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%.