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By Christine Benz | 10-04-2018

What's the right way to approach rising rates?

Vanguard economist Joe Davis thinks the Fed is unlikely to make a policy error and that there is no reason to abandon high-quality bonds.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How will rising interest rates affect investors and the markets in the years ahead? Joining me to discuss that topic is Joe Davis. He is the global chief economist and global head of Vanguard's Investment Strategy Group.

Joe, thank you so much for being here.

Joe Davis: Thanks for having me, Christine.

Benz: Joe, Vanguard has had a fairly moderate outlook for interest rates, and I think it's safe to say, you've been largely correct that the Fed has moved with a pretty deliberate pace. Would you say that your view, say, two years ago has kind of played out as you expected?

Davis: Generally. I think it's fair to separate, Christine, our outlook for short-term interest rates influenced by the Federal Reserve with long-term interest rates. Two years ago, we thought that Federal Reserve would continue on their very gradual tightening path, that they would lower their long-term expectations for interest rates--which at that time were elevated closer 4% or 4.5%--we thought they would lower their long-term expectations at the same time given what we anticipated or at least hoped for is more tightness in labor market that we would see them continue on their gradual pace. That's generally come to fruition. We continue to expect the Federal Reserve to raise rates to roughly 3%.

Benz: By when?

Davis: Every quarter through the middle of 2019. The one thing we have changed though, going into the year, we actually had a pause when the Federal Reserve would reach 2%, we thought that they would separate getting above the rate of core inflation, which is roughly 2%, seeing how the economy is doing and then proceed in a phase two approach. We've revised that and that's not what is going to happen. The Federal Reserve has been clear as well.

We still think the Fed effectively is doing a soft landing, which if one is going to be critical of our forecast, it would that that's really fairly unprecedented. History has generally shown that the Federal Reserve raises rates further than the bond market expects once it's in a tightening mode. Usually it only stops until effectively something has broken. We think the two things that give some source to our outlook, one is, by 2019, the economy, although very solid, will start to show some weakness from the deceleration of fiscal policy. The second one is that we don't see core inflation really rising materially above or below 2%. If core inflation continues to rise then our forecast is wrong, then the Federal Reserve will raise rates even more than the bond market is expecting.

Benz: That was my question about inflation. It sounds like you aren't nervous. There has been some handwringing recently …

Davis: One of our themes going into the year, however, was that there was risk to the status quo, which means we are never going to see any bout of inflation. We'd say, well, let's be careful. We're going to have periods where the market is ultrasensitized to any sort of looks like a breakout in either wages or inflation. I still think we are still going to see another period with which that may lead to some market volatility. We saw it in February. At the end of the day, when you smooth out that volatility, we still see core inflation slightly above and then coming back to 2% for a number of reasons. 

However, we do see wage inflation, importantly, rising higher, which would be good. I think it's important. The one risk that the bond market and even the Federal Reserve is, we separate our outlook for wage inflation different from core inflation. Some people put those two together. There is the risk that the Federal Reserve could overtighten because they see wage inflation rising. Let's say, in 2019-2020, assuming that it will bleed into higher core inflation. Those two in our minds statistically are separate. But that's the risk which would, I think, increase the odds of a recession into 2020. Again, the Federal Reserve is really smart. I don't think they will make that policy error. But that's something we debate internally a lot.

Benz: I want to talk about how investors should approach this environment. Because there has been a lot of concern. We've seen bond prices drop a little bit. Some investors have had principal losses in their bond funds, and I've talked to investors who have said, you know what, I don't need this volatility with my safe assets. I'm just going to hunker down in cash. What do you say to investors who are trying to figure out the safe parts of their portfolio in an era of rising yields?

Davis: Just personally, that's not something I do. I mean, I have those same conversations with my friends and family. I would say, importantly, cash is a savings vehicle. If one is a long-term investor, it's hard to make any case, investment or otherwise, that cash should have a role in their portfolio. You are going to lose out over long periods of time to inflation. You are not going to break even in that sense. Yes, with fixed income, you are going to have some of this rising rate volatility. However, there's a much more volatile asset class out there in the world that's called equities. There's more risk in the equity market today than the fixed-income market. We still view for most investors that high-quality fixed income as more of a ballast and bedrock to volatility in a diversified portfolio. That's still our message in rising rates.

For conservative investors, I think in regard to whether or not the Federal Reserve is raising rates or not, you can always think about shorter duration portfolios, because that's where you have the greater, quicker interest rate reset. You just have less duration or interest-rate exposure in that portfolio. But for long-term investors I wouldn't be introducing a Federal Reserve outlook for reasons why they should be considering changes in their fixed-income portfolio.

Benz: I want to talk about equities though, you touched on them. Equities are not immune to changes in interest rates, specifically some sectors like utilities and real estate. Let's talk about that. What implications you think that current interest rate environment might have for people's equity portfolios?

Davis: We went into the year, Christine, fairly guarded on the outlook because of valuations. Now, we think the U.S. stock market, which has had a continued strong run, higher than we would have expected this year--I continue to say, it should be a somewhat lower return environment and it seems like the stock market keeps laughing at that--but valuations are fairly expensive. The stock market is not a bubble because valuations should be higher today because of a lower interest-rate environment. But there's going to be a time with which valuations will matter. We are not very bearish on the stock market. I think it's unreasonable to expect this continued performance for a long period of time. It's not an exciting message.

It's not a surprise though that the market--again, we do not foresee a bear market imminent because to see that we would need to be suggesting that a recession risk is elevated. Monetary policy is still accommodative. It will become restrictive next year, modestly so. The fundamentals in the economy are fairly strong. That is, I think, offsetting valuations. But over the next five years, it is highly likely that the returns will be lower than they have been in the past, just given the prices that the market is already discounting going forward. That's really just a U.S. phenomenon, because in overseas markets valuations aren't nearly as stretched.

Benz: Joe, always great to hear your insights. Thank you so much for joining me.

Davis: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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