What to do with your money as rates rise and markets stumble
Few people oversee pools of assets larger than the economic output of major countries. But Gregory Davis, Vanguard’s chief investment officer, holds such a seat, overseeing $7.7 trillion in assets, more than Japan’s gross domestic product. At the top of his concerns lately: inflation and US stock market valuations.
Barrons recently spoke 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 liquidity, why Treasury inflation-protected securities might not be the best hedge against inflation, and why investors might want to look overseas. An edited version of our discussion follows.
Barrons: Inflation hit its highest level in 40 years in January. How bad is that?
Gregory Davis: Clearly, there are short-term pressures on the inflation side. The Fed will have to be more aggressive than what is valued in the market, in the long term. Our long-term expectation for the neutral rate is closer to 2.5% to 3%; the market expects 2% to 2.5%. They’re going to have to go a little further to get inflation under control longer term, but we think they’ll be able to make sure it doesn’t get out of control. If you look at what the market is pricing for inflation over five years, five years from now they are pricing 2.1%. The market therefore thinks that the Fed is credible in its ability to fight inflation.
What would taint that credibility?
If you see the Fed moving in a more gradual fashion and the inflation data continues to be strong and it’s not more aggressive even with the balance sheet runoff or the pace and magnitude of the runoff, they potentially lose some credibility. But we haven’t seen any signs of that yet. It will depend on the language and the first activity of the March meeting.
What do inflation and higher rates mean for bond portfolios?
If you start to see the Fed hike rates aggressively over the next couple of years and the 10yr hovers around 2%, we could arrive at an environment where the bond market segments look more attractive given the risks in the stock 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.
Isn’t rising rates bad for bonds?
It depends on your time horizon and how you invest. As long as your time horizon is longer than the duration of the fund, you are better off with rising rates because you can reinvest the coupon at higher returns, as opposed to short-term price appreciation. If someone has a bond fund with a duration of three years and a horizon of 10 years, it is better that the rates go up rather than down, because as these 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-term bond fund and has a short-term horizon. It’s bad because you get a drop in price because rates go up, and you don’t have time to take advantage of coupon reinvestment and cash payouts.
How to get ballast in your bond portfolio?
We encourage investors to consider the broad fixed income market. A US global bond product will have a longer duration, but if there is a stock market correction, you want duration. If we see a 10-20% decline in equity markets, we will start to see a flight to quality and 10-year and longer bonds will rally, so duration will help provide that balance. But if you’re income-only and have a short-term horizon, say, you need a down payment in the next 12-18 months, you don’t want duration risk. You won’t have the benefit of recovering from rising rates, just a negative capital loss upfront.
Where should you put money if you need it in 12-18 months?
Cash. We will see money market rates start to rise. Short-term bond funds might be another place to look. It’s going to have a slightly longer duration of a year or less, and you might get some extra yield because there’s more credit exposure.
Are you concerned about credit risk?
This is a concern when the economy begins to slow down, incomes deteriorate significantly, and the consumer begins to drift away from economic activity. But we are far from it, given the cash flow [on corporate balance sheets] and personal debt reduction. The consumer is well placed. There are 10 million jobs to fill and employers are struggling in a very robust job market. This bodes well for economic activity.
How can investors protect themselves against inflation?
A lot of people are talking about TIPS [Treasury inflation-protected securities]. They are useful in the event of an unexpected rise in inflation. But to benefit from TIPS, inflation must be higher than expected. If you’re a long-term investor, provided inflation is in a reasonable range, stocks are a great hedge. We don’t expect that, but if we had runaway inflation – consistently high in the single digits or double digits – it becomes difficult for equities.
What indicators should we monitor?
A big driver will be wage growth. If companies are struggling to find labor and still have to pay, wage gains must ultimately be passed on. Once supply chains return to normal, it will be important to look at wage growth and determine what proportion of those who have left the labor force are choosing to re-engage.
The S&P 500 is down 6% year-to-date. What is your outlook for US stocks?
The US stock market is at its highest valuation since the dot-com era. Over the past 10 years, the S&P 500 has recorded an annualized gain of 15.5%. Historically, it has been closer to 9%. The market therefore got ahead of itself. Our forecast for the US stock market is 2% to 4% over the next decade, which is considerably below the long-term average because yields have been so high over the past decade and valuations seem tense.
Does this mean there is more pain ahead for US equities?
Volatility is likely as Fed policy becomes less accommodative, but we don’t necessarily call for another 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%, due to valuations. We always encourage investors to seek a global allocation, for both equity and bond markets. After this period of American outperformance, it is important to rebalance, like those who started with a portfolio of 60% stocks and 40% bonds which is now completely shifted after five years [of a bull market in stocks].
What does this mean for the 60/40 portfolio?
There have been a number of articles about the death of the 60/40 wallet. Having a diversified portfolio is always important because it gives you dry powder to rebalance when you see a big drop in the market. You need to be comfortable with the amount of volatility [in a portfolio] so you don’t sell stocks when the market is down 30-40%.
Speaking of volatility, what does that mean for the growth stocks that have dominated the market?
If you look at a discounted cash flow or discounted cash earnings model where the rates are zero, it doesn’t matter if the earnings come 20 years from now or five years from now. But in an environment where the Fed will be very active for a few more years to raise rates, you have to start discounting long-term cash flows, and companies won’t be worth the same as those generating them over the next period. -two years.
Should we care more about debt and balance sheets?
Balance sheets are in very good shape because companies have refinanced their debts and borrowed at incredible rates, and profits have increased. We expect earnings in 2022 to be lower than last year, but funding costs and debt servicing are relatively well maintained. We don’t see a lot of risk in the balance sheets. [The risk] comes more from valuations. We will likely see a contraction in valuations, not an expansion. We expect 9% earnings growth for the S&P 500, which is still above the long-term average, but will moderate as the economy begins to slow.
What does this mean for large-cap tech stocks?
The majority of our assets are in indices. You want to be broadly diversified as a baseline. If you want a slant, it should be at the margin. If you look at the valuation metrics – book price, price to earnings, price to cash flow – the value segment looks more attractive than the growth segment. The Russell 1000 Growth Index has outperformed the Russell 1000 Value Index by 11 percentage points per year for the past five years. It’s likely that value could outpace longer-term growth because valuation is so different.
As another Black History Month draws to a close, the industry still faces a lack of diversity within 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 interested in investing], and Diversity Investment Management Engagement for recruitment to ensure our entry-level programs are highly diverse. Our goal is to impact the pipeline and grow this talent over time to higher ranks. As an industry, we need to reach out to people from non-traditional backgrounds. For example, if someone has an engineering background and a good quantitative background, why wouldn’t we want to talk to them?
Getting people to the entry level is only part of the problem. How do you engage them to make meaningful change?
The environment must be good. Are there people really invested in your development? Otherwise, it’s hard to give candid feedback on what someone is doing well or not doing well. It’s different from mentoring, but more like sponsorship. This person will speak on your behalf when you are not in the room and will use their own capital to push you. And [everyone in the company] must see it as a business priority and realize that making the pie bigger is good for everyone.
Write to Reshma Kapadia at [email protected]