 Welcome everyone to the 65th edition of Bogle Heads On Investing. This month my special guest is Dr. Qian Wang. Dr. Wang is Vanguard's Asian Pacific Chief Economist and Global Head of Vanguard's Capital Markets Model. Today we'll be discussing current global economic conditions and Vanguard's forecast for 2024 global financial market returns. Hi everyone, my name is Rick Ferry and I am the host of Bogle Heads On Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a non-profit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at bogelcenter.net where you will find a treasured rover of information, including transcripts of these podcasts. This month my special guest is Dr. Qian Wang. Dr. Wang is Vanguard's Asian Pacific Chief Economist and Global Head of Vanguard's Capital Markets Model team. She's also a member of Vanguard's Strategic Asset Allocation Committee, which determines the asset allocation strategies of global multi-asset class portfolios such as Vanguard's target date retirement funds. Dr. Wang earned her Ph.D. in Business Administration from Stamford University, a Master of Arts in Economics from Duke University, and a Bachelor of Arts in International Economics from Beijing University. She has been at Vanguard since 2014. Today we'll be discussing Vanguard's Economic and Market Outlook for 2024, a report that was recently published and is available to you online. So with no further ado, let me introduce Dr. Qian Wang. Welcome to the podcast. Thank you, Rick, so much. First, I would say a great job pronouncing my name, which is not easy. My name, Qian, has the same pronunciation in Chinese as money. Oh, no kidding. So, Rick, money is coming to your podcast today. Well, there we go. We hope money comes to all of our listeners as well. Qian, you are on a very powerful team of Vanguard's Global Economics and Markets team and consists of four Ph.Ds and you are one. And Joe Davis is the Global Chief Economist and you are the Asia Pacific Chief Economist and the Global Head of Vanguard's Capital Markets model, which we'll get into in a bit. But before we get into this report that you helped publish, I want to ask about your background. Tell us a little bit about yourself and how you ended up at Vanguard. The true meaning of my name, obviously, is no money. It's actually a short name for my hometown. So if you read Chinese, people can easily tell where I come from. I remember back in early 90s, China just started a market economy. Yet in the college, the teacher still taught us Maxism, where only labor, not capital, creates value. And then I wonder, if capital doesn't create a value, then who's willing to make investment at all? So I remember in 1997, when I graduated from college, I traveled all the way to the U.S. for my graduate study. First in the East Coast, Duke University, Go Blue Devil. And then you come to the West Coast, Denver for my Ph.D. So after graduate, I have been working as a professor, a cell-side economist, a sovereign wealth fund. And then eventually when I come to Vanguard, I feel like I found the answer to a lot of my questions. So great place to be. Well, we're certainly happy to have you. And every year we interview a different economist. We've had Joe Davis on a few years ago. Last year we have Ed Yardeni, and you are the noted economist this year. So again, thank you for joining us. Thank you. Let's get into your report, which is the Vanguard Economic and Market Outlook for 2024. And the byline is a return to sound money. So before we get into the meat of the report, what do you mean by a return to sound money? By sound money, we are talking about a persistent real interest rate. Basically, that means what we have seen, the nominal interest rate, that is going to be higher than inflation. This actually, in our view, is the single best financial development over the past two decades. It really set the foundation for a solid risk-adjusted return for our long-term investors. By that, do you mean just short-term like T-bills, or you're talking about 10-year treasury? What do you mean by a real rate of return over the inflation rate? For all asset classes, we talk about higher interest rate environments. Part of the reason is because we feel like the risk-free rate, which is determined by our star, the neutral rate, we can talk about that later, is higher. Now you think about it, risk-free rate is the foundation for all asset returns. You get the yield for long-duration bond, risk return plus term premium. You get the yield for credit, you plus credit spread. Equity risk premium, you get the earnings yield, so equity return. Leaving the price change aside, then higher risk-free rate means you get higher expected rate for all asset classes. Isn't that good? I think it's good to actually outperform the inflation rate because, of course, we haven't factored in taxes yet. The outperform inflation is a good start. Central Bank has been literally going to zero or in some places negative interest rate. And that raises a lot of concerns, especially when investors also see a significant fiscal policy expansion. That raises a lot of concern about future inflation and also devaluation of fiat currency. I think that's one of the reasons why cryptocurrency started to gain its popularity. So now, I think when central banks are exiting those ultra-accommodating monetary policy, that together with some kind of more prudent fiscal policy down the road, I think that will restore people's confidence in the fiat currency. And to me, that's another way to interpret this, the return to sound money. Well, it's kind of interesting that you bring up cryptocurrencies and this, but I never really thought about it, but you're right. I fear that monetary policy would cause a devaluation of the dollar. Most people who are big followers of cryptocurrencies believe that this is needed in order to just have a stable currency. That if the new policy long-term is to have positive real rates, then that solves the problem. The budget deficit, though, how does that work into all of that? How do you maintain real rates above inflation and when we have such a large budget deficit and it keeps growing? Yeah, totally. So this is where when we say the transition into a higher interest rate environment is best financial development for in the long term. But I'm also saying that the transition could be very bumpy when everybody is adjusting to that higher interest rate environment. For household, saving will be more attractive. But for corporate, that also means when you make investment, you're going to be more prudent and you need to allocate the resource to the most productive, profitable opportunities. I think that also has very profound implication for government and fiscal policy. You could have a very vicious cycle between higher government budget deficit and also higher interest rate. I would raise a lot of concern about fiscal sustainability. I think this is one of the questions a lot of people were asking at this moment. Now, one thing I would say is that Vanguard actually has quite some research there trying to think about how much can the fiscal expansion go down the road. So one of the exercises we did is that we tried to calculate the maximum sustainable debt burden for the U.S. Because at this moment, the U.S. federal government debt is about 100% of GDP by the end of 2022. You could say, wow, that's high because remember, people always have the 60% number in mind. That's what European Union said that's a limit. But then you think about Japan. Japan has government debt at 260% of GDP, yet the government is still running. But Japan has had negative interest rates forever. Exactly. So the maximum sustainable debt burden is actually different across countries, really depending on three things. One, the maximum primary balance the government is willing to or able to implement. Basically, the primary balance of payment, that means the difference between your revenue and spending netting out the interest rate payment. And then the second is interest rate, as you point out correctly. And the third is the countries economic growth in the future. So Japan, yes, that was sustainable because of low interest rate, but even for Japan, now we are talking about they're going to lift up interest rate down the road. So this kind of higher interest rate, higher debt serving cost will make fiscal sustainability into question. We assume that if the US government is willing to run our primary budget surplus of 2%. And if we follow the CBO Congress budget office forecast of the interest rate and economic growth down the road, then we estimate the maximum sustainable debt GDP ratio for the US is actually 225%. Don't give them any ideas now. Come on. I hope nobody in Washington DC is listening to this. But the condition is that they need to run a fiscal surplus of 2% surplus. And guess what we are going to do, you know, down the road, the CBO office is estimating projecting a deficit of greater than 3% of GDP in coming decade. So the government is going to significantly eat into this fiscal buffer over the coming years. And the fiscal space, the estimation is based on some quite favorable projection of interest rate and economic growth. What if we end up with another severe recession, what if the demographic transversion or what if the investors panic and interest rate rose more than expected. And then in that case, the fiscal space will be much lower. So to us, the rising debt has become an issue that must be tackled by this generation, not the next. So that's where we caution against complacency. And you mentioned a maximum taxation level and you had done this work on a report and what did you come up with? Well, you know, this is where we think the government, instead of running the 3% structural deficit, persistent fiscal deficit, they have to be more prudent with how much they spend and also what kind of tax revenue they collect. So turning from over 3% deficit into a 2% surplus takes a lot of the efforts there, you know. So this is where we think either they may want to minimize unproductive spending, limiting contingent liability and make them more targeted and also increase taxes where the revenue are low by international standard. That should be helpful. So overall, I think it's very critical to maintain a prudent approach to the government to finance down the road. Well, we could get into this for hours, but we're going to move on to the next level. Now, the Fed has two mandates. One is to limit inflation and their target is 2%. And the other is to maintain low unemployment. In an era where there was zero interest rate environment or negative real interest rate environment, it became really hard for the Fed to do anything to stimulate the economy. Do you feel as though this has been resolved because we have higher interest rates that Fed policy may become more effective? So thank you, Rick. I do think that the transition to a higher interest rate actually works well for central banks because in the case of economic downturn or a recession where you do have GDP contracting, labor market softening, unemployment rate rising, then the Fed has more room to cut interest rate to support the economy. But I think at this time, one thing we do want to highlight is that we are expecting an economic downturn, a milder recession in the second half of 2024, and we do expect the Fed will cut interest rate, the Fed fund rate probably starting in July. But one thing we do want to highlight is that we don't think Fed will cut back to zero anytime soon. I think a very important part of that is indeed because of the R-STAR neutral rate is higher. Could you explain what R-STAR is? Yes. R-STAR is our equilibrium interest rate level that is consistent with stable growth, full employment, and 2% inflation. So that is a theoretical interest rate level that is neither stimulating or restricting economic growth. And what level is that? Do you believe? Yes. One thing, Rick, is that neutral rate is not observable. So you can only infer that from how the economy is faring in the face of monetary policy tightening. So one thing we would say is that, well, it was estimated that before the pandemic, during after the GFC period, it was estimated that the neutral rate is about 2.5% in nominal terms, 2% inflation plus 0.5% real rates. And this is a T-bill. This is very short-term money. Yes, very short-term. The fact that after the pandemic in the last several years, that the economy has fared so well in the face of aggressive monetary policy tightening, literally 500 base point hike in less than two years, actually is telling us that the neutral rate, the equilibrium interest rate level should be higher. That it should be higher than 2.5 nominally, which if the Fed's target is 2% would mean a half a percent. So you're saying it actually should be higher than a half a percent real. Yes. I think then the next question is, how much higher? That would have been my next question, yes. So this is where we actually has done our estimation model, econometrics model to estimate what is exactly the level of the neutral rate at this moment. And our model shows us because of this demographic changes, because of this persistent structural deficit, fiscal deficit, and also because of higher productivity growth down the road, we see that the neutral rate in the U.S. nowadays is 100 base points higher than what we have seen in the past. We are actually expecting a 3.5% of neutral rate in nominal terms at this moment. So at 3.5, if the Fed gets inflation down to 2%, and you could get 3.5 from a money market, and then you have about 10 years and you got to pick up 1% there as well, at 4.5, that's going to compete against equities. Will it not? Yeah, I mean totally. I mean Rick, this is where we say at this moment, one of the big message from our paper is that the bond is back. Bond is back. Yeah, bond is back. I think in the past decade, when you have very low yield from the bond market, then essentially I think it's a very tough time for our bonding investors. Basically, the only return you get is because of the price changes. For bond, you have two components of return. One is the coupon income, and the other is a price change. When your coupon income is very low or zero, then you actually suffer a lot from the volatility in price changes. But down the road, what we have, the coupon income returns back. I think when you could have let's say 4.5% from this long duration bond return, the valuation is reasonable. That's decent return from your fixed income portfolio. Now on the other hand, you have equity valuation pretty stretched at this moment, especially in the US market. This is where we actually see the US equity market. The valuation is currently about 15% above our fair value estimate. So given this very compressed equity risk premium, we would actually prefer to go into bond, go into fixed income portfolio more in the balanced bond equity portfolio. We're going to get to the market model, but I wanted to continue to move on with the implications for a higher interest rate to consumers. Go to buy a car, it's going to cost more money. Go to buy a house, mortgage rates are going to be high, and this is going to drain money from consumers. And so how did this new regime of higher real rates in the long term affect consumer spending? Yeah, higher rates obviously will make saving much more attractive for consumers. And I think they will also be more discreet in making foreign decisions as housing also a big ticket items that are often financed with debt becomes more expensive. So I think this actually will bring consumers into a more healthy situation, which is actually going to benefit the economy, make the economy more resilient in the longer term. Because there would be propensity for people to save more and maybe spend a little less your forecast for GDP growth or economic growth in the United States still positive, but much lower than it's been say even in the last 12 months. Yeah, Rick, I think this is where we differentiate our more long term outlook with our more near term outlook. When you think about why the economy has stayed so resilient in the face of over 500 base points tightening by Fed, consumer consumption spending is one of the very important factors behind that. Consumption has been holding up so well in 2023. There are several setting factors, fiscal support. When you think about a lot of the fiscal support during the pandemic to the household, small business and also the fact that we cannot really spend that much during the pandemic and consumers end up with a lot of excess savings. And we haven't seen that excess savings being exhausted at this moment. Well, we'll soon but not yet. And then they also have very healthy balance sheets and leverage on the other side. Let's compare now to 2008 during the GFC period. A lot of the consumer credit, consumer loans at this moment are fixed rated. So only 8% of consumer credit at this moment is based on viable rate compared to 40% in 2008. So that actually shelled them from the pain of higher interest rate and also more excess savings on their balance sheet means that they don't need to borrow that much at this moment. Plus labor in market is so tight, wage growth is pretty decent. So all of those actually has supported consumer spending so far. Now in 2024, what we expect is that some of those offsetting factors will fade. So we do have excess savings will largely exhausted probably towards the middle of next year. It has already exhausted for low income cohorts of household and then some of the fiscal support actually will fade. And then you also have labor market that will start to cool. And also another reason, you know, when you look at the business side, I think in the last several years, we had a lot of industry that financed the industry policy from the government. Actually that supported a booming pace of investment in the infrastructure and also construction space. Those things are actually supporting the economic growth in the past 12, 24 months, but the pace could also slow down the road. So this is why we are expecting the economic growth to slow, especially when monetary policy finally becomes more restrictive when inflation fall. So in real terms, monetary policy will become more restrictive and start to bite. So this is where we expect the economy to cool down, labor market to cool, and then the economy comes into a minor recession in the second half. I am 65 years old. I live in an over 55 community with a whole bunch of people around me who are in their late 50s, 60s, 70s. People around here are spending money, but their homes are paid off. They've got money in the bank. They've got Social Security coming in. They've got 401ks that have good amount of money in it. They're spending money. So these higher interest rates don't affect certain demographics and the boomers are a huge demographic. I just see that this will continue for a while until my generation gets older and doesn't go on as many vacations. How is that affecting the scenario that you just laid out? Rick, I think that's one of the reasons we expect the recession to be a pretty mild one. The consumer fundamentals is actually the private sector fundamental is pretty resilient, pretty solid. So I think this is where it's very different from 2008 during the subprime crisis, GFC, when the consumer sector is so highly leveraged and then when you have the subprime crisis, this trigger a much deeper downturn led by the deleveraging of the private sector. I think when you look at what we have right now, especially in the consumer sector, as we just mentioned, balance sheet look pretty solid. And then the labor market, what we are expecting is that because of a structural labor shortage in this economy, even in a mild recession, in a recession, we are not expecting the unemployment rate to shoot up like significantly. In a typical recession, unemployment rate will shoot up to say over 6%. What do we expect? We're expecting 4.8%, like 1% higher than what we have today. This is higher than what Fed is expecting. But still, it's not a big jump. So I think overall those things coming together, I think that's helped to explain why the economic downturn and economic recession will be rather mild. People will be more prudent when they spend, but they probably will continue to spend. Well, let's look outside the United States, the rest of the world. Are we leading the world or are we in line with the world or are we behind the rest of the world as far as the recovery from COVID? I mean, I think in the past several years, the U.S. obviously has been leading the global economic recovery. I think that's also one of the reasons why the U.S. dollar has been so strong. Because the currency is like a horse race. It's not just about how fast you run, but also how fast or slow the other horses run. This is what we call the U.S. exceptionalism. U.S. economy being strong and then that is where we are seeing the currency actually has been strong. But I think in 2024, what we are expecting is that what we call the fading of U.S. exceptionalism. In 2023, what do we have in terms of economic growth is 2.5 to 3% well above the trend of growth that in our estimate is about 1.8%. So now you think about the U.S. economy has been holding so well in 2023 to the very resilient private sector and also a lot of the offsetting factors. In fact, in our estimation, we think the U.S. growth could have been 0% growth this year without those offsetting factors. But instead, you know, this year, what we see is about 2.5 to 3% growth. But in 2024, what we expect is a slowdown in the U.S. economic growth. We are actually expecting only about 0.5% growth to 1% in 2024. And then the rest of the world, the Europe will stay muted around 0.5% as well. And then emerging market is actually going to hold up pretty well. In fact, I would say a milder recession from the U.S. is probably the second best thing for emerging market. A recession means Fed will cut interest rate. And then a milder recession means the growth shock won't be too big for emerging market. So with U.S. actually slowed down more evidently, then this is what we call a fading of U.S. exceptionalism. Probably U.S. is no longer leading the global recovery next year. Interesting that you said when the Fed cuts, the emerging markets benefit. Could you explain that a little bit more? How do the emerging markets benefit when our U.S. Fed cuts? So when you think about the link between the emerging market economy and the U.S., emerging market actually face significant the global financial condition. That actually will significantly influence the emerging market. A lot of the emerging market actually gets funding, U.S. dollar funding, rely on the international capital flow for their funding. So when U.S. the Fed start to cut, U.S. dollar weaken and risk appetite will start to turn more positive towards more risky asset. And that's where money actually will flow back to emerging market. This is where emerging market central banks, they also get more room to cut their own interest rate. So that's where I would say they could actually benefit from the Fed cut. You said that it's been a muddle of the recovery in Europe for several years and it's going to continue. What's holding Europe back? Yeah, there's a lot of structural problem in Europe, but it is really about the monetary policy tightening. The monetary policy tightening is actually much more effective in Europe compared to the U.S. because they don't really have those offsetting factors. And also when you think about the monetary policy transmission channel in Europe, the European economy is much more reliant on the bank credit. So that is where banks can quickly adjust those interest rates. So that's where higher interest rate actually bites into the European economy much faster than what we see in the U.S. And then that's where we see the European economy is already flirting with a recession by the end of this year. So their economic growth was very muted in 2023 and also will be continued to be muted in 2024. And plus they don't have the fiscal policy buffer. This is very different from the U.S. as well. Fiscal policy has been restricted in 2023 and also in 2024 for Europe. Well, let's go to the other side of the world and speak to us about China. Our presidents just got together trying to bring in an era of better cooperation. It seems as though they need us. We need them. And so let's talk about our differences. That's the way I see it, but you have much better insight. Could you tell us your views on what's going on with China and U.S. and the relationship and also China's economy? Yeah, I mean, there's a lot of uncertainty around the U.S.-China relationship since the 2018 trade war. I think that's also one of the reasons why the domestic confidence, especially among the business person, is pretty low at this moment. Now, for the U.S.-China relationship, I think one thing we have to understand. This is a structural issue that cannot be solved overnight or just by a meeting between the two presidents. I think there are two reasons for that. One is that between the two countries, there are so many discrepancy on many fundamental issues, right? Like the economic model, the role of the government, intellectual property protection, investment, and even many political or geopolitical issues. And second, I think, let's say, even China, say, continue to make the market reforms or even get into political reform. I think the long-term competition between U.S. and China is still unavoidable. From a historian perspective, there will always be competition, tension between a rising superpower and an existing superpower. That's what people call the subsidiaries trap. I think the tension between the U.S.-China will just continue in coming years and probably decade as well. Now, of course, I would say G7 realized that it may not be realistic or possible to entirely cut the economic tie with China, right? Given how much China is actually integrated in the global trade, global economy, right? And increasingly nowadays in the global financial system. So I think that's where they raise the concept. They say it's not about decoupling from China. It's de-risking, right? De-risking. So that is a 3C strategy. They're going to collaborate in some areas. For example, climate change. They're going to compete in certain areas like technology, right? And then they're going to confront in some areas like human rights and geopolitical issues. So I think this will be the strategy down the road and it's not going to be surprising that this will have profound implication for the whole world. We are going to see a slower and also more fragmented globalization down the road. We don't think it's de-globalization, but the pace is going to be slower and more fragmented. And this actually will have negative implication on the resource allocation across the world. Think about capital, technology and talent. So I think that this will be a hit on the productivity growth and the economic growth everywhere for everybody. Interesting. Can we talk about Japan? There seems to be a renaissance starting in Japan finally since basically the market collapsed in 1990 and hasn't been taxed since. Yeah. You know, I think Japan has suffered three decades, right? It's not just one lost decade, it's lost three decades ever since the market collapsed. So I think over the past 30 years, I think the biggest problem for the Japan economy is actually lack of confidence. People don't really see the future. Now, one of the things over the past three years, you know, some people call balance sheet recession is basically deleveraging both household and corporate. They are trying to clean up their balance sheet, reduce their leverage, sell their assets. And then because of this lack of confidence about the future outlook, then there is no incentive for people to spend, especially when there's deflation. And there's no incentive for business to make investment. After all, demographic is one of the very important factor there. By the United Nations estimation, Japan population will be 40% lower by the end of the century. Yes. If you don't really see people, and we know that immigration policy in Japan has been more strict, then who are you going to invest for? You know, you build up the factory, you produce those products for whom, right? So I think a very important thing, you know, happened over the past 30 years, two things. One, the leveraging for the private sector. That's also why the Japanese government debt is so high, because without private demand is really the government public spending that's holding up the economy. And second, the lack of confidence. So coming to now 30 years later, what do we have? One, the private sector balance sheet is pretty healthy at this moment. They have a lot of money to spend. And second, the confidence has finally started to turn around because inflation is now up, right? People see inflation down the road. And there is a structural change in the price setting and which setting behavior, which growth is finally picking up because of the structural labor, you know, shortage. And then behind the scene, the government has done a lot of reform, trying to push for labor market reform, corporate governance reform. So I think at this moment, this kind of higher inflation after the pandemic was really just a trigger. When inflation is back, confidence is back, private sector has money to spend. That's where we think the Japanese economy will actually start to continue to grow down the road. I just have one more country that I want to ask about because it's been coming up so much in the news and it seems really interesting. And that's India. Can you tell us a little bit about outlook for India? Yeah. You know, I think from an economic perspective, we are indeed quite positive about India. This is a vast market with a very large population. If I resemble, you know, China a little bit, you know, almost 30 or 40 years ago, and especially when the government, the Moody government is actually starting to do a lot of structural reform. Land reform, building up the infrastructure, financial reforms, right? So this is where actually they are ready to leverage the significant potential of the economy. In fact, you know, most recently, you do see that India is benefiting from this global supply chain adjustment as well. They are actually getting more FDI, foreign directly investment, building up factories. I think this is where India actually will benefit from this global supply chain adjustment and continue to unleash its gross potential down the road. Now, I think the question for investors is, again, the most important question, what is the price we are paying for that? Because sometimes what I see is that investors get too optimistic and we know that structural reforms is not that easy. I think there's a lot of encouraging progress in India. Structural reforms, macro reforms, they do come up with a decent macro policy framework like monetary policy, fiscal discipline. A lot of them are very encouraging, but structural reforms, especially when it involves vested interest groups, you know, sometimes it takes much longer than people expected. So I think that is where we would say, yes, on the economic front, we see a lot of potential, but on the equity side, I think on the investment side, I think investors should be careful about what price we are paying for that and what is priced in by the market. Interesting. Let's go ahead and get into the second part of this, which is valuation and actual investing. So we're going to take the economic side of everything that we talked about and we're going to equate it back to expected returns from U.S. stocks, international developed market stocks, emerging market stocks, bonds, both in the U.S. and internationally. And we're just going to go through these asset classes. And again, this is Vanguard's view based on your economic outlook. And starting with the U.S. stock market, I'm just using a very simple model of expected return, which would be three parts, which would be earnings growth, dividend yield, which would include some buybacks, and valuation change. So using that as a backdrop for looking at the U.S. stock market, you see lower returns going forward and how would that break down among earnings growth, dividends, and change in valuation, which is price to earnings ratio? Yeah. When you look at the three components, I think what is driving lower return in the U.S. market, the one biggest thing I would say is indeed the valuation change. In fact, I would say what is really driving the outperformance of the U.S. equity market in the past decade was really because of the significant valuation expansion. Now that, I think it has something to do with the macro environment, a low interest rate, low gross environment, and also the nature of the U.S. equity market. As we know that U.S. equity market was more tuned towards gross company, like IT technology companies, where their cash flow usually happens much later in the future. So a low interest rate in environments, the discount rate for future cash flow is pretty low. That gives you a higher price. And also in a low gross environment, investors gross is scarce, and then investors are willing to pay a higher price for gross. So this actually explains the valuation, significant valuation expansion in the U.S. market. And in particularly those mega cap 8 stocks, whereas the rest of the market, the small cap, mid cap, really didn't see that. No. I think it's perfectly fine for investors to be forward looking. You incorporate future news into today's price. But sometimes investors just get too optimistic, and sometimes we get ahead of ourselves. So I think at this moment, what we see is that the U.S. market is quite overvalued at this moment. We have a fair value estimation, and we found that at this moment, the U.S. equity market is about 15% above the fair value estimate. We say trees does not grow to the sky. It will have to eventually converge. Now, first, it will converge to its fair value, and then even the fair value itself will start to decrease in a higher interest rate environment. So this valuation normalization or contraction is one of the big reasons that we expect the expected return for the next decade will be much lower than what we have seen in the past decade. You talk about the building blocks. Other than the valuation contraction, then the other ones obviously is also earnings growth. Earnings growth will be lower than what we have seen in the past. Now, I think a very important reason is because of the profit margin that will start to come down. Important reason, like the near-shoring, unshoring, when we focus the global supply chain adjustment, focus more on resilience, security. In addition to efficiency, then that tells you there will be more cost involved. And then also the lower, slower pace of globalization, more fragmented also means that we may not be able to enjoy the low labor cost across the world in the best way. That also increases labor cost, and we know there is a structural labor shortage even domestically as well. So this is where we actually see earnings growth will also be lower down the road. And yet when we look at the valuations of small cap stocks and mid-cap stocks, the PEs, forward-looking PEs are at the lowest they've been in decades. Do you see any improvement there? Yeah. I mean, Rick, I think that's exactly what you said. Yes, overall it seems like the U.S. equity market is overvalued, but not for everybody. If you think about the market performance this year, it was pretty much all because of the Magnificent Seven. Yes. There could be opportunities, actually, if you look into the market. What we see is that large cap and also gross company are pretty overvalued. But on the other hand, we do see opportunities of value company as well as small caps, especially when we get into a higher interest rate environment, and those companies will benefit more. So let's go outside the U.S. We don't have the high valuations. The PEs are almost half, not quite, but price to book, return on equity, everything showing foreign stocks look very much like mid-cap value companies. So what is your outlook for expected returns from developed markets and then emerging markets? Right. So when you look across the world, what we have seen is that non-U.S. development market valuation are pretty reasonable. They didn't really expand that much over the past decade. So at this moment, I would say they are actually reasonably valued and in some places even undervalued. And then emerging markets is also undervalued in our view. So this is where in terms of our outlook for the next 10 years, we actually expect international market, that's non-U.S. market to outperform the U.S. Let me give you some numbers here. We actually expect about the annualized return in the coming decades, about 4.2 to 6.2 percent for the U.S. market. But on the other hand, our expectation for non-U.S. development market is about 7 to 9 percent per year over the next 10 years and 6 to 6 to 8.6 percent per year for emerging market. So this is where we would encourage our investors to have a globally diversified portfolio. And part of this is the currency changer expecting the dollar to be softer, say over the next several years. And this will boost up international stock returns because they trade in native currency, according to your report, about 1.1 percent or 1 percent as you're expecting. Right. First, I would say the U.S. dollar is also expensive. We also estimate that the U.S. dollar is about 12 percent above our estimates of fair value. And the second thing, in the coming decade, we do think that there's more headwinds to the U.S. dollar than tailwinds because of the structural fiscal deficit and also because of the current account deficit as well. Those do not vote that well for U.S. dollar. So we do expect U.S. dollar to depreciate in the coming decade. But Rick, one thing I would emphasize is that when we make those forecasts, it's really for the long term. Right. So they expected a return. We are not saying that every year, you know, international market will give 8 percent return. We're saying that on an annualized basis, this will be realized. It could be that in the near term, especially if we get into a sharper economic downturn, investor risk appetite start to decrease significantly and everybody fly to safe assets. So we are talking about when your investment horizon is actually much longer than the fundamental will reassert themselves. And that is where we see the U.S. dollar is heading towards depreciation. And this is indeed one of the reason we expect international equity to outperform in U.S. dollar terms. So before we get to your Vanguard capital markets model where you provide guidance on percentages to each one of the asset classes, I just want to summarize what the report says. And there are three parts. The first one is monetary policy will bear its teeth. Yep. So I think this is where we all know that there is a long and viable lag of monetary policy transmission. And then we also had a lot of offsetting factor in 2023 that actually keeps the economy gross pretty solid right in 2023. However, in 2024, we expect those offsetting factors will fade and then monetary policy will become increasingly restrictive when inflation fall. So monetary policy will be more restrictive in real terms. And that actually will weigh on the economy where we see the economics actually get into a minor recession in the second half of next year. But we also see our start, which is the neutral rate where it's neither recessionary nor expansionary that this number you believe is actually going to be moving higher and has moved higher and will stay higher. Yeah. And you mentioned that you thought it would be about a real return of about one and a half percent on short term money, which would be T bills. Yes. So when it comes to the monetary policy, what federal will do in response to that economic downturn, we think of fat and global central banks will cut interest rate next year. But even if they cut, we don't think we will get back to zero interest rate anytime soon. Zero rates are just yesterday's news. You know, beyond this business cycle, we believe we will settle into a higher interest rate environment. A very key important reason as you just mentioned is because of the R star. The equilibrium interest rate that is neither stimulating nor restricting the economic growth is permanently higher in the US. We estimate that neutral rate level is now 3.5%, 100 base point higher than what we have seen in the past decade. And so all this leads for investors to bonds are back US stocks, not so much, but developed markets and particularly emerging markets look good. Yeah. I think it's a great news for our bonding investors, not just that coupon income is back, but also, you know, at this more reasonable valuation and higher yield. The diversification benefit of bond actually is coming back as well with bond actually being returned outlook being pretty attractive. And also because the equity market valuation somewhat stretched, especially in the US, we would actually, number one, of course, they continue to stay diversified stay long term. But on the other hand, I think that they could actually come up with a more defensive portfolio. That is where we could overweight to bond and underweight equity a little bit. And within the equity, we would also overweight international equity that includes emerging market as well as non US development market as well. Well, let's go ahead and get into that model. And the model is the Vanguard capital markets model, which you chair that committee. Yes. This is your thing. Yeah. And it's in the report so you can look at it and has all the breakdown, not only just US stocks, international stocks, but it gets into factors, you know, value versus growth. Yeah. So let's go ahead and go through just the numbers really quickly. You compared it to a basic 6040 portfolio, 60% stocks, 40% bonds where 36% of these stocks were US and 24% were international, which is the global split between US and international. And on the bonds, you had 28% US and then international, you had 12%. So that's the benchmark. Right. That never changes. Right. So your time varying asset allocation, if you are going to be a tactical, I know you maybe don't like that word tactical, but I'm using it. If you were going to be tactical, it would look much different. First of all, the stock and bond mix would be far less equity. I see here you have equities overall would be just over 40%. And bonds are fixed income overall would be just shy of 60%. So talk about that first, and then we can get into the nitty-gritty. I think the first thing, Rick, is that our time varying asset allocation model is different from a tactical asset allocation. Okay. Because as it's long-term and also strategic in nature. So I think when we say time varying, what do we mean? We mean we take the current market evaluation into consideration because through our research, we do find that starting valuation, both for bond and equity, is the most reliable. You know, predictor for the long-term expected return, not for the short term for long term. So that is where we actually get more confident with this forecast when the time horizon gets longer. And then we are still trying to maximize the risk adjusted long-term return of a balanced portfolio. In this case, we are actually have 10 year time horizon. I think this is a critical difference between us and a tactical asset allocation. We are not focusing on the performance in the short term. And then I think coming to this, how we allocate to make an allocation, right? We look at the global 6040. I think sometimes when people talk about global 6040 is really that exact number. I doubt. I think the 6040 is really like a symbolize the concept of diversification. It's a mix between bond and equity when you have bond as a blast to the portfolio when you are experiencing our equity down term, right? So I think it is really about that concept of diversification. But I think, you know, coming down the road, I think when we use the global 6040 as a benchmark. So we say, if we want to achieve the same expected return for global 6040 in 10 years, and then we take it into the current valuation into consideration. What can we do? And we found that if we go 59% fixed income and 41% equity, that still give us the same expected return as global 6040, but at a lower risk. So essentially we end up with higher risk adjusted return. Very good. So on the equity side, it's interesting because rather than having total market equities, total US market being 60% and international being 40%. You are taking a heavier weighting towards value and a lesser weighting towards growth. You are taking a larger weighting towards small cap. You are taking a quite an equal weighting between emerging markets and developed markets. These are pretty radical shifts. I mean, you're not ignoring US large cap growth. You're not ignoring developed markets, but you're really focusing on value, small cap emerging markets, the ones where you see valuation. Yes. This is where we do see the value, the opportunity in the long term, you know, a large part of that is because of the valuation that we just mentioned. We do see that relatively speaking value, small cap and also emerging market and non US developed market are relatively more reasonably valued or even in some cases undervalued. So that is where we do see higher expected return in the long term. Now, I think there are several things I do want to highlight. When we talk about valuation, and I just mentioned the valuation is the most reliable indicator for long term expected return. But even so, I would say, remember the keyword of long term. It doesn't mean that immediately the valuation will converge will contract or increase. I would say valuation is never really a good timing tool for the short term development. In fact, valuation can stay overvalued or undervalued for a very long term, especially if the macro environment say interest rate to stay persistently lower for longer or higher for longer. Right. So I think that's one caveat. Don't use that say to predict value or small capital will immediately outperform next year or next month. Right. So that's one caveat. I think that small cap value investors have learned that lesson over the last several years. And the other thing I do want to say is that our performance is not guaranteed. So this comes back to our Vanguard capital market model. The VCMA model operates in a probabilistic framework. When we predict about the future is not just one scenario. We actually do 10,000 simulation. There could be 10,000 scenarios in the future. And that gives you a probability distribution of the future. Everything is about probability. So let me use the international versus US as an example. Back in 2015, we say, oh, there is a 65% chance for international market to outperform in the next 10 years. And today the chance actually increased to 70%. So you could always argue there is still a chance that the US continue to outperform over the next decade. But even if that happens, our analysis suggests that it will still be difficult for the US to outperform to the same degree as it did over the last decade because of the higher interest rate environment. So I think in the end, this is where we still say we caution our US investor against a very strong home bias. Or we caution against, say, putting all your bet into one sector. Diversification is still the best preparation and also stay long term for all kinds of possible outcomes in the future. Let's get to your fixed income asset allocation. Because here, again, you've got almost 60% allocated to fixed income of which a little bit more than half of that is allocated to the US fixed income markets. But a large majority of this, almost all of it is allocated to treasury bonds. And a very minor amount is allocated to the aggregate bond market, which would also have corporate bonds, mortgages and so forth. So you see a real undervaluation relative to credit risk and mortgage risk. You see intermediate term treasuries as the place to be. Yeah, I think that actually is based on our assessment of the valuation where we actually see the treasury is more fairly valued. On the other hand, I would say when you think about the credit spread to us at this moment is still somewhat pretty tight. The credit market may not have priced in a lot of the downside risk down the road, especially if we get into a recession and also in a higher interest rate environment than the profit margin of the company will also get squeezed. So this is where we are a little bit cautious about the credit we think on the treasury side, that is where the valuation is pretty decent at this moment. We also think international bonds would deserve a higher allocation being almost 50% of the fixed income is an international whereas the 6040 it's far less than that. Now is this hedged or non-hedged? Hedged. Rick, this is a difference between our equity investment and also bond investment. The equity investment is unhedged, you know, when you invest in the international market. That's why we need to watch for the currency change that will have an impact on the relative performance. But on the other hand, you know, the bond market we do actually hedge the currency risk. To that extent, in the end, the US bond expected to return and the return from the international bond market is actually very similar. We actually had a US bond to return a nominal analyzed 4.8 to 5.8% over the next decade, and then it's 4.7 to 5.7% from the international bond market is not that different. But this is where I think we come to a very important concept about why we want to go international. It's more than just the return outlook, both in the equity side and also the bond side. It's because of the diversification benefit. We think about the rest of the world. They may not be perfectly aligned with the US market in terms of their business cycle in terms of their policy cycle. So especially for emerging market and even to certain extent China, the correlation there could be even lower. So I think regardless of the outlook, bringing those into a diversified portfolio help you to harvest those diversification benefits. Essentially, that's where you reach the same expected return but with lower risk. Well, that's all the time we have. It's a very interesting discussion. So I want to thank you so much for being with us today. Thank you. This concludes this episode of Bogleheads On Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit bogelcenter.net, bogelheads.org, the Bogleheads Wiki, Bogleheads Twitter. Listen live to Bogleheads Live on Twitter Spaces, the Bogleheads YouTube Channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get others to join. Thanks for listening.