AI has the potential to unlock a new wave of productivity that replaces an aging workforce. Alternatively, it could fail to reach the lofty expectations, potentially leaving the U.S. economy in a fiscal drag. Those are the two most likely outcomes for the U.S. economy that Vanguard researchers expect through 2040, according to new research from the asset manager.
VettaFi contributor Dan Mika spoke with Kevin Khang, Vanguard’s head of global economic research, about what AI, structural fiscal deficits, and an aging workforce could mean for investors in the coming decades.
The following interview has been edited for clarity and brevity.
Dan Mika, VettaFi: To start off, please explain why Vanguard developed a megatrends model, and why it’s useful for investors to have a model like this for investing in general — not just what you tackle in this paper.
Kevin Khang, Vanguard: When you follow both the economy and the financial markets day in and day out, week in and week out, month to month, even year in and year out, the amount of attention that each GDP release, data release, as well as inflation-data release gets, and then what the Fed’s going to do. The amount of attention that goes into understanding how markets work at that level of high frequency is staggering.
Compare and contrast that with things like, what is the longer-term trend on the productivity of the economy, or labor force participation? Not month in and month out, but longer term. Those considerations, those questions get far less attention when you live in the ecosystem of markets and information and insights.
When we take a step back and take stock of things, we asked what really drives the path of economic growth, GDP growth, interest rates, stock market valuations, all those key economic and financial market quantities?
There was a very strong sense among the economists and observers here at Vanguard that it’s longer-term things that drive these things in the end. Maybe the way we allocate and divide our time, our very scarce attention … is somewhat not optimally allocated between the short-term cyclical things and longer-term trends.
We made a very deliberate decision to focus on longer-term things that we believe really matter. They set the stage for the return environment and the economic environment. Once you have that shift in focus and mindset, we thought we were going to learn a lot from data that may look very familiar looking back.
That was the motivation: Can we have a different approach to the same questions like, what’s going to happen in the future in terms of the economy? What’s going to happen to financial markets? Based on what we know and anticipate, how do we position ourselves as investors with a long-term focus? We thought that with a long-term focus in our investment orientation, it called for an understanding of the economy, and financial markets also developed from that long-term frequency.
VettaFi: Let’s zoom more into the question in this paper about what effects AI will have on economic output, as framed against demographic changes. Why is that the best way to view how AI will impact the economy in the long term?
Khang: Our belief and observation so far is that those two are the most predictable and potent drivers that will actually shape the economy into the next decade. That’s the short answer.
The longer answer: What we really achieved by looking through the economic history and financial market history of the last 130 years in the U.S. is identifying all major mega trends that we thought have existed throughout that period, and seeing how they actually interact and ultimately impact the economy and financial markets.
The key megatrends that we really focused on were technology, demographics, and globalization, as well as fiscal deficits, debt, and geopolitical risk. These are the major trends that we identified as having an important impact on the economy.
Technology is a really important thing because that determines the long-term supply capacity of the economy. Demographics historically hasn’t been that important, contrary to a lot of other people’s beliefs. But fiscal deficits could matter a lot. So those were some of the key takeaways, and having quantified all of them, we then apply those lessons to thinking through the future.
Technology’s modern-day rendition is obviously AI and what it’s going to transform or evolve into. On the fiscal side, what’s going to really matter there is aging demographics and the entitlement spending that’s tied to it. That’s how we converged and arrived at those two trends to be the key to understanding the next decades.
VettaFi: Let’s look a little bit more at the scenarios laid out here. The pessimistic scenario, which is AI failing to overcome the headwinds of the aging workforce and age-related government spending, is between 30% to 40%. The status quo scenario is 10% to 20%. In the optimistic scenario, where AI increases productivity at scale, is 45% to 50%.What are the major factors that will decide which scenario comes to pass?
Khang: One thing we learned about the way technology works is that technology always comes in the form of some sort of an innovation. It has an effect on changing the way we work, generally speaking, but not every technology is transformative.
What is required of AI right now is for it to actually become a transformative technology. That will then get us to the upside scenario, which is actually our baseline of 45% to 55%, when it actually becomes a GPT — a generalized purpose technology.
A couple of historical counterparts would be electricity in the 1920s. And then, computers and the internet in pretty much all of the 1990s and early 2000s. Its impact is not just limited to one industry. But it really has a way of transforming the way we live, not just the way we work.
That is the kind of scope we’ll need to see coming from AI for it to have a pervasive, widespread impact on the economy.
Each industry will take a cue from its transformative capability. And we’ll realize that we need to really reorganize ourselves for us to actually realize the type of productivity surge that we’re anticipating from AI.
It’s been a long time coming in the last decade or so; we have been battling with the absence of anything like that. The next decade will almost need to see something like that for that scenario to come to pass.
I think the closest thing that an ordinary sort of person sees is ChatGPT. If AI basically falls short of becoming something far more generalized and applicable across different industries … then it’s not going to have the intended effect. That then means we’re not going to have that long-term productivity boost. We’re not going to have a transformative phase to the American economy. Then the only megatrend that we’re going to be stuck with is rising structural fiscal deficits, and at some point, a really high debt-to-GDP ratio. This will bear down and weigh on the economy as well as the financial markets, and it’ll start having an inflationary impact.
That’s the simplest way to think about the two scenarios panning out. The structural deficit rising at this point is almost a very strong certainty. That is projected to rise — short of some sort of significant and dramatic fiscal consolidation — given where the American demographic calculus is right now, and then where it’s projected to go. There’s a lot of certainty around that path. The key factor here is what AI is able to deliver becoming a GPT into the next decade.
VettaFi: What are the main takeaways of this study that you would give to either an individual investor or financial advisor who’s trying to figure out what all of this means when they intend to retire by 2040? Are there any practical ways to start positioning a portfolio with all this in mind?
Khang: No. 1 — and this is a sharp takeaway — is that we actually do not see a path to see a very low, short-term policy rate, and that is different from the consensus that’s out there. The 10-year consensus on the U.S. economy is about 2% nominal growth, maybe a 3% shorter-term interest rate and 2% inflation rate.
If I were to put a label on that consensus, that would be very similar to pre-COVID, moderate to low growth, and somewhat moderate, well-controlled inflation. Nothing really exciting, nothing terribly concerning. It’s just a continuation of what we saw in the last decade.
What we’re saying with this research piece is that we actually do not see that happening with a lot of probability. We don’t think that the continuation of the pre-COVID trend is really what we’re looking at as we look into the next decade. We think it’s going to be one of the two scenarios.
So, what are some of the practical ways in which people can start incorporating this in their investment portfolio?
No. 1 is, we actually don’t see the short-term interest rate coming down. I’m not talking about this particular disinflation cycle. But, in both scenarios that we have in mind, the interest rate is going to have to remain at a level closer to the higher level that we’re seeing right now.
Upside and Downside Scenarios
In the upside scenario, what we’re seeing — and what we’re going to see — is there’s going to be really high real GDP growth. And then the neutral rate just has to be higher to match that level of productivity in the economy.
On the downside scenario, if the productivity boost doesn’t pan out, what that means is there’s going to be a whole economy that’s weighed down by the growing debt. The market is going to start pricing in more inflationary impact of growing debt, as it is concerned about the government’s ability to eventually pay. It feels like an eternity away now, but it could happen. If that were to be the case, then the central bank will have to be much more active and raise rates to keep the inflation rate close to the target. For those reasons, we also think that the structural neutral rate, even in the downside scenario, will have to be high in recognition of the structural deficit.
At the end of the day, all appreciate having lived through different return environments for the last 15 years. That neutral rate is a way of setting the return on an investment environment. Last year, we came out saying this is really the return of “sound money,” because the neutral rate in the economy is now higher. We maintain that view into the remainder of this decade: that it’s going to remain at a very high level compared to what we were used to pre-COVID, which is effectively zero.
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