Vanguard’s global chief economist handicaps the odds of recession and higher inflation and discusses how investors can thrive in an era of AI, aging populations, and a rising US deficit.
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Our guest on the podcast today is Joe Davis, global chief economist at Vanguard and global head of the firm’s Investment Strategy Group. He chairs the firm’s Strategic Asset Allocation Committee, which governs multi-asset class investment solutions. And he is a member of the senior portfolio management team of Vanguard’s Fixed Income Group. Joe is the author of a new book called Coming Into View: How AI and Other Megatrends Will Shape Your Investments. Joe earned his B.A. from St. Joseph’s University and his master’s and Ph.D. in economics at Duke University.
Coming Into View: How AI and Other Megatrends Will Shape Your Investments
“Tariffs and Market Volatility: Perspectives for Investors,” by Joe Davis, vanguard.com, April 7, 2025.
“Vanguard Warns of 9% Treasury Bond Yields if Deficits Keep Ballooning,” by Sam Bourgi, investorsobserver.com, June 17, 2025.
“US Equity Outperformance,” video commentary by Joe Davis, vanguard.com, Feb. 4, 2025.
“America Needs an AI Boom to Grow Out of Our Debt Problem. There Is No Guarantee,” by Joe Davis, barrons.com, May 23, 2025.
“AI’s Impact on Productivity and the Workforce,” by Joe Davis, vanguard.com, March 4, 2025.
“Active Investing? Don’t Overlook Value in the Age of AI,” by Joe Davis, vanguard.com, Feb. 20, 2025.
“Megatrends and the US Economy, 1890-2040,” by Joe Davis, Lukas Brandl-Cheng, and Kevin Khang, papers.ssrn.com, June 10, 2024.
“Joe Davis: ‘We Will See China-Like Growth for a Time in the United States,’” The Long View podcast, Morningstar.com, April 14, 2021.
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Christine Benz: Hi and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Dan Lefkovitz: And I’m Dan Lefkovitz, strategist for Morningstar Indexes.
Benz: Our guest on the podcast today is Joe Davis, global chief economist at Vanguard and global head of the firm’s Investment Strategy Group. He chairs the firm’s Strategic Asset Allocation Committee, which governs multi-asset class investment solutions. And he is a member of the senior portfolio management team of Vanguard’s Fixed Income Group. Joe is the author of a new book called Coming Into View: How AI and Other Megatrends Will Shape Your Investments. Joe earned his B.A. from St. Joseph’s University and his master’s and Ph.D. in economics at Duke University.
Joe Davis, welcome back to The Long View.
Joe Davis: It’s wonderful to be back, Christine.
Benz: Well, it’s great to have you here, and congratulations on your book. We’re going to be delving into the book later on in this conversation. But before that, we wanted to do a bit of a temperature check on current conditions, starting with tariffs. It seems like US stocks have largely shrugged off the tariff worry since the spring. Do you think investors are being overly optimistic?
Davis: Well, I think the good news, Christine, is that we’re unlikely to see a recession despite the pretty eye-opening rise in tariff rates. Our internal forecasts certainly had a slowdown. We will see a slowdown, but we have not had a recession. And so, in one sense, I think the equity market, the financial markets have been cautiously optimistic on that front. That said, we have not seen all of the negative effects from a near-term growth perspective. And some of the inflation readings that we’ll see, I think in part because companies have held off on some of those implications should we see the tariff rates stick higher. So again, I think we’re in store for a little choppiness. So, you can take my words, I think they’re a little bit priced to perfection, but we don’t have recession. So, if we had a steep fall on equity markets, that would surprise me.
Lefkovitz: Yeah, it seems like all the talk of stagflation has sort of receded. Curious, whether you think that there’s any risk of inflation flaring up?
Davis: Well, I think more important than the inflation flaring up, Dan, is just the fact that it’s remained stubborn above 2%. Now, again, it’s in the low- to mid-2% range. It’s not going to turn over the fixed-income market in any way, shape, or form. I think we do have some headline risk of businesses have really been waiting for clarity. But I think that will push both ways, at least on the bond market, because you’ll have some of that drag on growth. So, we’re not overly concerned on stagflation.
I think where you would be concerned is if there was a really rapid rise that’s being also followed on by—we just hope to see continued vigor, strength in the labor market, that would keep the Fed on hold for an extended period, and the financial markets on price for that.
Benz: I wanted to ask about the equity selloff back in the spring. When we saw Treasury bonds drop at the same time stocks did, in the worst of that period, should we be worried about the nice inverse correlation that Treasuries have had with stocks, that that is undoing itself in some way? I know that some people have been worried about that. I’d be curious to get your take.
Davis: Well, again, in our diagnosis—is in the next several years bonds will clearly still remain a ballast, which is that negative correlation you mentioned, Christine. But I think with our diagnosis, we put our finger on it over three years ago, is that we’re going to have a higher interest rate environment, which we currently are in now. I’m talking about three years ago, and we were closer to the zero bound. Why that’s important is in that environment, a good decade or more, we had really negative correlations. You talk about supercharged diversification. We’re still talking about bonds as a ballast. Maybe the correlation is, I don’t know, 0.1 or zero. So, when stocks fall, you’re generally going to have bond prices eventually increase. Will it be as rapid on average as in the past? Maybe not just because you have slightly higher interest rate, but that comes with a very positive dynamic, which is higher income for bond portfolios writ large.
Lefkovitz: Despite interest rates seeming to remain higher for longer, we have seen some weakening in the dollar since the start of the year. Wondering what you see as the major forces pushing it down, and should we be worried?
Davis: Well, again, I think it’s not so much worried, because I think—and Dan, I’m not going to pick on your words. It’s more of just worrying. There are two forms of worry. One is you’re aware of it from a risk management perspective, and then secondly, one could be very alarmed. I’m not alarmed, but I think it’s a glimpse of one potential future.
I know we’re going to get to the book. I think what ultimately is driving some of the dollar weakness, it’s partly related to our building national debt and fiscal dynamics, this gap between revenues and expenditures. I know the tariffs were generally at first the headline, but underneath that gets effectively financing of financial dynamics. So, I’m not alarmed, but it’s with a capital A, but I think it’s a glimpse of a future where there may be a little bit higher interest rates that we have to demand from overseas investors, will demand for sustaining our debt. But again, I don’t want to paint that as an alarmist picture, but it’s a glimpse of one potential path if AI doesn’t really accelerate.
Benz: We have seen non-US stocks perform pretty well relative to US for the year to date.
Davis: Finally.
Benz: Yeah, right. Right. I wanted to ask about that, because you and the team for several years running, coming into this year, had been pointing to non-US as being inexpensive relative to US. Is that still the case, even with the rally factored in?
Davis: It is, although I’d say to be fair to all your listeners, you have to hold yourself accountable to forecast. It’s a dated narrative. Someone could be kind and say, oh, Vanguard was early. You could also say we were just wrong, because you’re talking about five years, saying that there was a prospect for overseas outperformance. Now, again, that drags into valuation, which you mentioned, Christine.
I will take a step back. We’ve been digging at this hard, because what’s really going on with what some call US exceptionalism, this sort of US equity market stellar outperformance and how sustainable is it? Our rationale for all investors to have some non-US exposure really has nothing to do with valuations. In other words, how cheap or rich certain markets are. That has a bearing on how much you have, say, of non-US stocks.
But in terms of why would one have any at all? I mean, our founder, Jack Bogle, wasn’t a huge fan of overseas investing. It comes down to two reasons, and it’s around risk management. One is the fact that on average, over long periods of history, roughly 4% of the stocks in the US and 2% globally have driven roughly half of the equity risk premium. You’ve talked about this on the show, and otherwise. It just so happens, the past decade, virtually all those companies have been based in the United States. So, I think from a risk management perspective, if you don’t have any non-US exposure, you may not realize that that’s a really strong technological bet that the future 4% of companies will solely be based in the United States. It could, but I’m not 100% confident that would be the case. And you could do one minus that probability of that happening as a loose rubric or rule of thumb to have non-US exposure. The other is modest risk management from our currency. I mentioned some of our fiscal pressures. I am not being an alarmist on the US dollar, but from a risk management perspective, that’s also a modest reason why you’d have some non-US exposure. That has nothing to do with the relative valuation of stocks in the US and overseas. Now, then, that would bring in how much you would overweight non-US.
Lefkovitz: Joe, when it comes to deficits and the debt, you do write about this in the book. You don’t seem as, I’m not going to use the word worried, you don’t seem as alarmed as others about the debt growing. Why is that?
Davis: It gets back to your word, Dan. Again, it’s a formidable issue. So, in one sense, I think the value of why I felt compelled to even write about it in the book is, listen, of all the forces we care about out there, it’s becoming increasingly apparent, at least through our framework, our data-driven framework, that fiscal deficits are a serious matter, more so than I think some may believe, and perhaps some in the political sphere would believe. And so, they are having a modest effect. We know, given our framework underneath the surface, they’re modestly pushing up interest rates, they’ve pushed up inflation expectations, they’ve even pushed up where we first came to this conclusion, the so-called neutral rate, or where the fed-funds rate levels off over a long period of time. But they’re not at alarmist levels yet, not at a 6% or 7% 10-year Treasury, which we see very low odds of that happening over the next year or two.
So, in that sense, you would say, yeah, I’m not alarmed, with a capital A. However, when we look out four to five years, if you don’t have a lift from technology, they’re going to have a more meaningful impact than I think the bond market realizes. It means a compelling real interest rate for bond investors, but that would be a little bit of a transition period. But I want to underscore, this is not an imminent transition in our framework. In one sense, you could say, OK, I’m not alarmed by it. But if you have a three, five, seven-year investment horizon, you have to have it on your scorecard in thinking through the risk on the horizon.
Benz: I want to segue into talking about your book, Coming Into View. And I think it will be a nice transition because we want to talk about globalization. The conventional wisdom these days is that the era of free trade and globalization is over, or at least in decline. Yet in the book, you talk about the fallacy of globalization’s retreat. So maybe you can talk about what you think conventional wisdom gets wrong.
Davis: Well, I think it was really focusing on a key component of trade that’s at least in my judgment, Christine, has rarely talked about. Now, that said, tariffs and the movement of goods, whether it’s a piece of cheese or a car part, they’re obviously fundamental to supply chain and manufacturer goods, everything that we purchase, say, for our own household. But when you step back, that’s roughly only one-third of consumer spending in the United States is goods. And two-thirds is services. And even within goods, manufacturing goods, we all know, I think would appreciate the technology and productivity, the sort of innovation rates, where the new products come from. That’s a bigger driver of growth in earnings over a long period of time than the efficiency of doing those existing products and where they’re produced.
So, trade and tariffs are important. But what I find remarkable is, and what’s never mentioned is where the ideas for the products are coming from themselves. I talk a little bit about a popular consumer product such as the iPhone and how the nature of innovation has changed and has benefited from the globalization of what I call ideas. So where are the human capital ideas coming from? If you looked 100 years ago, they pretty much would have been within the sole country—the United States with the primary driver of ideas through competition. It’s not all collaboration. There’s more global sourcing of ideas, including from China. And I think regardless of the tariff rates that we slap on different countries, I think that’s a reason to be a little bit more bullish on growth than perhaps one would be if you just looked at tariffs themselves. And so that’s what I mean by the fallacy of globalization’s retreat. I mean, unless you’re literally shutting down the internet and the movement of people across all goods, and again, there’s some headlines on that too, it’s very unlikely that globalization is going to retreat in the broader sense.
Lefkovitz: The book deals with this concept of megatrends. And I just wanted to get you to talk a little bit about how you define a megatrend—why you think they’re so important, and how do you factor them in? Some of them seem so long term and difficult to forecast.
Davis: Sure. Well, I think what’s eye-opening to me is, I’ve been in the economics profession for over 20 years, which is a fancy way for saying, I’m getting old. But ever since I learned in graduate school, and what’s a common approach to this day is, if you care about the economy, if you care about the financial markets, on any short to intermediate horizon, it’s what’s reported in the business press, it’s what’s GDP or the Fed is going to do in the next six months. These are all important things, by the way, something I’m asked to opine on internally and externally. My team does research on the near term.
However, what I think the industry really underestimates is two dimensions. One is the fact that the so-called trends that are, in one sense to your point, Dan, they’re so slow moving that someone says, you know what, unless I care about the next 20 years, I don’t have to worry about them. So, they’re kind of like glaciers in the ocean. They move so slowly that it’s like watching paint dry. It turns out that small changes in these trends have a large bearing on the business cycle.
I’ll give you an example. If you just look at the past two years, the biggest surprises in the growth in inflation in the equity market front have been things such as, oh, we had changes in the immigration. Well, that gets the demographics and small changes there. We’ve had, obviously, movements in tariff rates and the supply chain. That’s globalization, which sounds like a megatrend, but it is moving. Then underneath the surface, some of the investment around AI and even some of the productivity boost that we saw over the past year or two, which is affecting the labor market and corporate earnings, these things that when you zoom out, they look like they’re slow moving. But actually, when you try to capture little changes in their movement, you actually really improve. I can tell you that those changes in the so-called megatrends explain half of the movement in the S&P 500 from month-to-month and quarter-to-quarter, which means even if you’re a near-term investor, looking through the lens of these forces is actually really important. I think that’s news to many in the profession. It’s changed how we approach macro forecasting. It could change how the industry forecasts them. You shouldn’t hold these things constant. Rather, they’re a living, breathing organism that affect the day-to-day more so than I think we realize.
Lefkovitz: That’s so interesting. How do you quantify that?
Davis: Well, I think you use the best—what we did is for our framework, when I got tired, just take a step back, Dan. You have really good questions from our clients, investors, really smart people. They’re listening to your podcast. They have views on AI, globalization, and all the questions we’ve tackled today thus far. But when you would ask me my opinion, I think I would give an informed response, but there wasn’t really quantified estimates of how much AI could drive growth or how much could inflation rise if we step back in globalization. Give me probabilities and magnitudes, because if we can start talking about that, whether it’s growth or the stock market, now we can start talking about risk management in a portfolio context. Because without that, it’s tough to do.
So, that’s where we set on a path to incorporate all these so-called trends, which move around, along with the near-term stuff that people care about, CPI for inflation and interest rates of the Federal Reserve and the 10-year Treasury yield for the bond market. All we’ve done is incorporated them in one living, breathing system and operationalized the best of the data science field and the academic economic world has. We didn’t create any new theory. What we did is we joined them all, which are really three different groups in academia. You have those that focus on business cycles, those that focus on asset pricing, such as stocks and bonds, and those that focus on these long-term growth trends. All we’ve done is united them because we had practical problems that we had to answer. Like what is the stock market? How is that going to react if AI lifts automation or if it doesn’t? What’s the timeline in that doing so? So, again, I think we’re trying to bring—by definition, our approach has limitations because it’s a model. So, any model has limitations, but we’re proud of the fact that we’ve united them in one system. It’s opened my eyes for sure. And it’s because of our economic diagnosis and quantifying these forces that we felt compelled to write the book. I would not have done it had the sort of outcomes of our diagnosis not been so different from what I think the consensus expects.
Benz: Joe, I wanted to ask, you mentioned the profession—why do you think there is this tendency to focus on very short-term data about what the latest inflation report was or the latest jobs report or whatever? Why do you think the gravitational pull is so much there when you think observing and incorporating these very long-term trends is a really good direction to go in?
Davis: Sure. I’ll give you three. I think one is, listen, if you’re an active manager—some of your listeners could be managing their own portfolio. They’re trying to take modest risks to their long-term targets. Say, Christine, you gave them in your book for my retirement plan, but they’re wanting to take a little active risk. I work with our portfolio management teams. There, I think when you’re thinking about relative modest positions versus a benchmark, there’s a tendency to focus on six to 12 months because that’s really the business cycle. That’s where the Federal Reserve can do things more or less than expected. I think that is natural.
I think secondly, it’s the comfort with the most recent. I’m not saying it’s a bias, like a recency bias, but it’s what’s right in front of us right now. Because that has such prominence, my point is that that’s just overweighted solely those things. It assumes that all the changes we see in the economy are related to what economists call demand, meaning if GDP is higher than expected, it’s because consumers are spending more. All of our framework is saying, well, sometimes that’s true. Other times, they’re actually spending more because actually incomes are going up because we actually have productivity increase, which is really related to technology. So, we’re getting to the root source. We saw this during the soft landing.
What was eye-opening to me, Christine, is that many thought the Federal Reserve pulled off a soft landing because they got interest rate calibration just right. So, you may remember, they cooled growth down in the labor market just to keep inflation right there, with avoiding recession, surprisingly. It turns out in our framework, it was because 80% of the soft landing was due because these megatrends were moving. It was the immigration, the huge surge across the border that really cooled the labor market more than the Fed did. And we had good luck from a productivity, from a technology perspective. So, that matters in terms of where you say value the stock market. It has different implications for interest rates. If demand is too hot, you should have the Federal Reserve raising rates.
I’ll give you a concrete example. If, however, growth is high because of these megatrends, these shocks are hitting the year very positively, you should have the Fed not raising rates at all because you’re going to have growth go up without inflation. So, it matters in the near term. And then finally, if you’re an asset allocator, one of the fundamentals, which brought me to some of the rationale, I did this. I remember Jack Bogle asking me, what’s a reasonable framework to have expectations for earnings and interest rates? He was really getting at these megatrend forces. If I’m on an investment committee, should I assume 4% interest rates for the US, which is where they currently are? What’s the sort of risk assessment if I’m an investment committee or a financial advisor constructing a portfolio? Personally, we believe the industry should put a little bit more weight on these megatrends because they’re going to explain virtually all of GDP growth and earnings over the next seven years.
Lefkovitz: So, there’s this fundamental premise in the book, Joe, that the status quo for the US economy is unlikely to persist—status quo regarding growth, inflation, financial returns, even. Why is that?
Davis: And this was a surprise, the eye opener for me, in full disclosure, I’m asking my role at Vanguard, chief economist, I felt these what’s called consensus surveys. What’s the outlook for growth, GDP, or inflation, where the stock market for the next three, five, seven years? And for GDP growth and inflation, I put down what most put down, which is 2% growth and 2% inflation. I wasn’t being lazy. Maybe there’s comfort because everyone else says the same thing. Virtually 90% of the economists say the same thing. And I’ve been in that crowd because it was kind of like, I’m probably indirectly, I was doing in my head in a more narrative sense, well, we’ll have a little bit of lift from AI, a little bit, but we’re going to have slower demographics through the aging of the baby boom. And so, net-net, we’re going to be roughly at the same growth rates and inflation 2%; 2% as we have on average for the past 10 or 15. Hence status quo, no real change.
It was only when we developed this data-driven framework did I see that that was just a lower probability event. Effectively, we have trouble generating that as greater likelihood than 20%. Because of the push and pull of these medium-run forces, and in particular, the push down on growth and up on inflation and interest rates from our deficits, because they’re structural and they compound over time versus on the other hand, AI—I’m calling it AI, although it could be another technology, but AI is probably the most likely one—AI pushes up growth and keeps inflation at bay. And what I was surprised to find is the push and pull of those dynamics over the next three or five years generates effectively statistically a bimodal outcome, which is not the normal sort of status quo distribution where you get 2% on growth and inflation with the risk of a little black swan on either side. It’s just very unlikely we’re going to get that sort of fulcrum. It’s more of a seesaw. And one of those forces is going to push us one way or the other.
Benz: So, let’s follow up on that, Joe, because in the book you talk about two possible outcomes from that tug of war. Can you walk us through that? So, this is a tug of war between technological innovation, probably AI, and an aging population and rising deficits.
Davis: So again, we’re incorporating a lot of forces that could matter—geopolitical risk and uncertainty, even climate. But you nailed it on the head, Christine, in terms of the two that rise to the top: aging and deficits on the one side, which push up interest rates and the prospect for technological change, much like we saw in the 1990s, if you recall, and the computer and the internet on the other side. We don’t always get these sort of seesaw dynamics because we’ve tested this framework back 130 years. It’s just there’s times in history when these megatrends are pushing in certain directions.
So, let’s break it, each one. The more optimistic one is the most likely. And I think what’s powerful is from a risk management perspective, we’ve put odds and quantified the probabilities and magnitudes of this. So, it’s roughly a 50% chance that over the next five to seven years, we will see GDP growth that’s meaningfully above the consensus expectations, so roughly over 3% for the United States, well above consensus expectations, roughly double them. And we get that with our deficits not being a serious issue. It doesn’t mean we’ve grown out of them. It doesn’t mean that they’ve gone away. But like the late 1990s, we don’t talk about it because we have strong earnings growth and economic growth. And we get that along two dimensions of AI.
The first one is it starts to lift automation. Yes, there’s significant job disruption, some job loss. But the fact is, is that through our framework, the biggest issue with the US economic growth is that we have a lack of automation. It’s subtracting the most from economic growth in 130 years. And we know this because of our framework incorporating all these factors. It effectively comes at the right time. It effectively means—and I didn’t know this until we quantified it, Christine—it effectively means that the rest of the baby boom that is retiring right now—we’re in peak age, 65, right now in the United States. The number of people who are age 65 is peak in the year 2025—it’s effectively that that generation from here on through, say the year 2032, it’s as if all of those Americans, those individuals do not retire at all because of the lift that AI comes to offset some of that loss in the labor force.
So, demographics don’t become destiny because of technology—and we’ve seen this multiple times before—that is a very positive dynamic. In effect, we grow into the valuations that we have in the United States. And from a positive investment perspective, the greatest beneficiaries are outside of the US technology sector. It’s in the US; it’s the areas that have really dragged. It’s outside of effectively the Mag 7, because AI makes a value-based company, say healthcare or finance, a little bit more productive. And then you get some new products. I wish I knew what they were because I’d be able to retire from Vanguard, but I really don’t know what they are.
And it lists a little bit of the valuation. You go back to your fair question, Christine, on outside the US. We’ve seen this in other second half of other technology cycles. The non-US sectors do a little bit better. So, I would call that a good convergence, and AI wins, and deficits don’t really rear their head, at least over the next seven to 10 years. However, you can see where a lot rests on AI. AI is important. It will have some effect. It’s already having a modest effect on growth. But if it does not continue to progress, which means advancing its capabilities, and our projections show that more often than not, they do. But there’s a one-in-three chance because we’re still early here, that it plateaus at a lower plane. And if that happens, you can see now where we have not gotten the lift through automation, new products through let’s call it AI. We have GDP now through no lift in innovation. We now have demographics dominating. We have GDP growth not at 2%. Now it’s starting to inch closer to 1%. Our deficits, however, are still now are 8% or 9% of debt to GDP in peacetime, so without a recession. That starts to push up inflation expectations in our framework. The Federal Reserve, however, fights that, which only leads to another modest headwind to growth. So, you get a higher interest rate environment without the growth dividend with it. And you have equity markets that are not prepared for that. Earnings are starting to disappoint because you have lower economic growth. And you can see the flywheel goes from positive to modestly negative. And in the US, given where valuations are—I hate to be a downer—but you have an elevated risk of a lost decade in the US stock market.
So, you can see the stakes are high between this tug of war. And this was the eye opener to me. It’s over the next seven or 10 years, that’s why I felt compelled to help investors because as an economist, I can’t say, hey, there’s two doors we go down. There’s a good one and there’s a not-so-good one. Good luck to you with investing. So, we try to push ourselves to say from a risk management perspective, how can I think about a portfolio that’s kind of resilient to both scenarios?
Lefkovitz: Yeah, I was going to ask about what you think the implications are for portfolio positioning. It sounds like you think global exposure is key.
Davis: Well, it’s one for the heads and it’s not being defensive, I just did the mea culpa. I was on this podcast, on The Long View, three or four years. I said non-US and that was from a valuation perspective. This is from a risk management perspective. We can debate the weights. I assumed in the book just because there’s tons of what someone’s benchmark is. I made up just a representative one, 60/40 US only, which investors in the US tend to have significant home bias, has served them really well, by the way, for the past decade, let’s be clear. But you’d want to have a modest position outside the US. Twenty percent is where you at least would want to be in our framework.
The irony is that when you have a deficit-dominate scenario, where AI becomes more like social media. We use it all—and I’m picking on AI here—but we are just too early in the technology, despite it being around for five decades. It’s not being used widely enough that if it plateaus, it becomes like social media. We use a lot of it, but it hasn’t lifted growth like the personal computer, which is where the right-hand side in our most likely scenario is.
And so, from there, there’s some transition here, but it actually pushes you in the fixed income from a risk management perspective, because you have an environment with deficits dominate, if you think real interest rates are high now—on average 2%—so a 10-year Treasury yield of 4%, minus 2% inflation, you can get, I don’t know, seven years from now, you can get a 6% 10-year Treasury yield, with the Fed still trying to keep inflation around 2%. So, bond investors would be asked to pick up the fiscal tab, but they’re compensated for it. And so, that’s where it pushes you from an asset-allocation perspective in a defensive nature. That’s ironic, because it’s called deficits dominate. It would potentially suggest to some that you’d want to steer clear from fixed income. On a strategic basis, exactly the opposite.
So, that was the eye-opening for me as an asset allocator, is that on the upside, if I’m the most bullish on AI—I tell people, if you’re the most bullish on AI, you would actually want to invest outside of the Mag 7 and technology sphere, because it’s going to be that transformational. I’m not picking on those companies at all. I’m talking about the second half of the chessboard. If you’re pessimistic on deficits and you’re pessimistic on AI, I would strongly suggest you consider fixed income. Of course, in our balanced scorecard, we have probabilities elevate in both scenarios. So, it doesn’t deviate you materially from the 60/40.
If the risk were all to one scenario or the other, you could see that, but it doesn’t do that because you have this sort of bimodal future. But I would say fixed income. The only way you get gold or some of these other really end-of-the-world scenario concerns, we’ve seen gold up a lot this year. It’s a deficits-dominate scenario. We’ve actually estimated this world. If you have the deficit-dominate, but you have the Federal Reserve, who for whatever reason doesn’t care about inflation anymore, they take the backseat to the Treasury or to their mandate, then you get a higher inflation world. Yes, in our data-driven framework, it’s possible. It’s roughly a 5% probability. If you go down that path, then there are two assets that you’d want to consider, but they are only 5% of our probabilities. But you would consider things such as gold or unhedged fixed income, but that’s a really more of a tail risk. That’s why you don’t see that dynamic, because you have the Federal Reserve trying to hold the line.
Benz: I’m sure you don’t want to get political, but I am curious to get your take on the independence of the Fed chair and what you see as maybe the importance of that to our system. Can you talk about that?
Davis: Well, I think the independence of the Federal Reserve and the Federal Reserve as an institution has been one of the finest institutions. If you’re an investor or just a global citizen, perhaps had one of the greatest contributions, a public good, so to speak, Christine, on the welfare of the economy to keep in generally stable inflation. They’re not infallible. They can make mistakes as any group of individuals can. But when we talk about the depths and the trust in US financial markets, and generally even with all the shocks from covid and some deficits, how we still have fairly anchored inflation expectations on average, that’s really testament to Federal Reserve credibility.
I know some of that is in the headlines. I still have confidence that we will see that. But for whatever reason, if you’re worrying about that, I think the one thing that’s different from the past, where if there was that threat of freedom at the Federal Reserve at all, is that we do have the bond market and particularly the inflation-protected market that gives us real-time inflation expectations. I think that’s a little bit of a governor—a market can be a little bit of a governor should you worry about one path, which is code word for saying, listen, if someone was really seriously talking about losing Fed independence, or if the Federal Reserve was just going to effectively say, we’re going to be easier on inflation than we ever have been. I think the bond market will be a little bit of a governor to that. And I don’t think that those dynamics will change anytime soon.
Lefkovitz: Well, getting back to AI and its impact, you’ve got a lot of great history in the book. And you look for some historical precedents for technological disruption. You draw a contrast between two professions that have been disrupted by technology: telephone operators and mutual fund accountants. I’m curious if you can talk about that juxtaposition a little bit and what those precedents can tell us maybe about AI?
Davis: Well, and again, we started doing research on AI almost a decade ago. And again, we were … I was reading a lot—increasingly research that, particularly the technology field, Dan, it’s just going to be a big deal, right? But we started looking at, well, how it’s going to change the nature of work. And I used those two professions as an example that you can have a technology come along, in this case, it was the personal computer and related telecom technologies in the 1990s that effectively the same technology boosted the prospects, the number of jobs, and the average pay in those jobs very positively. That was the fund accountant. It fundamentally changed the nature of the fund accountant. But wages went up, the number of accountants went up. Effectively, the computer, I’ll call it the computer with air quotes, “the computer” was a complement to that job. At the same time, that same technology obviously was the last nail on the massive automation of telephone operators.
What we found fascinating by our top-down data-driven framework as well as when you look at any technology, including AI, and if you look at through our lens of tasks—and we’re not the first ones to do this, there’s been a lot of academics who have looked at tasks who think of a job description—you have a decent chance of knowing how a technology will affect the labor force over the following decade. In other words, you don’t know exactly how the future will unfold, but you can have a sense: high, medium, or low. Because you could have looked at a job description—and I talk about this in the chapter—you could have looked at the job description of a fund accountant and a telephone operator, and if you were reading Computer magazine in the late 1980s, you would have had some sense of what was going to happen to those two professions.
Now, the real trick though is knowing that the technology world now will continue to advance. AI right now has certainly some eye-opening capabilities, but it’s certainly not—we don’t have advanced general intelligence, we don’t have consciousness, we don’t have the merging of AI with robotics at a very advanced level. So, there’s always some uncertainty to these projections. But I use those same, those two professions to give some glimpse of—and we looked at 800, all the occupations in the US, but I focused on four in the book, and it’s mixed. But on average, we’re talking about more likely than not, over the next seven years, the greatest change in how we do our work, since at least the personal computer, which is a pretty big deal.
Benz: I wanted to ask about your career advice. It seems like new grads are job hunting in one of the least hospitable markets, probably since the great financial crisis. In the book, you do offer some advice on how young people can set themselves up for success and make themselves future proof. Can you discuss some of the key messages that I’m thinking that people at all career levels could maybe internalize a little bit?
Davis: Yeah, and I will do my best. I’m certainly not an educator, Christine, and I do have 30 years of experience of what not to do, and what I wish I knew, but I just learned, perhaps, the hard way along the way. But I’m asked this question a lot, particularly with AI. What should I major in as I’m entering the workforce? Or if I’m 45, and I’m dating myself, I remember walking into the office and seeing something on my desktop called Microsoft Excel, and I’m like, should I use this thing or not? It sounds dated, but I’m like, I had some co-workers say, you know what, I’m close to retirement. I’m not touching things. I’m not learning anything.
So, what I would say, though, and this for any technology, but for AI—and I’ve had to educate myself—I would say one thing that everyone should do, and it’s helped me a lot, and that is, it has nothing to do with technology itself, but I say to everyone, I at least aspire personally to read three hours a day, either in my domain or in tangential areas, because the more I can be aware of, the more context I will have to connect the dots, whether I’m using technology or not. And I tell my children, who are both college age—so now I’m sounding like a father, a parent—but I say social media doesn’t count. That’s actually a penalty. So, if you’re an hour on social, you got to do four hours. But now I sound just old school or dated, but I think if you just read voraciously, if you know what other smart people have known and written, and podcasts, such as The Long View, would count for sure—you now have that collective wisdom of hundreds of people. And I benefit from working with a hundred other fellow researchers at Vanguard. You ask me certain questions, Christine or Dan, that I know the answer to, not because I did the research, but because I’m building upon what I’ve read. And so that can be huge, particularly starting out in the career.
When I started out at Vanguard, I didn’t even know what an ETF was. I only knew the very basics of mutual funds. They don’t teach you that in grad school. I was working on Matrix Algebra. That helps on some things, but not in others.
The other one would be on the technology itself. So, if you’re 20 and you’re in college, or if you’re 35 and your career is really starting to zip, or if you’re like my age, I’m in my early 50s, and you’re like, well, I still have 10 years before retirement. In any of those episodes, I’d be saying, try to automate—this is going to sound sensational—try to automate your job away with AI. And what I say about that is the learning by doing it. I don’t know all the full capabilities of AI. I say that with air quotes, because if I’m using it as much as I can, either two things are going to happen. Either I’m going to get 30% or 40% more productive, which means I have a case at the end of the year to ask my boss for a raise and I could help my peers. Also, if we’re in a flat job labor market—let’s be honest, life is competitive. I want to be more productive than the economist sitting next to me. So that’s helpful.
The other one is, let’s say—there’s only about one in six occupations, but they exist. You start to find out, you know what, I can do 60% or 70% of my job, maybe not today, but I can see the writing on the wall. That gives you a little bit of time to start thinking about tangential occupations. Is that a fun consideration to think about? No, but Dan, back to your question about the telephone operator. Maybe it’s 1985 and you have a little bit of time. It’s not 1995 yet. You have a little bit of time to think about what I would do in perhaps the second chapter of my career that’s not thrust upon you in 1994. And so, I say that with humility, but also a point of caring, because I look at the dad and as an economist, you can be cold just looking at statistics, but there’s people behind all of these numbers. And so, I’ve seen it in my own family—what the positives and some of the headwinds that technology can create. And so that would be the two-pronged advice I give—will be on the reading front and then use it as much as you can. And you’re going to learn something from it. Either way, it’s going to be beneficial to you over, say, a two-year period.
Lefkovitz: We have a lot of financial advisors who are listeners of this podcast. In the book you do discuss AI’s potential impact on the financial advice business. Curious if you could talk a little bit about that, where you see AI affecting financial advisors’ practices.
Davis: One, and something that obviously Vanguard has been a big proponent of, even Trademark called this advisors’ alpha and the positives of behavioral coaching. That’s one of the fundamentals, it’s where we see is one of the number of dimensions of the value of advice if you can try to quantify it, which is tough. But when we’ve done that, we’ve seen the power that the financial advisor can do. I can tell you in my personal life, the value that they have brought, particularly when markets get jittery. Also just giving you greater confidence to make the decision that you could have done it on your own, but it gives you greater confidence. It’s that emotional value of advice. And technology, I think AI can do some of those dimensions too, but I think the role of a human-centric advisor, I long believe is more in a bull market, but that doesn’t mean change isn’t coming. That’s why I picked financial advisors as one of the just representative occupations.
Again, I’m not a financial advisor. I don’t pretend to practice. I don’t know the depths of practice management. All I know is I can look at financial advisors relative to 800 occupations. And by doing that over the past decade, what I can say is from a technology perspective, I know the value of behavioral coaching and a lot of people focus on that, and so they would say, OK just spend all of your time doing that. I don’t think it’s that simple. I think that’s a lump of labor fallacy. I think what’s going to happen is that the value of advice is going to go up and the scale of the practices potentially will go up. I think the expectation what’s in the financial plan will also go up through the technology. So, for example, I would not be shocked five years from now—maybe I’m a little too early—but there’s not healthcare diagnostics from my iWatch or from some diagnostics that’s not sent into my financial plan.
Like that’s basic. So, think of what happened to car assembly, it’s a completely different occupation a hundred years ago, but think about that. The assembly line made it quicker to construct a car. Yet the value of the car went up. Think about that. Less time spent on the car, there’s fewer car workers, but the wage of the auto mechanic went up. The value of the car itself coming off the assembly line went up. Why? Because there’s more bells and whistles in the plan. Now, I got 500 horsepower. I got air bags and I got a lot of other diagnostics. Today a car is a computer. I think financial plans, if you read the AI and what it can do and the job task, I think for financial advisors, table stakes for what’s in the plan will go up. But the ability, the scale of the practice could go up for those advisors that are able to harness that even if the time spent on each plan goes down. So it’s exciting if I’m a financial advisor. It means some change just like it does for economists or nurses or other fields. But I would be bullish on the sector, but it doesn’t mean it’s just status quo and how one does the job. And again, full caveat, I am not a financial advisor. I’m just looking at how financial advice looks relative to 800 occupations that we’ve diagnosed.
Benz: You also make a link in the book between active management and AI. I’m wondering if you can explain that and perhaps, Joe, tie that back to Vanguard’s own efforts. It seems like Vanguard has been a little bit proactive at active management over the past, I would say five or so years. I’ve been hearing that from people at Vanguard. Maybe you can talk about that.
Davis: I’ve been at Vanguard for over 20 years, Christine. I think in one sense, it’s a little bit back to the future. And no one would disagree with, and certainly Vanguard deeply believes is the power of low-cost investing. Because we know 50% of the assets in any market, private or public, will outperform; 50% of the dollars traded will underperform. And so, if you can minimize the cost—this is Jack Bogle’s elegant beauty of all his research—you can minimize the cost, the more you, the end investor, the listener on the podcast, get to keep. That’s beautiful. I think what was just, I think sometimes omitted from that conversation is just Vanguard and I think any investor should believe in lower-cost investing, period; not that’s only indexing.
I think that got left out. And I remember the early days of Vanguard, it was, OK, if you had to paint the ends of the goalposts, you would have high-cost investing, which tended to be active strategies because indexing was in its infancy. And then you had this low-cost index at the other side of the spectrum. But what I’ve long thought and always look forward is just low-cost vehicles. So, if there’s a viewer, a listener that has a 150-basis-point index fund, I would strongly suggest that they sell that even though I can’t provide financial advice, as well as I have assets, I can’t provide—but if something is 20 or 30 basis points, you think about the net return. And if you have a manager that you think can add, oh, I don’t know, Christine, 50 basis points or even 1 percentage point in the equity space on average over long periods of time, if you think they’re going to be smarter than the average person, they have a little bit more skill. If they’re charging 30 basis points, but you think they’re going to add 1 percentage point or 100 basis points in alpha, net, net, as I have an alpha expectation as the end investor of 70 basis points. And so, I think, the combination of low cost and skill has always been important. Jack Bogle probably launched more active funds than head of any of the company of Vanguard’s history. And I think that’s a little bit of a surprise, but what has not changed is the focus on low cost.
And so, that’s why I think many investors can be served by a blend of low-cost index and low-cost active strategies. You generally don’t go 100% in active just because of the possibility of extended underperformance. But rarely do you get, I think for investors with any modest risk tolerance, active risk tolerance, do you get 100% index portfolios. And if that sounds surprising coming from Vanguard, I’m trying to set the record straight. And all the research we’ve done in my group over the past 20 years.
Lefkovitz: Joe, you made a comment earlier, I wanted to come back to, about value stocks and how they might be a surprise winner from AI. Wondering if you could lay that out a little bit more.
Davis: Yeah. And this was a surprise. I didn’t know this and it’s not infallible like motions of the tide, the ocean. If the tide is going out, they’re definitely coming back in. But I think the odds are tilted that way. And what was a surprise to me is that there’s stylistically, so very loosely, there’s two phases to a technology cycle. So first of all, you have to know that you’re actually in a transformative technology cycle. Like, did I know in 1992 that personal computer—I know now a personal computer was transformative, but did I really know in 1992? Probably not. Our system, our data-driven framework, gives you a modest sense, but with uncertainty in real time in 1992, because of the signals it picks up. Today, it says we’re certainly likely to be in this extended technology cycle, which means there’s a general-purpose technology likely to emerge.
Now, in periods when they happen—I wish we had hundreds of those examples. Dan, we just don’t. You have electricity, you have combustion engine. And people, even economists, debate what a general-purpose technology is. Just because we use something a lot doesn’t mean it lifted everyone and fundamentally changed society. Like the microwave oven, it’s a new technology. It’s not a general-purpose technology. However, we are in that, and our odds are more likely than not that AI is a general-purpose technology. What happens is there’s, what I was surprised to find is that there’s two phases to the technology cycle. The first phase is what I call just the production of the technology is starting to spread. There’s a massive investment into the space. A lot of new businesses are formed trying to produce the technology. It was in the personal computer. It was hardware, software, some of the dollop internet. I’ll use that as an example because it makes it tangible.
And some will say, oh, there’s a bubble that emerges. I don’t know. I mean, yes, generally enough, I don’t want to make that claim. And that’s really almost immaterial to the second half. What emerges in the second half of the investment cycle is what was surprising to me and gets to your question, Dan. And if this technology is that transformational as we think it is, it starts to benefit companies through higher earnings, to productivity, to new products with that technology as a platform. I’ll give you two examples.
So, in the personal computer, now I know with benefit of hindsight, things such as online shopping, companies that sell it all, I don’t know, books and music ended up being 4% of the company—I’m trying not to use company names, but you can think of like the jungle, Amazon emerged. But that was not technically a technology company by the true letter of the law. It was consumer staple. With electricity, guess what powered the assembly line? Well, two winners emerged. They were called Ford Motor Company and General Motors. Now electricity didn’t lead to their profitability, but without those disruptive technologies, I don’t think we’re talking about those companies today. So, it’s spread to sectors outside of electricity on the one hand and computers on the other. But that’s how technology works. And if it’s not that transformative, then it hasn’t lifted growth, then it’s a dud to begin with.
So, that’s what was surprising to me is that if we play out—and you have to give this five or seven years, and again, the irony is that outside of the tech sector, parts of those investing universes don’t have the multiples that say the Mag 7 or the technology stocks do have. And I’m not saying they’re not delivering value. I just said that this AI has the likelihood of being as transformative as a personal computer. That’s pretty high praise. But what it says is that if it is truly this transformational, other opportunities emerge, and that’s where it pushes you at the margin, given the multiples outside of value and outside of the United States. It’s not being skeptical on technology. Quite the contrary. It’s actually saying, no, if this thing has legs, then it’s going to spider web into outside of Silicon Valley.
Benz: Joe, for our last question, I wanted to ask you about an anecdote that actually kicks off the book. It was lovely. It’s about you having lunch with Jack Bogle right after you started at the firm. Or maybe even when you were interviewing. Maybe you can talk about that and talk about Jack’s impact on you and your career.
Davis: It was when I had lunch with him, and everything at Vanguard has a nautical theme to it. So, it was in the galley. To this day. I was just at the galley actually before our conversation, Christine. And I think what I was telling was twofold and a lot of companies have great culture. I think you can tell a company’s culture by, as a leader, how you spend your time. And so, Jack—I just got my key card, I’m a new employee. I’ve been here six months. I’m out of grad school. I know nothing, right? And he made the time to meet with me. I mean, here he is, the founder of the firm. He could have won the Nobel Prize. And not only did he make time with me, he was asking me about my background. And I tell a little bit in the book—he was asking questions that I hadn’t been really asked as economist that you get in that next six months. The good, the important questions. But he’s like, “Hey, Joe, I’m excited you came to Vanguard. Can you help me think through, I have this simple framework …” He was being humble. I mean, he actually had a pretty good framework to think about valuations and stock market for financial plans. But he said, “Can you help me think about how I can think about earnings from the economic perspective?” And that was actually the megatrends. I didn’t use that phrase at the time. I wish I had a better phrase than megatrends. But he was on to something. So, it shows you the power of his insight. But more more importantshowed the humility. He is spending time with who is a nobody. I was a nobody. And that said a lot to me. It’s why I told the story. And it’s something I try to keep in the forefront of my head, no matter how busy as a leader you get, there’s been so many people in my own life that had made time for me. Am I paying it forward, Christine?
I’ve been at Morningstar. It’s the same culture. It’s a giving, servant leader culture. And so that’s why I told the story. Yeah, there was an economic motivation. By the way, it took me 20 years to complete that project he asked me about. Jack probably would have done it in two years. So, I’ll leave you with this. I now lead the group that was really Jack Brennan, who was head of the company at the time. He could see the aging of Jack Bogle and thought we needed a group to carry on some of Jack Bogle’s thought leadership. And I give Jack Brennan really great foresight to do that. So now I lead that group that I was hired into. Now we have over 100 crew members or a 100 employees. I think that’s how many people it takes to fill Jack Bogle’s shoes. But he has been an inspiration to this day. And so, I owe Jack Bogle a lot and all the leaders at Vanguard that have followed since then and including other experts outside the profession because you learn from everyone. And if you can put that into your own thinking and your own reading and put 10% of yourself into it, I think you’re going to be good over your career.
Benz: Well, Joe, that is wonderful advice. Thank you so much for being here today. Congratulations on Coming Into View. We’ve really enjoyed our time with you.
Davis: Thank you. It’s an honor to be on the show again, Christine.
Lefkovitz: Thanks so much, Joe.
Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
You can follow me on social media at @Christine_Benz on X or Christine Benz on LinkedIn.
Lefkovitz: And at Dan Lefkovitz on LinkedIn.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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