The Federal Reserve (Fed), the US central bank, has made it clear in recent months that reining in runaway inflation by raising interest rates is its top priority. Unfortunately, the Fed’s rate hikes have not been helpful for the traditional balanced portfolio, hurting both shares and bonds – a rare occurrence historically¹.

In addition to going higher, US rates may stay elevated for a while, which has clear implications for global markets given the importance of the US economy to the global economy.

Inevitably, given these developments, investors will be asking:

• When will the pain end?
• Is the balanced portfolio obsolete?

To give an exact answer to the first question would be the height of hubris, but at some point the Fed will get ahead of inflation, probably sometime in 2023 – and most likely amid a mild recession.

But a recession isn’t necessarily a bad thing for the balanced investor’s portfolio. In fact, it will mark a new beginning.

A brighter outlook for bonds

If the Fed’s aggressive actions finally pay off, we should see inflation continue its gradual move downwards. Under this baseline view, the Fed will stop hiking rates in 2023, and a key source of uncertainty in the markets will dissipate.

The beginning of a recession is usually accompanied by bond prices going up and yields going down, particularly for bonds with longer maturities (because they are more sensitive to changes in interest rates). Shares and bonds have fallen in lockstep this year but if bond prices start to rise, the more usual negative relationship (with bond prices rising when share prices fall, and vice versa) would reinstate itself. This leads me to answer the second question: No, the balanced portfolio is far from obsolete.

When all this comes to pass, bonds will resume their role as a buffer for shares.

And there’s another factor in favour of bonds and balanced portfolios: Interest rates are likely to stay elevated even as inflation moderates, likely ending many years of negative real (that is, inflation-adjusted) rates in bonds.

We’re on the verge of entering a period of positive real rates, strengthening the case for bonds.

If history is any indication, the patience of balanced investors will pay off: Over the past half-century, the traditional 60/40 portfolio has never had a three-year period with negative returns for both shares and bonds. We don’t yet know where the bottom is, but investors who get out now will miss the rebound.

Shares closer to fair value

Based on the guidance the Fed has provided regarding the likely path of interest rates, we can reasonably project the performance of bonds, if not necessarily its exact timing.

Projections for shares are tougher to do, but there is room for cautious optimism over the medium term.

At the beginning of the Fed’s hiking cycle, the US stock market was overvalued: The price-earnings ratio²—which shows a company’s earnings relative to the price of its shares and is therefore a key measure of whether shares are over- or undervalued – for the S&P 500 Index at year-end 2021 was more than 30% above our estimate of the S&P 500’s fair value. This year’s downturn means we’re now more in line with the long-term average.

Those hoping for a V-shaped rebound, where share prices bounce back as sharply as they fell – like in early 2009 or, more recently, March 2020 – may be disappointed.

In certain ways, we’re closer to the market conditions of 1999–2000, when shares were overvalued and the subsequent plunge only brought valuations closer to long-term averages. After the dot-com bubble burst, returns eventually normalised but there was no market bounce.

The market’s current lower valuations have the upside of increased expected returns for some assets.

For UK investors, projected 10-year annualised returns for UK shares are down from a range of 4.8%-6.8% a year ago to a range of 4.2%-6.2% today, although return expectations for non-UK shares are up from 2.7%-4.7% to 4.3%-6.3%.

Projected 10-year annualised returns for UK aggregate bonds have risen from 0.6%-1.6%  to 2.4%-3.4%, while return expectations for global bonds ex-UK (hedged) have increased from 0.5%-1.5% to 2.3%-3.3%³.

The US dollar has recently strengthened, driven by the Fed’s aggressive rate hikes relative to other central banks as well as the natural flight to US Treasuries as a haven asset during times of global crisis. This means that returns for non-US investments will be muted over the short term relative to US investments.

In the long term, however, we expect these two drivers of US dollar strength to reverse, which would help non-US shares.

Overall, with improved outlooks for bond and share markets, return expectations for a balanced portfolio are gradually normalising back to historical averages. For most investors, staying balanced and diversified across asset classes and geographies remains a prudent course.

¹ Since 1995 the nominal total returns of global equities and high-quality bonds have both been negative about 13% of time, reverting back to the normal correlation relationship within a matter of a few months. Source: Vanguard. Based on monthly total returns, with dividends and income re-invested, of the FTSE All-World Index and the Bloomberg Global Aggregate Bond GBP Hedged Index. Returns are in GBP.

² Here we use the Shiller price-earnings ratio, a commonly used cyclically adjusted price-to-earnings ratio.

³ Notes: The MSCI UK Total Return Index is used as a proxy for “UK shares” and the MSCI AC World ex UK Total Return Index is used as a proxy for “non-UK shares”. The Bloomberg Sterling Aggregate Index is used as a proxy for “UK aggregate bonds” and the Bloomberg Global Aggregate ex Sterling Index Hedged is used as a proxy for global bonds ex-UK (hedged). The projections or 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. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 30 June 2021 and 30 June 2022. Results from the model may vary with each use and over time.