International Markets

Canada will benefit from U.S. resilience, says Joseph Davis.
By Michael Ryval | 26/01/17

Global economies will grow at a reasonable pace in 2017, while markets will only deliver modest returns as a state of "sustained fragility" will be the norm, says Joseph Davis, global chief economist for Vanguard Group Inc.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"Thematically, this year is a matter of stabilization for the global economy -- not stagnation," says Davis. "Markets are increasingly appreciating that the world is not heading for Japanese-style stagnation and it's one of the reasons we have seen strong financial-market performance over the past six months. That's welcome."

It is unlikely, however, that markets in major economies will accelerate, adds Davis, and recession appears to be remote. "Financial markets are anticipating growth in the U.S. north of 3%. Investors are sometimes presented with dichotomies and paradoxes. You can see a modest strengthening in global economies and yet you can have a year of modest investment performance. That all relates back to two things: one is, what is already priced into the market?" says Davis, global head of the Vanguard investment strategy group.

"Six months ago, markets were too pessimistic," adds Davis. "Now they have gone too far in the other direction. Second, what is the price being paid for growth? When you put these two factors together, although we are not bearish, we do not anticipate continued exceptionally strong financial-market performance. If we do see it, it would be a surprise."

In 2017, Vanguard expects mid-single digit returns for balanced portfolios, based on equity returns of 6% to 7% and 1% to 2% for fixed income. "It's not bearish. But we're probably the most guarded on the capital markets since 2006," says Davis, who is based in Valley Forge, Pennsylvania, and heads a team of about 60 people globally.

Even though the North American business cycle is getting long in the tooth, and is now entering its ninth year of expansion, Davis does not see the cycle nearing the end. "Business cycles end due to a combination of three reasons," he says. First, there are growing imbalances in the economy, such as in housing and excessive corporate leverage. Second, there is tight fiscal and/or monetary policy. And third, a shock to the system results in a drop in confidence.

"Every recession in world history has been due to a combination of those three forces," says Davis, who joined the firm in 2002 after earning a PhD in macroeconomics and finance from Duke University. Of the three factors, only a significant tightening of financial conditions, such as a dramatic hike in the U.S. federal funds rate, could lead to a recession. "You'd have to have four successive interest-rate hikes by the Fed, and an environment where inflation and growth were slowing, and finally, we would need to see this happening in the face of significant strengthening in the U.S. dollar. You would need all these conditions," says Davis.

In the near term, Davis adds, the biggest worry is Europe, with uncertainty about the outcome of several general elections. Longer-term, Davis admits there are concerns about excessive leverage in China's corporate and housing sectors.

The consensus outlook for the U.S. is close to 3% GDP growth. "Hope springs eternal. This year, we will not see growth expectations downgraded. Three per cent growth is certainly a possibility," says Davis, adding that U.S. business investment will pick up as business confidence improves and infrastructure spending kicks in.

As for Canada, Davis believes that it has been fairly resilient and will continue to benefit from the resilience of the U.S. economy. "There are fears about U.S.-Canada trade. But at the end of the day we are unlikely to see a uniform, broad-based material increase in tariffs and protection measures for no other reason than they are difficult to engineer and implement," says Davis, noting how supply chains are more and more globally integrated.

Threats of scrapping the North American Free Trade Agreement are unlikely to come to pass, Davis argues, but there will be a greater focus on trade deals and greater scrutiny of globalization. "Ultimately, globalization is not the enemy. I would hope that we will see a greater appreciation of the number-one reason why manufacturing employment has dropped as a share of every industrialized economy: technology," says Davis. "If there is rise in protection, the emerging markets would be most impacted. My hope is that we may see a stall in globalization, but not a sharp reversal."

Davis says equity markets have become somewhat complacent, as indicated by low volatility and high valuation measures such as price-to-book. "Valuations are not arguing for exceptionally strong returns," he says. "And they are pricing in better returns than two or three years ago. Investor risk appetites are positive. Combine all four factors and that's been generally associated with below-average stock returns over the next year or two."

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