Last Friday, the Commerce Department’s revision to fourth-quarter GDP indicated that the U.S. economy expanded by 2.4% in 2015, consistent with our expectations. In the year ahead, growth will most likely moderate toward 2%, our estimate of its longer-term potential. Vanguard’s estimates aren’t radically different from the economic consensus. In the decades before the global financial crisis, by contrast, the economy grew at average annual rates of 3%-plus.
How do we interpret this contrast between the robust growth in the decades before the crisis and our subdued expectations for the future? Is it evidence of “secular stagnation,” with growth depressed by insufficient demand and the threat of a pernicious deflation? Or does the contrast instead raise doubt about the sturdiness of our pre-crisis past?
From 1980 until the global financial crisis, the deepest downturn since the Great Depression, the U.S. economy grew at an average annual rate of 3.1%. Since the depths of the crisis in 2009, the recovery has been slow and underwhelming. Consensus expectations of subdued growth might suggest that the financial crisis demarcated a break between an energetic, expansionary past and a bleak, constrained present and future.
But this reading of economic history is wrong. In the decades before the crisis, the growth rates of 3%-plus reflected a combination of organic strength and performance-enhancing supplements. Labor force growth, capital spending, and productivity improvements were strengths. The explosive growth in debt-financed consumer spending was a risky, if temporarily effective, economic steroid.
In 1980, home mortgage debt amounted to 33% of GDP. At its early-2008 peak, this debt topped 77% of GDP. Credit-card borrowing, though lower, followed a similar trajectory. These borrowings underwrote steady growth in consumer spending, which rose from 62% of economic activity in 1980 to 68% in 2007. At that point, of course, debt service began to overwhelm household incomes, and bad loans burned holes through bank balance sheets, igniting the global financial crisis.
Without the debt-financed spike in consumer spending from 1980 to 2007, GDP growth would have been 0.76 percentage point lower. If we adjust that figure for the slower population growth that we (and the rest of the developed world) can expect in the decades ahead, GDP growth would have been about 2% per year. The new normal is mostly the old normal, minus the surge in performance-enhancing debt.
Stagnation or deceleration?
Economists who interpret the slower-growth future as secular stagnation advocate an aggressive policy response—a continuation of the Federal Reserve Board’s zero-interest-rate policies, purchases of longer-term debt, and fiscal policies designed to stimulate demand. In this view, policy is what stands between us and the 3% growth rates of our pre-crisis past.
We see 2% growth not as secular stagnation, but as structural deceleration—a reasonable expectation for a developed economy with a slowly growing labor force. Stable (if low) inflation expectations and an economy that is now at full employment justify the Fed’s decision in December to begin normalizing monetary policy. The risk of maintaining exceptionally accommodative policies is the creation of debt-inflated asset bubbles that could jeopardize financial stability.
Investors face a similar calculus. If 2% growth represents a “problem” to be solved, it’s reasonable to expect that aggressive monetary easing or fiscal stimulus will reduce interest rates and risk premiums, increasing returns from stocks and bonds. In this interpretation, risky assets are “cheap.” As soon as policymakers muster the courage to act, risk will rally.
Our expectations are more subdued, though not bearish. We see stocks as fairly valued—appropriately priced for an era of low inflation, low interest rates, and 2% growth. Prospective bond returns reflect this same reality. Our simulations indicate that over the next decade, the average annualized returns of a 60% stocks/40% bonds portfolio will most likely be in the 3%–5% range after inflation.* This is below the average after-inflation return of 5.5% for the same portfolio from 1926 through 2015.** The capital markets can help us meet our goals, but we’ll most likely have to save more than we would have in the past.
Sustainable and healthy
Just as steroid abuse can lead to long-term health risks, the bulked-up growth rates in the decades before the financial crisis reflected unhealthy distortions of our economic well-being. A future of 2% growth is neither new nor subpar—it’s sustainable and healthy. Less is more.
All investing is subject to risk, including the possible loss of the money you invest.
*IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM, derived from 10,000 simulations for U.S. equity returns and fixed income returns. Simulations as of September 30, 2015. Results from the model may vary with each use and over time. For more information, please see the important information note below.
** The long-term returns for our hypothetical portfolios are based on data for the appropriate market indexes through September 2015. We chose these benchmarks to provide the best history possible, and we split the global allocations to align with Vanguard’s guidance in constructing diversified portfolios.
U.S. bonds: Standard & Poor’s High Grade Corporate Index from 1926 through 1968; Citigroup High Grade Index from 1969 through 1972; Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; and Barclays U.S. Aggregate Bond Index thereafter.
Ex-U.S. bonds: Citigroup World Government Bond Ex-U.S. Index from 1985 through January 1989 and Barclays Global Aggregate ex-USD Index thereafter.
Global bonds: Before 1985, 100% U.S. bonds, as defined above. After 1985, 80% U.S. bonds and 20% ex-U.S. bonds, rebalanced monthly.
U.S. equities: S&P 90 Index from January 1926 through March 1957; S&P 500 Index from March 1957 through 1974; Dow Jones Wilshire 5000 Index from 1975 through April 2005; and MSCI US Broad Market Index thereafter.
Ex-U.S. equities: MSCI World ex USA Index from January 1970 through 1987 and MSCI All Country World ex USA Index thereafter.
Global equities: Before 1970, 100% U.S. equities, as defined above. After 1970, 70% U.S. equities and 30% ex-U.S. equities, rebalanced monthly.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.