A Top Vanguard Economist on How to Prepare for a ‘Shallow’ Recession

Asset manager Vanguard predicts the U.S. economy will enter a “shallow” recession later this year. That would boost unemployment, but probably not as much as we’re used to seeing during downturns, says Roger Aliaga-Diaz, Vanguard’s chief economist, Americas and global head of portfolio construction. The reason is labor shortages, which will remain a long-term concern as demographic trends compress the number of workers available, he says. 

Aliaga-Diaz, who joined Vanguard in 2007, studied at the Universidad Nacional de Córdoba in Argentina and got a doctorate in economics from North Carolina State University. He talked with Barron’s about the economy, his expectations for inflation, and why Vanguard expects international equities to perform better than U.S. stocks.

Roger Aliaga-Diaz

Illustration by Kate Copeland

Barron’s: Inflation remains elevated, but the economy is resilient. The unemployment rate is near its lowest level in decades. How’s an investor to make sense of these signals? 

Roger Aliaga-Diaz: We think inflation will start to come down more and more through the course of 2023 thanks to monetary policy being more restrictive. That will gradually lead to normalization in markets. We believe it’s going to be a slow and gradual progress, with inflation staying above 3% through 2023 and only returning to the 2% target by 2024.

We are seeing some signs that worry us. But we have said that normalization of inflation won’t come for free. It probably requires a recession. It’s paradoxical. The more the numbers for the economy remain strong, that leads some people to question [our] recession call. But for us, it’s like, OK it may get a little uglier. Essentially, if the economy keeps going strong, then monetary policy may not be doing what it is supposed to be doing, which is slowing things down so inflation comes down. That may mean that they [the Fed] need to be more aggressive. So right now we expect the Fed will need to keep increasing rates to a 5.5% range to slow down economic activity enough for the labor market to cool down and for inflationary pressures to continue easing.

But if the economy doesn’t slow down, maybe they need to go to 6%. That’s the risk and the concern with inflation. Will the Fed finally get in front of the problem? 

In an environment where inflation concerns continue, that isn’t good for investors. We saw it in the performance of the 60/40 portfolio last year. It’s a difficult environment for investors. But I think the thing that we need to keep in mind is that these inflationary periods tend not to last that long. We’re not talking about a change of regime. It’s a transition period until the Fed gets inflation under control. Because of that, we don’t recommend making big changes to a portfolio. If you are investing for the long term, we don’t expect this to really affect the long-term portfolio. 

Things will normalize, and the long-term outlook not only looks good, but better than when the Fed started to hike rates. Yields are now higher. Equity markets have come down a lot, and they are more reasonably priced. So if anything, the long-term outlook has improved despite the pain that investors have suffered to get here. At this point, it’s too late to get out, and this is actually a time when you can begin to see benefits for the investor. So be patient.

Vanguard’s base case is that there will be a shallow recession in late 2023. How should investors prepare for that?

Markets have to an extent adjusted for that scenario. What I am looking for markets to do is price the recovery on the other side. Markets are a forward-looking mechanism. We saw a correction in markets last year. They have been digesting the news about inflation and rate hikes. At some point, once the view is clear that a recession is coming, it could actually be the opposite. For a retail investor, if you are reading the news to consider a change in your portfolio, maybe it’s actually too late. We saw that back in ‘08, ‘09—the sense of “there is no bottom to this” in February 2009, but then in March 2009 the market began to rebound. This is why you want a strategic long-term allocation. You’re not timing the market.

If there’s a shallow recession, what’s the outlook for unemployment?

We look at long-term demographic trends. The slowing of population growth tends to compress the number of workers available. But that doesn’t prevent unemployment increasing in recessions. We see a shallow recession, and unemployment could increase to 4% or 5%. That’s higher than where we are now, but not higher than historical standards. We are more worried about labor shortages going forward. Not unemployment. We’ve been worried for years about automation. But we think it could actually help to solve these labor shortages because of the demographic headwinds. Hopefully, human ingenuity and technology can help overcome that.

Are there particular sectors that would benefit from automation?

We haven’t analyzed long-term projections for labor shortages at the sector level (we’re currently doing some research on this but no results yet), but for the economy as a whole. We can see aggregate labor shortages continue being an issue over the medium and long term. This is due to demographics headwinds that translate into a slow pace of labor force growth.

At present, the sectors showing the most acute labor shortages (for instance, measured by the V-U ratio, which is the ratio of number of vacancies per each unemployed worker) are: education and health services, professional and business services, information, and finance, with V-U ratios of about 2.5 to 3.5 open jobs per unemployed. Next we have manufacturing, transportation, and warehousing, and wholesale and retail trade, with V-U ratios of about 1.5 to 2 open jobs per unemployed. Construction is actually not that tight, with less than one job opening per unemployed.

Last year was one of the worst ever for the traditional 60/40 portfolio. What’s the outlook for this portfolio going forward?

Our actual 60/40 portfolio was down like 16%. That’s unheard of. But because of what we were saying before, even though that was painful, equity valuations have come down. In December 2021, valuation levels in our calculations were 40% over equilibrium levels for equity markets. The only time the market was as overvalued was in 1999. We created this model to calculate the fair value of the market, and we can see these bubbles. So, we were due for a correction anyway. The result is that now values are fairer. The expectation is for much more normal returns going forward. Our expectation for equities is for 5% to 6%.

Bonds weren’t too different. If you think about the years of super low rates, they were low because of all these other reasons, but they weren’t normal. The 10-year Treasury yield started 2022 at about 1.5%. So it’s more than doubled in the past year. 

Our capital markets prediction for a 60/40 portfolio for the next 10 years is a 6% average annual return. That’s a reasonable level of return. That’s what a 60/40 should return in normal conditions. Last year, when we were down 16%, that was really bad. But before that we had three years of outsize returns. So we are projecting now on average a 6% return annually for the next 10 years. So the 60/40 portfolio is doing more of what it should do. 

Vanguard anticipates higher annualized returns for non-U.S. equities (6.7% to 8.5%) than U.S. equities (4.4% to 6.4%) for the next 10 years. Why is that?

There are three elements. First, valuations in the U.S. have adjusted recently, but outside the U.S. they have come down too and from valuations that weren’t that high to start. If U.S. equities are fairly valued, then you could argue that international equities are cheap. That valuation differential accounts for one percentage point of the difference. 

But that’s not all. There’s a second aspect: The sector composition of the U.S. market, which has become more growth heavy. In international markets, it is more tilted toward value than growth. That matters because we foresee value doing better than growth in the coming years. In a regime where interest rates remain higher, that will benefit value more than growth. The value premium is back, and the international market is more value heavy. 

The third factor is the U.S. dollar. We think the dollar is at strong levels historically and it will normalize back to a somewhat lower level. That will add an extra tailwind. Adding those three factors you get more performance for international than U.S. equities.

What should investors do about it? A lot of things can happen in between. That’s why we won’t necessarily recommend big changes to a portfolio. But you could tilt a little more toward international and reduce a little bit your home bias, which we know is pretty common in portfolios. Our recommendation on the equity side is 60% U.S., 40% international. Many investors are more U.S. heavy than that. Of course, that paid off in recent years. But we think more global diversification offers benefits given this forecast. 

Many Americans have invested trillions of dollars worth of retirement savings in target-date funds. How can investors decide whether a set-it-and-forget approach or a more customized strategy is better suited for them?

A customized strategy will be better. But the reason why a target-date fund makes sense for some investors is that what really helps contribute to success in investing for retirement is staying invested and contributing to [to your retirement savings] regularly. So your portfolio allocation matters, but so do the behavioral aspects. In that sense, the target-date fund, which requires minimal engagement, is a big part of the success investors can achieve. 

The funds are outwardly simple, but internally there’s more going on there. The models and the asset allocation frameworks we use to develop them are the same that we use to run our financial advice offerings. There’s a lot that goes into it: the glide path, the minimizing of costs. The end result is that investors don’t need to think about it. 

We don’t include other asset classes, such as alternatives and commodities. Maybe from a pure investing case, you debate whether to include them. But from a behavioral component, it makes it more complicated and you need to explain it to investors, and [that complexity] could push them away from what is a simple and reliable portfolio.

Target-date funds have either a “glide-to” or “glide-through” path. Which does Vanguard use and why? 

For target-date funds, we have a glide-through strategy. It’s a strategy that follows you through your life. A glide-to strategy works well if you know that when you reach [the fund’s retirement date] you’re going to move to, say, an advice solution or into an annuity. 

For the glide-through solution, we look at things like mortality rates and the replacement ratio, how much income people may need to withdraw. There are all these variables that go into the framework that helps us devise a glide path. 

A lot of investors rely on the 4% rule as a withdrawal strategy in retirement. Does it still work?

Some of my colleagues here on the investment research team have done a lot of work on this. For years, we were in a low-return environment with interest rates that were very low. A lot of people were starting to question whether the 4% rule was still valid. But it’s interesting. At the level of yields now, 4% is more reasonable. But the rule depends a little bit on what the markets can give you. To be frank, we look at different spending strategies, especially the level of spending needed to sustain replacement rates. Four percent of a $1 million portfolio isn’t the same as 4% of a $100,000 portfolio. It isn’t the same living standard. There is a minimum standard of living you need to fund. A 4% rule is difficult to apply across the spectrum of investor needs. We think it is better to build a portfolio toward your spending needs.

There’s also longevity risk. You don’t want to outlive your portfolio. You need to have some equities for the long haul. The more you lower market risk, the more you raise longevity risk. To give an example. Our glide path for target-date funds has 50% equity at age 65. It continues gliding down until 72 years old when it reaches about 30% equity. And it stays that way. We know some people work past age 65 and some people don’t tap their portfolio right away. That’s why we feel good the landing happens seven years after.

Thanks, Roger.

Write to Andrew Welsch at [email protected]

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