The Federal Reserve Board meets March 14 and 15. The odds that the Fed will raise interest rates by 25 basis points (0.25 percentage point) have spiked in the past two weeks.1 The case for a hike is strong:
- We’re at more or less full employment.
- Inflation, which has slowly accelerated, hovers near the Fed’s 2% target.
We expect two to three rate hikes by year-end, which would put the federal funds rate at 1.25% to 1.50%, a level consistent with the Fed’s—and Vanguard’s—assessment of the economy’s strength.
The more interesting, and puzzling, economic analysis is happening in the stock market. U.S. stocks have been on a tear. The market is priced for long-term economic growth rates of 3%-plus, maybe 4%. (This estimate is based on our calculation of the earnings growth estimates implied by current stock prices.)
But like big hair and acid-washed jeans, those growth rates are an artifact of the 1980s. These days, the labor force is increasing slowly. Productivity growth, which could be turbocharged by a 21st-century Edison or Ford, is for now modest. And we’ve sworn off the growth-boosting but risky leverage that inflicted so much pain in the global financial crisis. The economy’s long-term potential growth rate is about 2%.
Where we were, where we are
We can see the economic differences between the 1980s and today through the lens of bond yields. (This analysis comes from Vanguard’s 2017 economic and market outlook).
During the 1980s, the 10-year U.S. Treasury note yielded an average of more than 10%. At the end of 2016, it yielded 2.5%. The following drivers, illustrated in the chart below, explain the change:
- Lower inflation. In the 1980s, prices rose at an annualized 5% per year. A cart of groceries that cost $100 at the start of the decade cost more than $160 at the end. Today, inflation is barely 2%.
- Slower productivity and labor-force growth. An aging population means slower labor-force growth. And workers’ hourly output is increasing more slowly—a rate of 1.6% per year in the 1980s, about 1% today. (That’s not bad! Before 1700, Europe experienced no productivity growth. As a result, a farmer born in the 14th century had the same standard of living as his great-great-great-grandson born in the 17th, though the latter at least had Shakespeare.)2
- A lower term premium. The term premium measures the additional yield paid by longer-term relative to shorter-term bonds. It’s related to inflation risk, which has declined significantly.
- Greater demand for U.S. bonds. The remaining drivers are increasing global demand for the world’s safest asset—the U.S. Treasury—and unexplained (residual) causes.
Drivers of U.S. interest rates since the 1980s
Decline in inflation has been the key
Notes: The decomposition of changes in real equilibrium interest rates is based on the sequential application of three models, which are presented in the sources.
Source: Vanguard calculations based on data from Holston, Kathryn, Thomas Laubach, John C. Williams. 2016. “Measuring the Natural Rate of Interest: International Trends and Determinants.” Federal Reserve Bank of San Francisco Working Paper 2016-11. http://www.frbsf.org/economic-research/publications/workingpapers/wp2016-11.pdf and Congressional Budget Office The budget and economic outlook: 2016 to 2026. Washington, D.C.: CBO (2016).
No time machine
Maybe new fiscal policies—tax reform that boosts investment, infrastructure projects that produce economic efficiencies—will nudge growth higher. Uncaged animal spirits, evident in business and consumer confidence surveys, could put near-term growth at 3%. But none of the new administration’s proposals include a flux capacitor that will take us back to the 1980s.
Our asset class forecasts, anchored on a future of 2% growth, assign the highest probabilities to:
- Global bond market returns of 2.5%–3% over the next decade.
- Global equity returns of 6%–8% over the next decade.
The U.S. stock market is giddier, suggesting a different economic future. Our advice: Stick to the target asset allocations for your clients, even as stock and bond prices swing with changing sentiment. Rebalance to that allocation as necessary. We’re not going back to the 1980s. The calendar and the outlook have changed.
1 After Fed Chair Janet Yellen’s speech at the Executives’ Club of Chicago on March 3, 2017, the odds soared to more than 80%. These odds are derived from interest rates built into contracts that will pay those rates to buyers in the future.
2 Thomas Piketty (translated by Arthur Goldhammer), 2014. Capital in the twenty-first century. Cambridge, Mass.: The Belknap Press of Harvard University Press. p. 94.