Policy takes hold
Vanguard expects monetary policy to become increasingly restrictive in real terms as inflation falls towards central banks’ targets. As economic resilience fades, central banks will be in a position to reduce policy interest rates. Vanguard forecasts US and other developed market growth below trend in 2024, with uncomfortably high odds of mild recessions, necessary to finish reducing inflation. However, a “soft landing” remains possible, as does a delayed recession. In Europe, anaemic growth is expected as restrictive monetary and fiscal policy lingers, while China will see additional policy stimulus to sustain recovery amid increasing headwinds.
After policy rates recede from cyclical peaks, Vanguard expects rates to settle at a higher level than before the pandemic. Zero interest rates are gone; a higher-rate environment is here to stay. Research finds the equilibrium real interest rate, or neutral rate, has increased around 1 percentage point driven by demographics, productivity, and fiscal deficits, making the nominal rate around 3.5%. Patterns exist across other developed markets, though China’s rate may be lower due to economic rebalancing.
Bonds are back
Higher interest rates mean higher returns for long-term bond investors. Vanguard sees global bonds as close to fair value, with the equity premium reduced. Bond return expectations have substantially increased to around 1.5% annually over the next decade for US and global bonds, compared to negative or low forecasts previously. If reinvested, income will eventually offset capital losses, such that portfolio values will be higher by decade’s end than if rates had not increased.
Equity valuations overvalued
A higher-rate environment depresses asset prices while squeezing margins. Valuations are most stretched in the US, leading Vanguard to downgrade US equity return expectations to 0.7-2.7% annually versus prior 2.0-4.0%. Value and small-cap US stocks appear attractive, and non-US equities present greater opportunities, with expected returns of 1.9-3.9% for euro area equities and 2.9-4.9% for emerging markets. The equity risk premium is the lowest since 1999-2009 “lost decade.” Returns are expected to be more balanced across asset classes.
Currency and earnings growth
Vanguard believes the US dollar faces more headwinds than tailwinds, depreciating modestly and boosting non-US equity returns. Slower expected earnings growth of 4.4% annually for US equities and 3.4% globally outside the US will weigh on returns as profit margins compress from higher costs. Geopolitical and economic uncertainties remain risks.
In summary, Vanguard believes the transition to sound money with persistently higher interest rates will benefit long-term investors through balanced risk-adjusted returns despite short-term volatility. The structural shift has significant implications for borrowing, saving, capital allocation and expected asset class performance in the decade ahead.