Sound money...

February 14, 2024 Rick Maggi

What investors can expect as interest rates remain at higher levels…

Around the world, central banks are in no hurry to start cutting interest rates.

It’s all about inflation. Until inflation levels start falling more rapidly, interest rates will most likely stay where they are. Or, as the Reserve Bank of Australia warned in its February monetary policy minutes, a further increase in interest rates can’t be ruled out.

Vanguard expects central banks won’t begin cutting rates until the second half of this year, and when they do, they won’t cut them back to the record low levels set during the COVID-19 pandemic.

Australia’s cash rate is likely to settle in the 3%-4% range – which is a long way from the 0.1% level between November 2020 and April 2022.

That’s not great news for borrowers. But the expectation that rates will settle at a higher level than before should be a welcome development for well-diversified investors.

That’s because higher rates will provide a solid foundation for long-term risk-adjusted returns. We call that a return to “sound money” – where lower-risk assets such as bonds will deliver improved income returns.

Higher bond return expectations

Our bond return expectations have increased substantially. Over the next decade we expect annualised returns of 4.3%-5.3% from Australian bonds and 4.5%–5.5% from hedged international bonds.

By the end of the decade, bond portfolio values are expected to be higher than if rates had not increased in the first place.

On the equities (shares) side, high share market valuations in the United States have prompted Vanguard to downgrade its U.S. equity expectations to an annualised 4.0%-6.0% over the next 10 years from 4.6%-6.6% heading into 2023.

The Australian share market is not considered to be overvalued, however Vanguard expects lower demand from China will dampen earnings growth over time.

Nevertheless, there is now an increased likelihood of stronger returns outside of the U.S. Vanguard projects 10-year annualised returns for non-U.S. developed markets of 6.7%- 8.7% and for emerging markets of 6.3%-7.3%.

The 60/40 portfolio is alive and well

As the chart above and below illustrate, the higher expected returns from bonds over the next decade has significantly narrowed the forecast difference in returns between Australian and global bonds and Australian and global equities.

In other words, the case for having a well-diversified portfolio split between equities and bonds is stronger than in recent history.

The chart below shows the gradual increase in Vanguard’s longer-term returns expectations over time based on a portfolio with a 60% allocation to equities and a 40% allocation to bonds.

The left of the chart relates to 10-year forecasts for U.S. equities and bonds, while the right relates to 10-year forecasts for Australian equities and bonds.

Spreading money across a range of investments is one of the best ways to reduce exposure to market risk. This avoids relying on the returns of a single investment.

Investment markets move up and down at different times. With a diversified portfolio of investments, returns from better performing investments can help offset those that underperform.

As well as gaining exposure to different asset classes such as equities and bonds, it remains important to hold a spread of investments within an asset class, in different countries, industries and companies, and in the case of bonds, different types of borrowers (governments and corporations).

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Important information:

The projections and other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

All investing is subject to risk, including the possible loss of the money you invest.

Investments in bonds are subject to interest rate, credit, and inflation risk. Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

This article contains certain 'forward looking' statements. Forward looking statements, opinions and estimates provided in this article are based on assumptions and contingencies which are subject to change without notice, as are statements about market and industry trends, which are based on interpretations of current market conditions. Forward-looking statements including projections, indications or guidance on future earnings or financial position and estimates are provided as a general guide only and should not be relied upon as an indication or guarantee of future performance. There can be no assurance that actual outcomes will not differ materially from these statements. To the full extent permitted by law, Vanguard Investments Australia Ltd (ABN 72 072 881 086 AFSL 227263) and its directors, officers, employees, advisers, agents and intermediaries disclaim any obligation or undertaking to release any updates or revisions to the information to reflect any change in expectations or assumptions.