News & Commentary

U-shaped recovery offers tried and true opportunities for patient investors, says Vanguard Chief Economist 18 Mar 10

Sydney, 18 March 2010: The global economy will be self-sustaining in the wake of the global economic crisis, despite some near-term risks and secular US concerns such as the jobless rate and high debt, according to Vanguard''s US-based Chief Economist, Joe Davis.
 
Mr Davis says the long-term prognosis for global stock and bond markets remains positive, and investors would be rewarded for adhering to timeless investment principles of being patient; staying diversified; controlling what they can control (costs, strategic asset allocation and portfolio rebalancing); and disregarding market noise.
 
In Australia offering a global perspective on investment markets for local advisers and investors, Mr Davis forecasts a longer, slower, U-shaped recovery but believes that a low growth environment need not imply low asset returns.
 
Mr Davis bases his views around assessments of four economic ''rocks'' - inflation; fiscal deficits; currency movements; and the ''twin engine'' effect of the slower growth of the developed over the emerging markets.
 
'Looking at history, current trends and forecast data relating to these four key areas can be a useful guide for asset allocation,' said Mr Davis. And, while acknowledging that there are risks ahead, Mr Davis considers that some of them may be overstated - inflation being a case in point. 
 
'If we look at core inflation momentum drivers, we see that wages are stagnant, pricing power weak and we have large weighted output gaps creating significant slack - all of which point to a low-inflation environment in the US. In addition, the behaviour of the banks at the moment is anti-inflationary,' he said. 'Similarly, on the interest rate front, although there have been some concerns that rises may erode long term bond yields, these may be premature.'
 
For investors, he said, the inflation outlook leads to a modest or mixed outlook for fixed interest, much of which depends on the activities of the Federal Reserve.
 
The same outlook does not apply to equities, where Mr Davis is somewhat more bullish.
 
'We then look at fiscal deficits, which are currently very high across the developed world, and what we see is that low GDP growth does not necessarily imply low asset returns,' said Mr Davis, who pointed to a low historical correlation between long-run GDP growth and long-run equity returns.
 
'In fact, the price stock investors pay for economic growth - that is, P/E ratios - tends to matter much more than any expected growth rate.'
 
Currency movements, too, should be considered when planning portfolios', according to Mr Davis, 'and whether or not to hedge should be strategic and used to reduce risk in the portfolio rather than to enhance returns'
 
He also counselled caution when investing in emerging markets, where the dramatic rise in comparison to those of the developed world, continues to attract significant investment dollars. However risks do remain in these markets and investors should consider their appetite for risk.
 
'All in all, while the long term market outlook is positive, there are some significant near term risks including high debt levels and the fortunes of troubled sectors such as commercial real estate and smaller banks, to name a few,' said Mr Davis.
 
'There are also sovereign debt issues in Europe and the question of how we are going to manage the scaling back of global fiscal stimulus. However, on the plus side, we are looking at strong performance in the global trade, manufacturing and technology sectors that are still at a favourable stage in the inventory cycle.'
 
'And we can never underestimate the impact of sheer animal spirits on the markets - while optimism prevails so, history tells us, does the market.'
 
For investors, concluded Mr Davis, all this spells out the need for a keen understanding of risks that prevail for each asset class. With global diversification across the portfolio, care should be taken with the temptation to invest in growth-value investments and the BRIC economies and investors should guard against overreacting to rising rate concerns in building bond portfolios.