- Higher interest rates are here to stay. The implications for the economy and markets are profound.
- Interest rates at a higher level is a positive development for long-term investors.
- A higher interest-rate environment will help investors achieve their long-term financial goals, but the transition may be bumpy.
Higher interest rates are here to stay. Even after rates recede from their peaks in the current cycle, they are likely to settle at a higher level than we’ve grown used to since the 2008 global financial crisis (GFC).
The implications for the global economy and financial markets of this return to a more ‘normal’ level of interest rates will be profound.
Vanguard believes that a higher interest-rate environment will serve investors well in achieving their long-term financial goals, because it will set a solid foundation for long-term returns from other assets such as bonds and shares. However, the transition may be bumpy.
"Despite the potential for near-term volatility, we believe this rise in interest rates is the single best economic and financial development in 20 years for long-term investors."
Vanguard global chief economist and global head of the Investment Strategy Group
Interest-rate rises to hit home in 2024
The global economy has proven more resilient than we expected in 2023. This is partly because interest-rate rises have not been as restrictive of economic activity as initially thought.
However, we expect interest rates to become increasingly restrictive in real (inflation-adjusted) terms as inflation falls and offsetting forces, such as Covid-19 pandemic support and tight labour markets, wane. The global economy will experience a mild downturn as a result. This is necessary to finish the job of returning inflation to target.
However, there are risks to this view. A “soft landing,” in which inflation returns to target without recession, remains possible, as does a recession that is further delayed.
Zero rates are yesterday’s news
A recession is likely a necessary condition to bring down the rate of inflation, through weakening demand for labour and slower wage growth. As central banks feel more confident in inflation’s path toward their 2% targets, we expect that they will start to cut interest rates in the second half of 2024.
That said, we expect interest rates to settle at a higher level compared with after the GFC. This is a structural shift that will endure beyond the next business cycle and, in our view, is the single most important financial development since the global financial crisis.
Vanguard’s 2024 economic forecasts
Country/ region |
Economic growth |
Unemployment rate |
Core inflation |
Interest rates |
|
Year-end 2023 |
Year-end 2024 |
||||
US |
0.5% |
4.8% |
2.5% |
5.5%–5.75% |
4%–4.5% |
Euro area |
0.5%–1% |
7%–7.5% |
2.1% |
4% |
3.25% |
UK |
0.5%–1% |
4.5%–5% |
2.8% |
5.25% |
4.25% |
China |
4.5%–5% |
4.8% |
1%–1.5% |
2.3%–2.4% |
2.2% |
1 Notes: Forecasts are as at 14 November, 2023. For the US, economic (GDP) growth is defined as the year-over-year change in fourth-quarter GDP. For all other countries/regions, GDP growth is defined as the annual change in GDP in the forecast year compared with the previous year. Unemployment forecasts are the average for the fourth quarter of 2024. Core inflation excludes volatile food and energy prices. For the US, euro area and UK, core inflation is defined as the year-over-year change in the fourth quarter compared with the previous year. For China, core inflation is defined as the average annual change compared with the previous year. For the US, core inflation is based on the core Personal Consumption Expenditures Index. For all other countries/regions, core inflation is based on the core Consumer Price Index.
1 Source: Vanguard.
A return to a more ‘normal’ environment for interest rates
For investors with well-diversified portfolios across global shares and bonds, the permanence of higher real (inflation-adjusted) interest rates is a welcome development. It provides a solid foundation for long-term risk-adjusted returns. However, as the transition to higher rates is not yet complete, near-term financial market volatility (or fluctuations in prices) is likely to remain elevated.
Bonds are back
Global bond prices have fallen (and yields risen) over the last two years because of the transition to the new era of higher rates.
Bonds are a type of loan issued by governments or companies that pay a fixed rate of interest over a given period to investors (and return the sum borrowed at the end of the term). Their yield shows the income as a proportion of the market price of the bond and this is significantly affected by interest rates. Rising interest rates tend to cause bond prices to fall (and yields to rise) and vice versa.
Despite the potential for near-term volatility, we believe this rise in interest rates is the single best economic and financial development in 20 years for long-term investors. Our return expectations for bonds have increased substantially.
We now expect UK bonds to return 4.4%-5.4% a year (annualised) over the next decade, compared with the 0.8%-1.8% 10-year annualised returns we expected before the rate-hiking cycle began1. Similarly, for global ex-UK bonds, we expect returns of 4.5%-5.5% a year over the next decade, compared with a forecast of 0.8%-1.8% when interest rates were low or, in some cases, negative.
If reinvested, the income component of bond returns at this level of rates will eventually more than offset the capital losses experienced by bond investors over the last two years. By the end of the decade, bond values are expected to be higher than if rates had not increased in the first place.
Similarly, the case for a portfolio of 60% global shares and 40% global bonds is stronger than in recent memory2. Long-term investors in balanced portfolios have seen a dramatic rise in the probability of achieving a 10-year annualised return of at least 7%, the post-1990 average, from an 8% likelihood in 2021 to 40% today.
Higher rates leave shares in some markets overvalued
A higher-rate environment can depress share price valuations across global markets (because they reduce the present value of company earnings) while squeezing profit margins as companies find it more expensive to issue and refinance debt.
Valuations are most stretched in the US. As a result, we have downgraded our expectations for US shares (for a UK investor) to 4.1%-6.1% a year over the next 10 years, down from 4.3%-6.3% heading into 2023.
We see an increasing likelihood of greater opportunities outside the US. We project 10-year annualised returns (for UK investors) of 6.8%-8.8% from non-US developed markets, of 4.7%-6.7% from UK equities and of 6.4%-8.4% from emerging markets.
In contrast to the last decade, we expect potential return outcomes for investors in portfolios diversified across global shares and bonds to be more balanced.
1 Return projections from our Vanguard Capital Markets Model® (VCMM). The VCMM is a modelling tool that simulates thousands of potential outcomes based on a statistical analysis of historical data. IMPORTANT: The projections and other information generated by the VCMM 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 VCMM are derived from 10,000 simulations for each modelled asset class. Simulations as at September 30, 2023. Results from the model may vary with each use and over time.
2 The 60% equity/40% fixed income portfolio is made up of the following: Equity: UK equity (MSCI UK Total Return Index) and global ex-UK equity (MSCI AC World ex UK Total Return Index). Fixed income: UK bonds (Bloomberg Sterling Aggregate Bond Index) and hedged, global ex-UK bonds (Bloomberg Global Aggregate ex Sterling Bond Index Sterling Hedged). UK equity: 25%, UK fixed income: 35%.
IMPORTANT: 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. 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 US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US 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
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