Are we on the road to recovery?

Are we on the road to recovery? Transcript Catherine Gordon: Hi, I m Catherine Gordon. We re here with Joe Davis, Vanguard s chief economist, to talk about economic trends and the outlook for the rest of 2009. Thanks for joining us today, Joe. Joe Davis: Thank you, Catherine. It s a pleasure to be here. Catherine Gordon: Joe, the recession seems to be slowing down and the markets appear to have stabilized. Do you think the worst is behind us? Joe Davis: Well, certainly the markets think so. I mean, if you look at the equity market, it s rebounded since its lows in March and if you look at the credit markets, credit spreads, the yields between lower rate securities and high rate securities, that yield spread has narrowed and then the steepness of the yield curve. So between, the difference between longer-term interest rates and short-term interest is also very steep, so it suggests that growth will stabilize at the end of the year. Personally, I think the markets are on point here. We did note that for the first half of 2009 the economic contraction would be significant, and it has shaped up to be that, unfortunately, with economic growth the weakest in 50 years. But I am seeing strong signals that economic growth will stabilize. The biggest one would be inventories. They need to replenish inventories. Inventory liquidation was so severe in the first half of 2009 that it is extremely likely that at some point in the latter half of the year that economic growth will be positive. Page 1 of 6

Catherine Gordon: What do you think of the results of the U.S. Treasury s bank stress tests and the other ongoing federal efforts to stimulate the economy? Joe Davis: Over the past year, year and a half of the Federal Reserve, U.S. Treasury, Congress, FDIC, various government agencies have collectively pledged to address the housing recession and the liquidity crisis and the deep mean recession at over or close to $15 trillion. That s equivalent to a year s worth of GDP. So if you put that in perspective, the rapidity of the response and the magnitude of the response dwarfs most government reactions to past financial crises. Now I m not here to be a policy cheerleader. There have been missteps along the way. If we focus on the stress test, though, I think the government s actually navigated a fairly tight tightrope because there was in one sense, some would argue it s a lose/lose situation. Either you say that there s no problems at all at the 19 largest financial institutions, and, hence, credibility would have been questioned, or there were problems, so many problems that the viability of the financial system would have been in doubt. I ve looked at the methodology. I actually think it s a fairly sound methodology. At the end of the day, the government is trying to provide as great a transparency as they can as to those institutions that perhaps are in a stronger position than in others. But they are trying to encourage, at the end of the day, private capital to return in confidence in the credit markets. And I m cautiously optimistic that this plan a year from now will have engendered that very outcome. Page 2 of 6

Catherine Gordon: And given the severity of this recession, will the recovery be different from past recoveries do you think? Joe Davis: That I think is the key, is a key question for the next year to 3 or 5 years. If you look at typical recoveries, let s say the number of jobs in this country, after recessions they generally have been what s so-called V-shaped. So after the recession has ended, there s been a strong rebound number of jobs and output in sales of small and large businesses. Reason for that? Role of the consumer. Consumer spending would increase sharply, the savings rate would fall relative to where it was before the recession, private leverage would increase, and then housing and finance would become a larger portion of the economy, ultimately, during recovery. Page 3 of 6

This recovery will be different. The biggest reason for that is the secular changes we are seeing in household behavior. In the long run, we are much better for this as a country. And what I mean by that is household savings rate, I believe for the first time in any recovery, will continue at least remain elevated, if not continue to increase. Private leverage, in part because of much tighter lending standards, will decrease as well. So I think it s a more balanced U.S. economy a year, 3, 5, 10 years from now. It s investment that s financed more by domestic savings so potentially less pressure on our currency and in need of foreign governments to fund our consumption, but that is a transition that is difficult in the near term, which is one of the biggest reasons why this recovery will be tepid in terms of its job growth. Catherine Gordon: What developments could slow down the recovery? Joe Davis: I think in any economic outlook there s always downside risks and that s generally the area of focus, at least it has been for the past year. The biggest single error that I m focusing on in the near term would be the unemployment rate. It s anticipated by the Federal Reserve to go in the high 9% range. It s currently almost near 9 some states are already double digit and it could very closely get to 10%. What I would be concerned about if the unemployment rate would go much higher than that, say 11% or 12%. That s a rate we had not seen since the late 1930s. Why that would be a big cause for concern would be that would be an economic weakness and be much worse than the U.S. government stress test and that would translate very likely into higher credit losses and bank losses for credit card rates, for credit card portfolios, bank loans, and so forth. So that to me would be the biggest risk. I don t foresee unemployment rates going to 11% or 12%, but that is the biggest risk to any economic outlook. Page 4 of 6

Catherine Gordon: And what could help the economy recover relatively quickly? Joe Davis: Well, I think for the first time in a long time I would argue that there s just as many, if not more, upside risks than actually downside risks, which is a nice change. I think a big, some of the biggest ones would be these issues around bank solvency, and the adequate capital levels of the U.S. financial institutions continue to abate. We see perhaps bank earnings come in even stronger than expected. I think also the Federal Reserve policy initiatives, which have already gained traction in a number of fronts, would continue to gain more traction. So I m seeing very encouraging signs, and so I think the biggest upside risk would be stronger improvement in either the housing market or the financial market stability initiatives. We are seeing improvements on both fronts, but I think if they would continue to improve at a greater than expected pace, that would be the single most important boost to investor and business owner. Catherine Gordon: What do you think about the threat of high inflation down the road? What s your assessment of the likelihood that the Fed will have to worry about inflation later this year or next year? Joe Davis: Policymakers continue to this day to make intergenerational tradeoffs, which means less risk of a depression and a deflationary scenario today which looks like that it s been well received for the upside risk of a higher inflation scenario 3, 5, 10 years down the line. Why I don t see inflation as a threat earlier than that is just because of the fundamental drivers of long-term inflation would be credit growth, wage growth, and the velocity of money going through the system. They are all decelerating if not, if nonexistent. Page 5 of 6

But longer term how the government at the end of the day is printing money and the federal obligations of our fiscal situation continue to rise, there is the risk that one of the ways out of that mess, if you don t raise taxes or cut back on entitlements, is to continue to monetize the debt and so that is a risk. I don t foresee a return to the 70s or early 80s where we had double digit inflation rates. But the Federal Reserve resolve 3 or 5 years from now is going to be tested like it never has been. I think that they will come to the light and not let inflation get out of control, but they will be tested. Catherine Gordon: Joe, there s been a lot of discussion in the media about the wisdom of some of the principles of investing that many of us have talked about for years, and we ve seen headlines announcing the death of diversification and that asset allocation is worthless. What are your thoughts on this debate? Joe Davis: I certainly don t agree with those arguments. I mean, diversification is not dead. I think, if anything, the crisis still underscores the importance of having a long-term strategic asset allocation. So, I mean, first of all, diversification is not insurance. So in 2008 as well as early part of this year, the higher the percentage of your portfolio that was in U.S. stocks or global equities, the larger your losses in the near term. And that s without question. But I think the importance of having a long-term allocation, and, again, it speaks to the fact that in the near term so much focus is placed on the recent performance. But just like not many individuals saw the significant losses in 2008, not many saw the significant rebound that we ve had since March. I, again, what I would continue to stress to investors the long-term portfolio decision. You know, how much in stocks, how much in fixed income and the roles of rebalancing and low cost and how you put that all together. How much are you going to need to spend on your portfolio? What is the ultimate goal? What is the rate of return you need to achieve over a long-term perspective? These are the questions that were here before the crisis and these are the questions that will be with us for years to come. Catherine Gordon: Thanks for your insights today, Joe. Joe Davis: Thank you, Catherine. It was a pleasure to be here. Catherine Gordon: And thank you for joining us today. We hope you ll join us for future updates on the economy and the markets. Disclosures All investments are subject to risk. The performance data mentioned represent past performance, which is not a guarantee of future results. Diversification does not ensure a profit or protect against a loss in a declining market. 2009 The Vanguard Group, Inc. All rights reserved. Connect with Vanguard > www.vanguard.com Page 6 of 6