Markets & Economy
Easy money, hard choices
November 06, 2013
Catherine Gordon: Hi. I'm Catherine Gordon at Vanguard. Welcome to today's program where we'll discuss the effects of the easy money policies now in place in many major economies including the United States. Joining us are Joe Davis, Vanguard's chief economist, along with Chuck Thomas and Andrew Patterson, two of our investment analysts. Joe, Chuck, and Andrew, thanks for being here today.
Joe, the Fed surprised many of us when it delayed tapering its bond-buying program last month. What's our outlook for Fed policy and its impact on interest rates and how does this affect bond investors?
Joe Davis: I think it's important to—which is what you stressed, Catherine—delay because I think ultimately, very likely the Federal Reserve will pursue tapering quantitative easing, which in effect—and in fact you and I talked about it the last webcast—tapering is just reducing the pace with which the Federal Reserve is adding to their balance sheet, which today is north of $3 trillion. So I think it's been important, it's been consistent with the gradual improvement we've seen in the economy. And I think investors should prepare for it going forward, the changing of the mix of the policy tools which they can use, which is now the expansion of the balance sheet which over time should begin to decline over the next several years—and then stressing forward guidance—which means when the Federal funds rate, the short-term interest rate, will rise.
So I think it's going to be important. I think at the end of the day, whether there's some hesitancy at the Fed is to see how strong the economy was given the fact that we saw a rapid rise in interest rates through the summer, from the 10-year Treasury [yield going] from 2% to 3%, to how strong is housing, and so forth. I think ultimately, the economic fundamentals will remain resilient in the U.S., which means that by the end of this year and if not by the latest, early 2014, we're starting to actually hear more details around the announcement of Federal Reserve tapering.
Andrew Patterson: I think it's really important to keep in mind the uncertainty around first the timing of any sort of announcement and policy—monetary policy in general—because the Fed has made clear in all their communications to date that once they do initiate the tapering, it's not a "set it and forget it," so to speak, policy. They are going to be evaluating the economy at any given point in time and making adjustments to policy based on that. So any investors trying to take advantage of what they perceive to be the Fed's policy going forward should really keep that in mind, if they're making asset allocation decisions based on that.
Charles Thomas: In addition, investors really need to keep in mind the role that bonds are playing in their portfolio. A lot of focus has been on the prospect for rising interest rates. We would encourage all investors to really evaluate the risk reduction role that bonds really offer in a balanced portfolio in light of everything that Andrew and Joe just said.
Catherine Gordon: Andrew, what effect has U.S. fiscal policy had on the economy this year and how might it shape economic conditions in the future?
Andrew Patterson: Fiscal policy's impact on the economy this year has been largely negative and for the most part, that's what's been expected. Any time you have policy such as the ATRA [American Taxpayer Relief Act] or the sequester, when those are implemented, you're increasing taxes and decreasing spending. That tends to have negative implications for economic growth. The Fed has been stating as much in their statements following their meetings. Since about March is when they began discussing the implications of fiscal policy on growth.
One of the positives though, is that the negative implication should begin to fade off as the economy, so to speak, gets use to this new level of spending and tax rates and begins to grow off of that.
Longer term, the issues we need to focus on would be entitlement spending and tax reform. So it's something to keep in mind going forward to make sure that if policies like the sequester may remain in place, you don't start to see what's called fiscal adjustment fatigue, wherein the policies implement so much harm because they weren’t as focused to begin with. They start rolling those back over time. You want to make sure that we stay on the right course in terms of fiscal policy.
Catherine Gordon: Andrew, how's the U.S. consumer holding up in all of this?
Andrew Patterson: The U.S. consumer, given all the headwinds they're facing, including persistently high unemployment, tepid personal income growth, and increasing uncertainty around both monetary fiscal policy, they've been holding up reasonably well. The U.S. consumer continues to be the engine that drives U.S. economic growth. They've been holding up well despite declines in the level of growth, even negative growth coming out of business, out of the government sector. They've been holding their own, so to speak.
Going forward, there are several factors that are impacting consumers, one being increases in house prices. As you're seeing, as prices start to appreciate, it's lifting more consumers back above water in terms of their mortgages, so they're not as apt to walk away, to be subject to foreclosure, and to just walk away from that debt.
That said, the debt that consumers do hold currently, while it has declined significantly since the pre-recession era, it is still high by historical standards. However, the cost of servicing that debt measured in ratios such as the financial obligations ratio is toward the lower end of the historical range. So consumers are able to finance the debt that they do hold and that frees up more money for consumption, for spending on other goods.
Catherine Gordon: Chuck, the U.S. Energy Information Administration recently released a report that indicated that the U.S. is poised to become the number one energy producer, oil and gas, in the world in 2013. What are the global implications of that current energy boom?
Charles Thomas: That's a great point, Catherine, and probably one of the underappreciated things that we've seen over the past five years. Since 2008, U.S. energy output measured by oil and natural gas production has increased by about 50%. That's pretty huge and we are really poised to become a net energy exporter, which can really change the dynamics of our economy.
So there have been some very interesting developments with natural gas. We'll focus on oil because most of our investors probably care about the gasoline they're putting in their tank and may be questioning, given this increase in energy production, why aren't gas prices any lower than they are? There are a couple of reasons for that. All of the new production that we have seen in the past few years is due to new technology. There are new ways of getting oil out of the ground, areas that we couldn't access before. That requires higher oil prices. It's really not profitable to extract oil from certain areas in the northern U.S. and Canada with oil prices less than $70 a barrel.
So we wouldn't necessarily expect to see prices fall that much from where they are today, a little bit above $100 a barrel, despite the increase in production. Not only that, these new ways of getting oil out of the ground, they decline pretty rapidly. Once new wells are dug, the production rate declines over time. So we are looking at a peak in production somewhere around 2020.
Add with that, the increasing demand from China and other emerging markets, it's very unlikely that we're going to get back to the gas prices that we saw in the late 1990s or 2000s. Now, there is some good news—partly due to the recession and partly due to better vehicle fuel economy and a move toward public transportation. Consumers are driving less, using less oil. So our demand is falling and our supply is increasing. It will be really interesting to see how that impacts economic growth over the next decade.
Catherine Gordon: Chuck, the news out of Europe seems to have improved in recent months. Has our outlook changed for the European economy and the future of the euro?
Charles Thomas: In terms of how we think about the Eurozone going forward, it's likely that we're not going to see a really robust return to strong growth anytime soon. That's really due to the causes of this current recession. We have very big divergences across countries. We have unemployment rates in the peripheral economies like Spain, Greece, and Italy that are very, very high. At the same time, the core economies of Germany and France are doing quite a bit better. So policymakers are very focused on correcting those imbalances. So we've seen a lot of push for structural reforms in the Eurozone. So that means freeing up labor market regulations, reducing cumbersome business regulations in the peripheral economies that allows them to compete at a level that's on par with Germany.
These take time so monetary policy has been focused on addressing the shorter-term issues. There's been a lot of fear of a breakup of the currency union and we've seen that reduced pretty drastically over the past year or so, which is a good sign. But in the long run, what's going to be key for Europe is the implementation of the structural reforms.
Catherine Gordon: So taking everything that all of you have said into consideration, do you think there are any trends that investors should be considering in managing their portfolios and given all that we've heard, are there any actions you think they should take?
Joe Davis: I would just start back with our investment principles around the balance costs and the long-term orientation. There was a great deal of consternation at the beginning of the year, some which has been realized but balanced portfolios have done okay. I think at the margin, I'm concerned about some of the trends. Really, I see a lot of momentum in the marketplace so it's not just reaching for yield and take on higher income oriented-strategies but you see it in frothiness in errors of markets and we talked about this for a year, Catherine, so I just go back to value and long-term perspective, if that's one central tendency. I think it's a good place to be strategically longer term.
Catherine Gordon: Joe, Chuck, and Andrew; thanks for your insights. And thanks to all of you for watching. We hope that you'll join us again for our next economic discussion of trends around the world.
All investing is subject to risk, including the possible loss of the money you invest.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Diversification does not ensure a profit or protect against a loss.
Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
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 issues 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.
Stocks of companies in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
Investments in 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.
© 2013 The Vanguard Group, Inc. All rights reserved.
A conversation with Vanguard Chief Economist Joe Davis and investment analysts Andrew Patterson and Charles Thomas
As global economic growth continues to be sluggish, many major central banks are pursuing unusually aggressive monetary policies in an effort to stimulate their economies. Are the policies working?
Vanguard Chief Economist Joseph H. Davis, Ph.D., and two of our investment analysts, Andrew Patterson and Charles Thomas, discuss the impact of easy money policies now in place in many major economies, including the United States.
- All investing is subject to risk, including the possible loss of the money you invest.