly for those corporations or households that have debt and a fixed liability, with their wages going down, their ability to service that debt becomes that much more difficult. And that's what happened, by and large, during the Great Depression in the United States in the 1930s. So, again, we were hopeful and optimistic that the U.S. would avoid that sort of outcome, and we have, fortunately, but there's still pockets of deflationary forces at work but nowhere to the same extent that we had two or three years ago, which is, again, I think, another reason why the Federal Reserve is thinking more seriously about tapering their sort of quantitative purchases.

Rebecca Katz: Okay. Our next question is from Vann in Union City, and he asks, "Given the quantitative easing version initiated by the Japanese government, how does it affect the U.S. and emerging market economy in five to ten years, and what's its impact to the U.S.-E.U. emerging markets' stock markets in the next five years?" So can we talk about that, because Japan—when we talk about deflation, the first country that pops to my head is Japan?

Joe Davis: Yes, and another reason why it's not necessarily that quantitative easing was going to be inherently inflationary from a consumer price or CPI standpoint was which country in the world has the largest percentage of Central Bank assets as a percentage of their economy? It's Japan. And they still have had until very recently deflationary pressures, and so, for the first time, they've become much more aggressive, following much more closely with the United States' pursuits several years ago, and expanding at least the intent to rapidly expand the size of their balance sheet to counteract those sort of deflationary expectations, which had been entrenched in the Japanese economy. So the impact and future impact on the financial markets, to the individual's question, for the next several years will largely depend upon how successful the Bank of Japan is in convincing the Japanese populous and Japanese corporations that their policy will be successful in helping to stimulate economic growth.

If they're unsuccessful in convincing world investors through higher inflation expectations and for businesses that at the margin pursue greater expansionary policy and perhaps weaken the yen, if they're unsuccessful, then perhaps one might not have any influence at all. It could be a positive influence at the end of the day. See, at the end of the day, I think of quantitative easing, by and large, as psychological warfare. Monetary policy is not a panacea, but what they are trying is to influence investors' or corporations' or business leaders' or consumers' minds that they will be successful and, by doing so, one may alter one's own behavior. In the United States, that generally at the margin has worked, but this is all-around calibration that sort of forces hitting the economy that the Central Bank, at the margin, is trying to offset. Japan, to this day, would seem—I would argue that that calibration was insufficient. They are trying to potentially guess or assess if they need a stronger response.

Rebecca Katz: I see. It's showing that level of commitment. Our next question is from Jessica, and it's on the emerging markets again, and she's saying, "What's your view on emerging markets given that equities there have dropped significantly in value?" So less from an economic perspective and more from a market perspective.

"Europe is still in recession and it does not show signs of bottoming at this present time. Japan has yet to show the vigor rebound that we have been hoping for. But that said, our view for some time has been that the U.S. could continue to expand in spite of volatility and disappointment throughout the rest of the world, because the U.S. still remains the predominate driver of growth globally."

Joe Davis: Sure, a market perspective. We did the webcast at the beginning of the year, Rebecca, we've done research and, again, our refrain—something I think Vanguard and our investors should be proud of—is that we were somewhat unique in the industry saying that much more important than economic growth for stock market investors was the price paid for growth in terms of assessing the long-run risk-return tradeoffs of equities. And so, several years ago, I know there was a great deal of interest in emerging markets because they were growing very quickly—

Rebecca Katz: Their economies were so strong—

Joe Davis: They were so strong. Now, again, there was some that would say, "Well, if they're going to grow faster than developed markets, they had to outperform." And we cautioned that the equity markets in emerging markets were already expecting a higher level of growth than in the United States, for example, so it's not a terrible surprise that in the past several years, emerging markets have significantly underperformed the developed world and, certainly, the United States.

Now, ironically, today much less interest in emerging markets. Actually, cash flows at an industry level are negative out of emerging market equities, and the expected growth for emerging markets has fallen, and yet, the valuations for emerging markets at the margin have become more compelling today than three years ago when there was all the interest. So it's one of these sort of at-the-margin contrarian for long-term investors that when there's not as much interest, one hears more negative than positive for that area of the world. That does not necessarily mean that it cannot have a compelling potential rate of return, and that's precisely where we believe that we sit with respect to emerging as well as broad global equities at this point.

Rebecca Katz: Yes, I think your research on this was really amazing, where you looked at different emerging markets—not even emerging. I mean, we looked at the U.S., too, I guess when it was an emerging market, and there was no correlation between economic growth and stock market growth.

Joe Davis: Yes, over long periods of time, there really isn't. Look at the past ten years. One of the fastest-growing countries in the world has been China; it has been one of the worst-performing equity markets in part because ten years ago the price being discounted for future economic growth was arguably higher than what they've actually achieved. So I think that's still an important point to keep in mind, although applying it today is actually different from where we were three years ago.

Rebecca Katz: Well, let's shift gears a little bit. You touched on this, but maybe put a finer point on it. Mel in Daytona Beach Shores, Florida—hi, Mel—asks, "What is your outlook for inflation over the next three to five years?" So you suggested that not significant inflation growth, but what are we thinking?

Joe Davis: Yes, so we always think about whether it's inflation or the economy or interest rates or the returns on the stocks or bonds. We always think of a distribution of outcomes, and we talked about this at the beginning of the year and our annual publication. That distribution today is extremely similar to where it was two or three years ago and that is, over the next ten years, we believe a reasonable central tendency, so to speak, for expected inflation on average for the next ten years is around 2% to 3%. Ironically, that's also the same expectation the bond market has. Now that does not then say that that will precisely be what it is. There's risk around that. But if we look at the fundamental drivers of inflation today for the next three or five years, if that's not correct and inflation is markedly higher on a trend basis, we would need to see significant acceleration in wage growth, which is possible. I just think it's unlikely given the current state of where unemployment is and the amount of slack in still some segments of the labor market.

Rebecca Katz: Are there some certain events or triggers that could cause markedly higher inflation?

JoeDavis: Well, if it's any, in a one month or year the most—most of the volatility in reported inflation is food and energy prices, so they can bounce around a lot, but when I talk about trend inflation, meaning netting—I'm not saying food and energy doesn't matter because it clearly does, but on a trend basis, they tend to—if it's broad-based, all prices are going up, and so that's where wages give a pretty good leading indicator of future inflation trends, and right now they're fairly dormant in the United States, I mean, they're around 1½% to 2%, and not surprisingly, where broad measures of inflation are, they're also right around that pattern today. So we may see a slight uptick in inflation over the next several years but, more likely than not, it will not get completely out of hand.

Rebecca Katz: Okay, great. Speaking of inflation, many people bought a certain asset class in order to combat possible inflation, and that's gold. So our next question is from Ed, who says, "With the markets going down and interest rates rising, why is gold taking such a big hit?"

Joe Davis: Yes, well, gold historically—and we've talked about this for several years—

Rebecca Katz: Again, gold is another one of those topics that for three years, we've been saying, "Be cautious, be cautious."

Joe Davis: Be cautious. Again, gold historically—over long, long periods of human history—has risen at times when there's really serious concerns about inflation, whether or not they materialize, or periods of really strong economic stress or even deflation, like during the Great Depression. But, at the same time, there's also a strong negative correlation between real interest rates and gold. So, in other words, if the real rate of interest—so, say the 10-year Treasury yield, which is around 2½% today minus the rate of inflation, that's the real rate— Historically, there's been a negative association in the United States between rises in real rates and then the fall in the price of gold relative to, say, a broad consumer price basket. In fact, the correlation is fairly strong in a negative direction. So if the bond market is right, and I'm sympathetic to this view, that the rise in interest rates—the potential rise in interest over the next several years—that if it occurs—real rates rise more so than actual inflation—that would imply, all else equal, that gold prices could continue to fall on a trend basis over the next several years, because relative to, say, the CPI, gold prices are well above their long-term historical averages. And then this is something that we've blogged about on for several years.

Rebecca Katz: Yes, "all that glitters is not gold." Our next question is from Gary in Federal Way, Washington, who says, "Why does Vanguard encourage participation in international markets given the volatility?" I mean, you just described a lot of volatility. "International markets impact domestic market performance and it seems as if entry into these markets significantly increases risk." So if you get the effects, anyway, through a U.S. allocation, why not just have a home bias?

Joe Davis: Well, again, there's a strong historical and expected future diversification benefit of owning all segments of the equity market, both the United States as well as abroad. Global equity markets or regional equity markets do move together but not in lockstep. In other words, they move around—the correlation is around six years, 70%. During the crisis, it was higher, so they're not "as true of a diversifier" as, say, a different asset class such as bonds—

Rebecca Katz: Right, when things go bad, they all go down.

Joe Davis: Yes, so high-quality bonds are much better, more powerful diversification benefits, although that also comes with the lower expected return. So it's one of the fundamental tenets of our investment philosophy to be diversified, and that would include global diversification. That does not mean, though, that when, say, the U.S. equity market is falling, that international markets may rise. They generally will move in the same lockstep, but they may not move in the same magnitude, and this, again, gets back to, because at any one point, there may be different monetary policy responses, different economies have exposure to different industries. Look at the performance end of late last year with Japan, up markedly strong, more so than the United States. So we would expect that going forward, and so you can still have some modest diversification from owning a more global portfolio.

Rebecca Katz: So, potentially, you're adding in something that might seem like it's more risk but, overall, it can sort of buffer the risk within your portfolio.

Joe Davis: Yes, even if two assets have the same expected return and the same level of volatility, but they're not perfectly correlated, there is, by definition, a diversification benefit, and you can get that even if one asset is slightly more volatile. But, again, that correlation is below one. That's actually some of the basic tenets of asset allocation and portfolio construction, and so we would expect that to continue going forward.

Rebecca Katz: Great. We have a question in from Arnold, who asks, "Earlier in the year, there was a lot of concern about the federal deficit." I think there's still a lot of concern about the federal deficit. "Is that still a risk to the economy?"

Joe Davis: It's clearly a long-term risk. I mean, our view as a firm hasn't changed, and it's one of the seminal investment, economic, and political issues for—I would argue for our entire generation.

Rebecca Katz: Do you see any movement on a plan?

Joe Davis: Unfortunately, no. I think there's a wonderful opportunity, because there's a number of bipartisan issues that I think that would, over time, address long-term debt sustainability, which is the broad issue, but whether we get that this year is unclear to me. I wouldn't put odds greater than 50%. I think in part because we have seen a rapid improvement—expected improvement in the deficit, because revenues have increased, as tax revenue has increased, and government spending is coming down as part because the labor market heals. So I think that's taken some pressure, potentially, off policymakers, and I don't think we have forever to address this issue before the bond market may become a little more forceful. If we don't see it this year, potentially we see it next year around time of the midterm elections.

Rebecca Katz: What can I say, but sometimes the elections can be a distraction without accomplishing anything.

Joe Davis: By the CBO, the Congressional Budget Office's own projections, we will have the same level of government debt with some assumptions five years from now as we do today. So, in one sense, that's saying okay, well, that does not mean we should not do anything personally. That just means that we have a little bit of time on this. The big issue is where that debt is expected to go three decades from now, and that's when we talk about unsustainability. So we have a window here, and if I had a magic wand and could have an influence on the economy, that's where I would dedicate my efforts toward.

Rebecca Katz: Right, for the sake—We both have kids about the same age—for their sakes.

Joe Davis: That's right, for their sakes, yes.

Rebecca Katz: All right. Our next question is from George in Steamboat Springs, Colorado, and I think we covered a little bit of this in your earlier comments, but he says, "What's your view on the path the QE withdrawal will take? What signposts will the Fed use to judge efficacy?" They've sort of hinted at that they'll be tapering, but I don't think they've unveiled sort of a specific time that that will start and—

Joe Davis: Yes, exactly. They're human beings, as well, right? They don't know exactly how the U.S. economy is going to unfold over the next several months. I think the Federal Reserve at the margin is still waiting to see some of the potential drag that sequestration and the fiscal tightening could have on the economy. I don't think we've seen it all bear out in the economic statistics, but I think, that said, at least certainly my expectation is that the U.S. economy, even with some of the fiscal drag, will hang in there and then some in the second half of the year, but that's still an open question. I think the more they see the U.S. economy and labor market hold up and accelerate the margin, they will be more explicit in terms of the rate with which they may taper the addition of the balance sheet. So, again, all else equal, if they're tapering, they will still be accommodative in their mind. They are still adding accommodation, just at a slower pace, and they're not actually tightening policy. Tightening policy is when—by their mind—when the size of their balance sheet actually starts to fall and then, ultimately, when they start to raise the Fed fund rates.

Rebecca Katz: So they're just not going to be buying bonds as aggressively.

Joe Davis: Buying bonds as aggressively, yes.

Rebecca Katz: Okay. So we have kind of a related question here from Jeff, who says, "Is the Fed's market involvement a new normal going forward?" So this was fairly new to us. I imagine historically they've done something like this before.

Joe Davis: Yes. As human beings, we have never seen in world history the amount of aggressive monetary accommodation globally in either size or scope. So, in that sense, we're on uncharted territory, and I think it's been reasonable. I've tried to think through this, and I think it's reasonable for all of us to expect periods of volatility, I think, like we were seeing, as we contemplate the next step. But that said, I don't think that should have any bearing in terms of the investment strategy we develop, because the worst case is, again, no exit at all because economic conditions are so poor. But I think it is important to appreciate that there were profound efforts going in. It had some influence, a positive influence on the financial markets, and so there may be some so-called repricing of certain risk, particularly in some areas that were a little bit frothy at the margin. But, longer term, history shows that equity markets, for example, over a 3- or 5- or 10-year period actually can perform fairly well in a rising rate environment if it's associated with a rising rate of economic growth and economic performance.

Rebecca Katz: Good. Our next question is from Warren, and he says, "Once interest rates begin to rise, which I think is inevitable, what does history suggest concerning the rate of increase in interest rates? Are they likely to rise gradually over a number of years or quickly to control runaway inflation?" So we've talked about this a little bit but, I mean, do we learn something from history? Does history really—and how the Fed has raised rates before—influence what we see coming in the near future?

Joe Davis: History gives some guidance, and I think that guidance or the historical experience is actually reflected in the bond market today by the shape of the U.S. Treasury yield curve. What I mean by that is the 10-year Treasury today is around 2½%, short-term interest rates are close to zero, which is saying that, all else equal, loosely speaking, the bond market expects short-term interest rates, say, a money market interest rate over the next ten years, to be at or around 2½%—on average over the next several years—right around the next ten years. That's how you get a 2½ 10-year Treasury. And not why would I own it instead of have the same cash and just let my money accumulate? So that's what the bond investors demand for that interest rate. So I think, in that sense, given the shape of the yield curve, it's saying, on average, the normalization interest rates will be somewhat gradual, and it will reflect over time higher real interest rates which, until very recently, have been negative, even out through ten years, which is very unusual. So I think the bond market is getting a little bit more confident in terms of stronger economic growth several years from now and so, if that is the case, that at some point short-term interest rates will rise because it'll actually be "preferred" from prudent monetary policy to do so as wage growth and potentially inflationary pressures would suggest higher short-term rates.

Rebecca Katz: Great. Well, another "new normal" question for you. "Isn't it possible that, with productivity improvements, that increased unemployment levels would be the new normal?" So there's been a lot of pushing in every company to get more work out of their workers, and certainly technology helps with that, so the unemployment levels we're seeing today, you said the Fed wasn't happy with them, but maybe that is what we should be expecting going forward.

Joe Davis: Again, these are all great questions. It's a legitimate and serious economic question in many circles, and I don't think we'll get the answer, Rebecca, for another several years. But given the productivity enhancements, I would say, at the margin, there has been what I would call structural unemployment in some segments of the market because of the skills that are needed in certain industries versus the pool of available labor, and there's some evidence that there is some level of structural unemployment, although the big debate is how much, and so—

Rebecca Katz: I'm sorry, just clarify what you mean by "structural unemployment." So some areas aren't needed anymore, so there will just always be unemployment until those—

Joe Davis: Yes, and you always have industrial—you always have creative destruction and changes in where there is demand. There's a great deal of demand in certain sectors of the economy, and there's just less so right now in others, and part of that's certainly cyclical because of the slowdown—housing market and construction would be one, but I would agree with some policymakers that I think the rate with which so-called full unemployment is a little bit higher today than what it would have been, say, 20 years ago, when it got to 4% or so. But that said, we are seeing small business, new job creation. We're seeing new industries emerge as we talked about several years ago. It just takes some time for those economies and industries to really expand at a vigorous pace. But taking a step back, the rate of innovation globally has not only not slowed, it's actually accelerated, if you look at the rate of patent innovation and so forth. So, ultimately, jobs will follow, but they will not match necessarily at the same frequency that we would like them to occur.

Rebecca Katz: You have talked about us being sort of on the precipice of sort of the next industrial revolution, but more from a technological perspective. I think you've had good examples of that over the years.

Joe Davis: A lot, and 80% of the S&P 500 companies we've mentioned—you're right—have been started during tough economic times. Now, that said, I am not here to say this is a Pollyanna assertion. There are winners and losers in any sort of when the technology expands or an industry goes through change, and it can be painful for those companies or those businesses that may be on the losing side of that. This is not Pollyanna-ish in any regards, but it is also not a zero-sum game. And so if you have an increase in the global standard of living, which is what productivity really means, that means there's overall greater demand, greater wealth, and hence greater prosperity, but it can be a painful process and not all may feel that's the case if they're on that side of the equation.

Rebecca Katz: Right, the buggy whip manufacturers weren't too happy at the automobile. We have a question to something you said earlier from Masuma in Florida, who said, "It was mentioned that rising rates are healthy. Can you explain that?"

Joe Davis: Rising rates can be healthy if they reflect stronger economic activity with little or controlled rates of inflation and so, for example, we've looked historically as real interest rates were at X and they rose to X plus some number, what has been the association or correlation over a 3- or five-year period with stock markets who, on average, over long periods of time in the United States have given a return around 10%—never in any one year, but on average. And what we found is that, at the margin, when real rates are rising, there's actually been an inclination or a tendency for stock returns over a 3- or five-year period to actually be higher than history rather than lower than history. That does not, in any way, suggest that that will necessarily happen going forward, but that has been the historical tendency. And, again, the reason for that is, historically speaking, a rising real rate environment associated with higher productivity growth, higher earnings growth, and higher, more job creation; so, in other words, a healthier business cycle, and so that's why. Now, again, if rates rise solely because inflationary fears rise, and it's not matched by a rise in the real rate, then that is not necessarily positive news for equity markets around the world.

Rebecca Katz: Okay. That's a good clarification. Our next question is from Martin in Missouri, who says, "How quickly will mortgage rates rise in the next few months?" So I know you can't predict the next few months.

Joe Davis: But there's historically been an association clearly between mortgage rates and longer-term U.S. Treasury—the seven-year, the 10-year. Again, there's a lot of nuances in the mortgage market, but there is a correlation and there's tends to be a little bit of a lag, but I think we'll leave it at that.

Rebecca Katz: Can't pin you down on short-term predictions. So just watch the seven-year and 10-year Treasury, I guess. Our next question is from Raymond in North Carolina, who says, "Where are current stock valuations relative to historical averages, and what does that imply for stock returns over the next ten years?" You talked about this a little in the context of emerging markets, but what about in the U.S.? Are valuations high? The markets have been up?

Joe Davis: And that's a great point because this gets to two very important points I'd hope we all take away today. One is, again, the concern with rising rates and the potential risk of loss in bonds. It'd still come back to what has more volatility, stocks or bonds, right? Stocks. And so the concern from some before of—should I take more equity risk in a rising rate environment? Just be prepared that one is taking on much greater potential for—a potential bear market in stocks dwarfs that of a bear market in bonds in terms of potential downside loss. Now, that said, for those investors thinking about taking on more risk, the valuations, if anything, have become somewhat less supportive given the very strong, rapid increase in global equity markets over the past several years.

Rebecca Katz: Maybe we should define what we mean by "valuations."

Joe Davis: Valuations such as P/E ratios, so price-to-earnings. There's other measures such as price-to-book.

Rebecca Katz: So that's the price you're paying for a stock relative to what it's actually throwing off in terms of a return.

Joe Davis: Yes, yes, exactly. So that P/E—and so, historically speaking, normal or average has been somewhere in the teens. Think of it, the inverse of a P/E is an earnings yield, so that would be an earnings yield of a 5% or 6%, perhaps even 7%. So, ironically, over the past several years, as the equity market has rebounded and as the economic—the global economy has rebounded, our essential tendency of our long-term stock projections has actually moved down as more investors have actually said, "You know what? Maybe stocks are the place to be." So it's ironic. Again, it's this long-term perspective, where in 2009, 2010, at the margin, our expected long-run stock returns were higher than they are today, even though today the economy in the private sector is healthier than it was three years ago. It's, again, because the valuation—

Rebecca Katz: You're starting off with a low base, right?

Joe Davis: Well, only more recently, prices have risen more quickly than earnings, and so the P/E, that ratio, has gone up, and by some measures it's above its long-term average. So I would say at the margin, but again, given the relationship, long term, it's not strong enough to say definitively, but at the margin the equity outlook, although it's still formative over the next five or ten years, is not as strong as it was just two or three years ago.

Rebecca Katz: And when you say at the margin, you mean just like—

Joe Davis: Oh, really at the margin.

Rebecca Katz: Little chance.

Joe Davis: Yes, yes. Again, the outlook that our range for stock returns, even on a 10-year annualized basis, is really wide. Some will try to pin me down on a number why Vanguard as a firm—I'm actually very proud of it. Why we don't provide numbers? Because we can't, because there's no historical—that's so much conviction in a signal that you and I could point to, point to our viewership today and say, "See this?" This implies with 90% precision that if there were, you could have that. In fixed income, the yield to maturity on bond portfolio can get you closer to a smaller range of outcomes. In stocks, it just tends to be that much wider.

Rebecca Katz: Okay. Our next question is from Robert in Hillsborough, California, who says, "How much of a correction in the equity market is likely to result in the event that the Fed sharply cuts back on quantitative easing?" Now, they're not signaling that they would make a sharp cut, but they haven't done anything yet and we've already seen a steep decline in the equity markets over the last two days, so what are your thoughts on that?

Joe Davis: Oh, boy. Clearly, when monetary policy becomes much tighter than expected and again, it's that word you use, Rebecca, relative to what's expected, in the person's question, client's question. In any one day, that same day or that same week, yes, I think volatility potentially could really rise, but, again, taking a step back as long-term investors where we have historically been very successful, why we've been successful, as you say, what's the long-term implication of that? So if they are tightening more aggressively than potentially was anticipated, that means the economy, and the labor market, is even stronger than they were previously anticipating three or four years ago, again, under this hypothetical scenario. So longer term, again, this would come back to good news for global investors. It would not feel like it potentially that they are weak, but investing is not about weekly movements, but we do. We have to have the fortitude to bear it. We really do.

Rebecca Katz: After what we've been through the past three years, I think a lot of us are feeling that what doesn't kill us makes us stronger. So let's scroll down and see if we can see another question. Our next question is from Dennis in Suwanee, Georgia, who says, "Over time, which economic indicators have the greatest impact, when officially released, on the stock market?" So we talked a little bit about employment. You talked about wages being really critical. Anything else that is key?

Joe Davis: Historically, the big three have been the labor market report—the nonfarm payrolls in economic circles is the first Friday, generally, of every month. The other one, historically, which has mattered, is the consumer price index, so if inflation is markedly higher than expected, sometimes that has an impact on the equity market and the bond market, certainly, because that would imply potentially the Federal Reserve becoming more aggressive, less aggressive. And then, ultimately, another very strong bearing is what Federal Reserve policymakers do and/or say. So, for example, Ben Bernanke's testimony yesterday: Exhibit A. So those three, by and large. Other indicators can matter from time to time, but they're generally warped by those three broad buckets.

Rebecca Katz: Okay. Come down to your office on that Friday, release those reports.

Joe Davis: From an economist's perspective, it's kind of like the Super Bowl, but it's 12 times a year.

Rebecca Katz: Our next question is from Phillip in Portsmouth, Ohio, and he says, "It seems that stocks and bonds are still too highly correlated, so what can a new, young retiree do to protect his or her assets? Is a stay-the-course philosophy truly the best thing to do with all the uncertainty around the world?" Have we actually seen a tight correlation between stocks and bonds?

Joe Davis: Actually looking over the past several years, the correlation is still well within the historical band in terms of low general correlations, right? Now again, in any one day, you're going to see jumps and if the bond market and equity market, as just an example yesterday with Ben Bernanke's testimony, were both under pressure. So, at the margin, in the past several months, correlations were higher than perhaps generally speaking, and I think part of that actually was an area of concern for us not because of what it implied for diversification; that's not the point. It was because of the considerable momentum we were seeing in the financial markets, right?

It seemed like every asset class was going up and regardless of the news in the marketplace, and that's uncommon. And, again, another reason why it gave us pause on the momentum, and the sort of modest froth we were seeing, and again raising rhetorically the question at the margin, was monetary policy globally perhaps working too well? And so, again, I think it's welcomed news that policymakers are starting to think about the marginal costs as well as the marginal benefits of monetary policy, and because there have been marginal costs and savers, and others have bared some of this brunt. I wouldn't get too worried about correlations on any week or month. Over longer periods of time, you're going to—we would expect those sort of ebbs and flows between stocks and bonds to still provide diversification.

Rebecca Katz: Okay, great. Our next question is from Don in Indiana, who says, "What are some of the leading factors that explain stocks retreating so drastically after the nice tick-up all year?" So is it really just this reaction to the Fed's comments and some other comments and concerns out there? Is there anything sort of more fundamental going on with stocks?

Joe Davis: It is tough to definitively answer that, Rebecca, because correlation is not necessarily applied to causation. If I had to pick one reason, it's yes, it's the potential reassessment of when the Federal Reserve may begin removing some of their accommodation, but part of this just could be the sentiment, and we have had strong gains in the equity markets thus far this year. We've effectively had the historical average in less than six months, right? We all know how volatile the equity market can be. Whether it's this, or whether it was the slowdown in China or some news out of Europe, there could have been something else that, if it wasn't the Fed, someone else would be labeling to some.  So, yes, I would say some factor could be the monetary policy, but no one can say with great conviction; they can attribute it solely due to what's been happening at the Fed.

Rebecca Katz: On a related question, Robert in Marion, Iowa, asks if 7% is sort of a reasonable expectation for a rate of return around a diversified stock portfolio. So we've talked about diversification, how important that is, and sort of that long-range range of returns. So, in a sense, probably in that range somewhere—

Joe Davis: You just said it, Rebecca. I think you had the perfect answer.

Rebecca Katz: So it's 3% and 12%.

Joe Davis: That number is within the range and, in fact, will continue. I think any of us—if I use one number that belies a level of conviction and predictability that just in our mind does not exist in this world. And as soon as one opens oneself up to the humility of the uncertainty of the future and that wide range, I think by definition that will lead one—encourages one to have greater diversification, because if one braces and has respect for the financial markets and how volatile they can be on a given day, and it catches everyone by surprise, that can serve investors well. So it's—there's a range, seven, that number seven is within that range, but I think that's just a good point to keep in mind.

Rebecca Katz: And it's smart because, at your end, you see all the articles about who predicted the best, who predicted the right number for stocks during the year, and most of them are wrong. There's always going to be one person who kind of gets close.

Joe Davis: It's like throwing darts, right? Initial conditions can matter, and that's why I'm so proud to work at Vanguard, because you will never find someone from Vanguard in one of the short-term surveys, right? Even though we follow the markets closely, I would hope we're not foolish enough to say where the S&P 500 may be at the end of the year.

Rebecca Katz: Right. Our next question, shifting gears a little bit, is from Todd in Houston, Texas, and he says, "In March of 2012 on the Vanguard Blog," Joe is one of our good bloggers, "you wrote an informative article titled, 'Why I still own Treasuries.' If you were to republish that article today, would it be exactly the same or would you make any changes to it?" I see a blog idea for your next blog. I think you should dust it off.

Joe Davis: Thank you very much for that suggestion. I always like repurposing old work.

Rebecca Katz: So, maybe for those who haven't read it, what was the key point in that blog post?

Joe Davis: Well, there were three key points. One is just as relevant today and I would repost it. I would just update some of the recent statistics but the takeaway—and I'm actually very proud personally; we should be proud of that message broadly around fixed income. It was one—was just because interest rates are low does not mean that they have to rise tomorrow and, again, that was more than two years ago, and so it's taken some time for rates to rise, and who's to say if they're going to rise immediately in the next two days, either? Secondly is that with low interest rates, that did imply muted return for bond portfolios over the next several years and that there was more risk of a one-year or one-month loss going forward than there had been over the past 30 or 40 years just because the low income cushions in those portfolios, and that has played out at least in the past day or two. And then, finally, most importantly, and why I still own U.S. Treasury bonds as part of a broadly diversified portfolio, is that bonds are just inherently, as a broad asset class, less volatile that equities, and that played out yesterday. Equities were down more than fixed income even though rising rates was the source of the concern, and so that's just the broad tenet. No, I think for all of us, we just have to know and realize why we own fixed income securities in a portfolio. And the one thing that I would say that would be different is that rates today are slightly higher than they were at that post and so, if anything, that would imply a slightly higher expected return going forward for bonds than at the time we did that.

Rebecca Katz: Yes, we didn't get to talk much. I mean, rising interest rates for bonds are actually good news for retirees and folks who are living off that income.

Joe Davis: You have to stay invested and reinvest the coupons or stay invested in the mutual fund structure that will automatically do that for you.

Rebecca Katz: Well, Joe, it's hard to believe, but an hour has just flown by and we are out of time, and we have so many great questions left. So, hopefully, I'll encourage that if viewers have questions they want to ask, they can post them to Vanguard's Facebook page, and maybe we can rope you into answering a few more online.

Joe Davis: We could do a few more blogs.

Rebecca Katz: There we go, exactly, so I just want to thank you for your time. Any last, quick, 30-second thoughts you would like to leave with our audience?

Joe Davis: No. Don't let the recent consternation of Fed policy—don't put it too heavy in one's mind to influence changes. The same way we said three years ago, don't let the profound losses that there were in equity markets really sway one if one was still comfortable with their long-term plan. And I tell you that's—I'm keeping that in mind and when I look at my portfolio every day, and so I was well-served three years ago and I truly believe we'll be well-served for the next several years if we continue to keep that in mind.

Rebecca Katz: Great, so you heard it here—stay the course, tune out the noise. Very wise advice even if it doesn't change much over the years. So thank you so much for being here with us, Joe. I really appreciate the time, and thanks to all of you for joining us and sharing your afternoon with us. We will send out an e-mail with a replay to this broadcast in just a couple weeks with a transcript, and look for some short segments on our website in the coming days. Also, if you do have more interest in what's going on with the Fed and in the economy, check out, where we will have lots of information and articles, and we are following this closely. So when you do shut down your browser, you should be prompted to fill out a survey. We'd love to know what you thought of today's broadcast, and [if you] have suggestions for others, please send those along. Once again, from all of us here in Valley Forge, thanks so much for joining us and we hope to see you on Facebook. Bye.


All investments are subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

Bonds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.

Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates. These risks are especially high in emerging markets.

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