Vanguard’s Davis: Facing The Slow Slog

August 23, 2011

The basics of investing haven’t changed, but a period of lower returns is unavoidable, Vanguard’s Chief Economist Joe Davis says.


When Vanguard Chief Economist Joe Davis spoke recently with Managing Editor Olivier Ludwig, the conversation was eerily similar to what they discussed about a year ago. They talked again about slowing economic growth, a volatile stock market and questions hanging in the air about what the Federal Reserve might do to rekindle growth.

Davis thinks the Fed is likely to step in and continue to try to jump-start growth, as whatever benefits such efforts may bring probably outweigh the consequences of the central bank doing nothing at all. Whatever the Fed ends up doing, Davis said that investors must understand that expected returns are likely to be lower than they have been for much of the past century, and that the market appears to be expressing just that.


Ludwig: When we last spoke in 2010, it was right after the “flash crash.” There were Molotov cocktails flying in Athens, and while there’s no flash crash this time, it seems that a lot of the themes we discussed a year ago are still very much in front of us.

Davis: Yes, with the concerns of a soft patch last year, the chances of a recession got about as high as one in three. But this time they’re higher. There’s a move toward more fiscal austerity, and I think things are a little bit more precarious because of that. There’s also a more serious undertone reflective of a structural change that needs to occur in our economy and in many other developed economies around the world. It’s starting to set in now. It’s potentially serious when you overlay some of the uncertainty with respect to Europe. In my mind, they’re still behind the curve.

Ludwig: What was your response to the Fed’s decision to keep rates low until 2013

Davis: I suspected that they were going to actually give a date. At the end of the day, what investors have to appreciate is that Bernanke and a few others at the Fed’s Board of Governors are extremely concerned about this longer-term malaise and Japan-type scenarios affecting expectations, which becomes self-fulfilling.

I have high confidence that should inflation continue to fall like last year, that the Fed will even do more. You have to put it in the framework—which I believe some of the Fed has—of what harm will it do if it does more as opposed to if it doesn’t. So the default is to lean more towards doing something as opposed to not doing anything because there won’t be much impact.

Ludwig: Let me try to understand the subtle distinction you’re drawing here. You’re saying that doing it—while it may not be terribly fruitful—is a better call than not doing it, which could make the malaise that’s setting in become more ossified?

Davis: Exactly. I’ve said to some clients before that they’re fighting psychological warfare. The Fed is trying to impact the expectations you and I have and those that are running businesses have. But it’s risky. QE2 arguably boosted energy prices to some extent.

Ludwig: But QE2 did coincide with the troubles in the Middle East, so it’s hard to separate the wheat from the chaff there.

Davis: It is hard. At the end of the day, policymaking is always about trade-offs. But they’re trying to fight that war. There are some positives, and I think one is that even if we do have another recession, more likely than not it may be mild—certainly relative to 2008, but even relative to other ones. My best guess would be it would be more similar to ’01 and ’02. After the fact, at least economists might debate whether or not it was a recession at all.

Ludwig: How do you respond to the arguments that Greenspan was too quick to run to the rescue back in 2000 and at the end of the Internet bubble, such that really there’s still some excess in the system that has yet to be completely wrung out? Is that preposterous to you?

Davis: No, it’s not. I think there’s certainly some arguments that one could make that interest rates were too accommodative in 2003, 2004 and 2005. I think, though, it goes beyond the Fed funds rate. The easiness of financial conditions and the provision of credit were generally to blame. And I don’t think it’s fair to single out any one party. But there were warning signs across the board.



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