Not that many people oversee asset pools that are larger than the economic output of major countries. But Gregory Davis, chief investment officer of Vanguard, sits in such a seat, overseeing $7.7 trillion in assets—more than Japan’s gross domestic product. Top of mind for him lately: inflation and U.S. stock valuations.
Barron’s recently talked with Davis—who is also part of a committee that meets quarterly to advise the Treasury Department on the strength of the economy and debt-management issues—about what to do with cash, why Treasury inflation-protected securities might not be the best inflation hedge, and why investors might want to look abroad. An edited version of our discussion follows.
Barron’s: Inflation hit a 40-year high in January. How bad is it?
Gregory Davis: Clearly, there are short-term pressures on the inflation side. The Fed will have to be more aggressive than what’s priced in the market, long-term. Our long-term expectation for the neutral rate is closer to 2.5% to 3%; the market is expecting 2% to 2.5%. They are going to have to go a bit further to keep a handle on inflation longer term, but we think they will be successful in making sure it doesn’t get out of control. If you look at what the market is pricing in for five-year inflation, five years from now, they are pricing in 2.1%. So the market believes the Fed is credible in their ability to fight inflation.
What would dent that credibility?
If you see the Fed acting in a more gradual manner and inflation data continue to come in strong and they are not being more aggressive, even with the balance sheet runoff or the pace and size of runoff, they would potentially lose some credibility. But we haven’t seen any signs of that yet. It’s going to depend on the language and the first activity in the March meeting.
What do inflation and higher rates mean for bond portfolios?
If you start to see the Fed get aggressive in raising rates over the course of the next couple years, and the 10-year is hovering around 2%, we could get to an environment where segments of the bond market look more attractive, given the risks in the equity market. The backdrop of still-low-but-rising yields, reduced policy support from the Fed, and already-stretched equity valuations suggests a challenging environment for the equity risk premium in the years ahead.
Aren’t rising rates bad for bonds?
It depends on your time horizon and how you are investing. As long as your time horizon is longer than the duration of the fund, you are better off with rates rising because you can reinvest the coupon at higher yields, versus short-term price appreciation. If someone owns a three-year duration bond fund and has a 10-year horizon, they are better off with rates rising versus falling because as those bonds mature, the coupon is paid in a rising-rate environment and reinvested at higher yields. The risk is that someone is in a long-dated bond fund and has a short-term horizon. That’s bad because you get a decline in the price because rates are going up, and you don’t have the time to benefit from the reinvestment of coupon and cash payments.
How do you get ballast in your bond portfolio?
We encourage investors to think about the broad fixed-income market. A U.S. aggregate bond product will have a longer duration, but if there’s a correction in the stock market, you want duration. If we see a 10% to 20% downturn in equity markets, we will start to see a flight to quality and the 10-year and longer-dated bonds will rally, so having duration will help provide that balance. But if you are only income-oriented and have a short-term horizon—for example, you need a down payment in the next 12-to-18 months—you don’t want duration risk. You won’t have the benefit of recouping from rising rates, just negative principal loss upfront.
Where should you park money if you might need it in 12 to 18 months?
Cash. We will see money-market rates start to rise. Short-term bond funds could be another place to look. That’s going to have a slightly longer duration of a year or less, and you could get some incremental yield because there is more credit exposure.
Are you worried about credit risk?
It’s a worry when the economy is starting to slow down, earnings deteriorate significantly, and the consumer starts pulling away from engaging in economic activity. But we are far from that, given the cash [on corporate balance sheets] and personal deleveraging. The consumer is in a good spot. There are 10 million job openings, and employers are struggling in a very robust labor market. That bodes well for economic activity.
Photograph by Aaron Richter
How can investors protect themselves from inflation?
A lot of people talk about TIPS [Treasury inflation-protected securities]. They are helpful for unexpected rises in inflation. But to benefit from TIPS, inflation has to be greater than what is expected. If you are a long-term investor, provided inflation is in a reasonable range, equities provide a tremendous hedge. We aren’t anticipating this, but if we had runaway inflation—persistently high-single digits or double digits—it gets challenging for stocks.
What indicators should we watch?
A big driver will be wage growth. If companies are struggling to find labor and have to still pay up, wage gains eventually have to be passed through. Once supply chains are back to a normal cadence, looking at wage growth will be important—and what proportion of those who stepped out of the labor force choose to re-engage.
The S&P 500 is down 6% so far this year. What’s your outlook for U.S. stocks?
The U.S. equity market is at its highest valuation since the dot-com period. Over the past 10 years, the S&P 500 has had a 15.5% annualized gain. Historically, it’s been closer to 9%. So the market has gotten ahead of itself. Our forecast for the U.S. equity market is 2% to 4% over the next decade, dramatically lower than the long-term average because returns have been so high over the past decade and valuations look stretched.
Does that mean there is more pain ahead for U.S. stocks?
Volatility is likely as the Fed’s policy becomes less accommodative, but we aren’t necessarily calling for further correction.
Is it time to look abroad?
If you look at international equities, we have a slightly better return forecast, closer to 6% to 6.5%, because of valuations. We always encourage investors to look at a global allocation, both for equity and bond markets. After this period of U.S. outperformance, it’s important to rebalance, similar to those who started with a 60% stock and 40% bond portfolio that is now completely out of line after five years [of a bull market in stocks].
What does that mean for the 60/40 portfolio?
There have been a number of articles talking about the death of the 60/40 portfolio. Having a diversified portfolio is still important because it gives you dry powder to rebalance when you see a large downturn in the market. You have to be comfortable with the amount of volatility [in a portfolio] so you don’t sell stocks when the market is down 30% to 40%.
Speaking of volatility, what does this mean for the growth stocks that have dominated the market?
If you look at a discounted-cash-flow or discounted-cash-earnings model where rates are zero, it doesn’t matter if earnings come in 20 years or five years from now. But in an environment where the Fed will be very active for a couple more years in raising rates, you have to start discounting long-term cash flows, and companies won’t be worth the same as those generating it in the next one-to-two years.
Should we worry more about debt and balance sheets?
Balance sheets are in very strong shape because companies have refinanced debt and borrowed at incredible rates, and earnings have come in strong. We expect in 2022, earnings will be lower than last year, but funding costs and debt service is relatively well-maintained. We aren’t seeing much risk from balance sheets. [The risk] is more from valuations. We probably will see a valuation contraction, not expansion. We expect earnings growth of 9% for the S&P 500, which is still above the long-term average, but it will moderate as the economy eventually starts to slow.
What does this mean for big-cap tech stocks?
The majority of our assets are in indexes. You want to be broadly diversified as your baseline. If you want a tilt, that should be at the margin. If you look at valuation metrics—price to book, price to earnings, price to cash flow—the value segment looks more attractive than growth. The Russell 1000 Growth index has outperformed the Russell 1000 Value index by 11 percentage points a year over the past five years. It’s likely that value could outperform growth, longer-term, because the valuation is so different.
As another Black History Month nears an end, the industry is still facing a lack of diversity in its ranks. How does this change?
The industry must aggressively reach out to underrepresented communities. Vanguard has engaged with historically Black colleges and universities, organizations like BLK [Capital Management, a student-run nonprofit focused on college students…
Read More:What to Do With Your Money as Rates Rise and Markets Stumble
2022-02-18 14:26:00
