International Markets

Joe Davis says valuations should be more important to investors than economic metrics.
By Jess Morgan | 03/10/16

In an environment of low returns, a broadly diversified portfolio is more important than ever, according to Vanguard’s global chief economist Joe Davis. He says investors should take a cue from his team at Vanguard and adopt a "global mindset" to their portfolios.

About the Author
Jess Morgan is the associate editor of Morningstar Canada’s website. She began her career as a television producer and freelance writer, often making appearances on TV and radio as a commentator on politics and culture. She holds a BA in communications from the University of Winnipeg and a diploma in Creative Communications from Red River College.

"It's natural to want to retract from investing overseas when you see some of the geopolitical headlines or some of the weakness overseas," says Davis, who is based in Philadelphia. "However, I think that's all the more reason to have a globally diversified portfolio. I think investors are increasingly embracing that. But these are the sort of environments that kind of test that resolve."

Patience is the key for long-term investors, Davis says: "A balanced portfolio will have lower expected returns, and somehow we're going to have to react to that. So this patience is just saying, listen, the market doesn't care necessarily what we want. It's just going to provide what you think is a realistic return. Odds are that they are going to be lower than the past 10 years."

While some investors are keeping an eye on specific geopolitical risks, such as Brexit and the U.S. presidential election, Davis and his team are taking a "holistic" approach to their outlook on the markets.

"If you go back historically, there's always something to be cognizant about," he says. "There may be, perhaps, a little bit more sensitivity today, given the fragility of the global economy, which for several years we've focused on, and we don't see economic conditions changing materially."

He cites a number of conditions that together create "structural deceleration," as described in his 2016 economic outlook paper.

"I think there needs to be a shift in mindset for investors in terms of what is 'normal,'" says Davis. "I don't think there is a new normal at all. I think it's actually a misunderstanding; what was normal was forgotten. There's nothing new about it."

He says Vanguard's view, which factors in supply-side elements such as an aging and slow-growing population, manages to reconcile strong equity market performance with low unemployment rates worldwide -- which, he adds, the view that the world economy is in secular stagnation does not.

"I don't think we should be doing a lot of handwringing that the recovery is slow at 2% in the U.S. or other developed markets," he says. "If you believe in stagnation, that means it's weak demand. Well, then, why isn't the unemployment rate twice the rate it is now?"

In Canada, Davis says the economy features strong catalysts for long-term growth, including a stable financial system and openness to trade. "I think Canada is a little bit more evenly balanced in terms of the economy," he says. "Housing does give me some concerns, but I don't have nearly the same concern as I would have had seen in 2005-2006."

That said, he adds, economists should stop expecting emerging markets to help bring about a strong rebound in commodity prices. "We have long been of the view that the emerging-markets slowdown is structural, which means they are not going to rebound in growth," he says. "They have not de-levered. It's actually the one area of the world that has not gone through private-sector deleveraging, like parts of the developed markets."

Davis advises that investors who are concerned about any of these economic expectations should try to divorce them from their investment decisions.

"A common surprise of investors is that there's effectively no correlation between long-run stock returns and the growth rates of economies," he says. "Our return expectations have come down consistently every year. It's not because we are bearish on the world economically. It's because where valuations are in multiples that it just deems a lower expected return, particularly given our very muted outlook for central-bank policy."

For investors thinking of altering their portfolio significantly to adapt to economic conditions, Davis recommends considering how closely their expectations align with the behaviour of the markets.

"I hear this from U.S. investors: 'Well, I don't want to be in fixed income because I think interest rates may go up.' I say, respectfully, interest rates are already expected to go up by the bond markets. If you're going short in duration, it's going to be because you expect interest rates to go up more than what's implied in bond prices today. Just having a firm understanding of what the consensus is, what the financial markets are pricing in, is very important."

Davis, who is a member of the Vanguard Fixed Income Group's senior portfolio- management team, says investors should not be too quick to reduce their exposure to bonds, despite an overall low-yield trend.

"Some investors either want to have a more local portfolio, or don't want to have as much exposure to fixed income because of low yields. But when there are periods of equity-market selloff, these lower-yielding conservative investments certainly will provide a ballast. I think that has benefited investors in the past several years, and I think it will continue to do so despite the lower expected returns on those assets."

A fixed-income ballast should be paired with a low-cost portfolio, Davis says, expecting high risk will not pay off for investors as well as it did in 2009.

"With the lower expected-return environment, the tax, so to speak, from high-cost strategies it's going to be even more of a headwind going forward," he says. " If one is going to take on more active risk, you'd want to at least think about in an environment where the risk premiums are wide enough that you would be compensated more."

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