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Higher interest rates are here to stay. Even after policy rates recede from their cyclical peaks, in the decade ahead rates will settle at a higher level than we’ve grown accustomed to since the 2008 global financial crisis (GFC). This development ushers in a return to sound money, and the implications for the global economy and financial markets will be profound. Borrowing and savings behaviour will reset, capital will be allocated more judiciously, and asset class return expectations will be recalibrated. Beliefs believes that a higher interest rate environment will serve investors well in achieving their long-term financial goals, but the transition may be bumpy.

Monetary policy will bare its teeth in 2024

The global economy has proven more resilient than we expected in 2023. This is partly because monetary policy has not been as restrictive as initially thought. Fundamental changes to the global economy have pushed up the neutral rate of interest—the rate at which policy is neither expansionary nor contractionary. Various other factors have blunted the normal channels of monetary policy transmission, including the U.S. fiscal impulse from debt-financed pandemic support and industrial policies, improved household and corporate balance sheets, and tight labour markets that have resulted in real wage growth. In the U.S., our analysis suggests that these offsets almost entirely counteracted the impact of higher policy interest rates. Outside the U.S., this dynamic is less pronounced. Europe’s predominantly bank-based economy is already flirting with recession, and China’s rebound from the end of COVID-19-related shutdowns has been weaker than expected.

The U.S. exceptionalism is set to fade in 2024. We expect monetary policy to become increasingly restrictive as inflation falls and offsetting forces wane. The 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. In Europe, we expect anaemic growth as restrictive monetary and fiscal policy lingers, while in China, we expect additional policy stimulus to sustain economic recovery amid increasing external and structural headwinds.

Zero rates are yesterday’s news

Barring an immediate 1990s-style productivity boom, 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 targets, we expect they will start to cut policy rates in the second half of 2024.

That said, we expect policy rates to settle at a higher level compared with after the GFC and during the COVID-19 pandemic. Research has found that the equilibrium level of the real interest rate, also known as r-star or r*, has increased, driven primarily by demographics, long-term productivity growth, and higher structural fiscal deficits. This higher interest rate environment will last not months, but years. It 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 GFC.

2024 economic forecasts

GDP Growth

Unemployment rate

Core inflation

Monetary policy

^{Notes: Forecasts are as of November 14, 2023. For the U.S., 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. NAIRU is the non-accelerating inflation rate of unemployment, a measure of labour market equilibrium. Core inflation excludes volatile food and energy prices. For the U.S., euro area, and U.K., 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 U.S., 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. The neutral rate is the equilibrium policy rate at which no easing or tightening pressures are being placed upon an economy or its financial markets.}

^{current as of November 14, 2023.}

A return to sound money

For households and businesses, higher interest rates will limit borrowing, increase the cost of capital, and encourage saving. For governments, higher rates will force a reassessment of fiscal outlooks sooner rather than later. The vicious circle of rising deficits and higher interest rates will accelerate concerns about fiscal sustainability. Research suggests the window for governments to act on this is closing fast—it is an issue that must be tackled by this generation, not the next.

For well-diversified investors, the permanence of higher real 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 is likely to remain elevated.

Bonds are back

Global bond markets have repriced significantly over the last two years because of the transition to the new era of higher rates. In our view, bond valuations are now close to fair, with higher long-term rates more aligned with secularly higher neutral rates. Meanwhile, term premia (compensation investors may expect for the unknowns associated with holding longer-term debt) have increased as well, driven by elevated inflation and fiscal and monetary outlook uncertainty.

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 bond return expectations have increased substantially. We now expect Australian bonds to return an annualised 4.3%-5.3% over the next decade, compared with the 1.3%-2.3% 10-year annualised returns we expected before the rate-hiking cycle began. Similarly, for global bonds, we expect annualised returns of 4.5%–5.5% over the next decade, compared with a forecast of 1.6%-2.6% when policy 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 over the last two years. By the end of the decade, bond portfolio values are expected to be higher than if rates had not increased in the first place.

Similarly, the case for the 60/40 portfolio is stronger than in recent history. Long-term investors in diversified portfolios see a dramatic rise in the probability of achieving a nominal 7% return, from 11% in 2021 to 38% today.

Moving up the risk spectrum, credit valuations appear fair in the investment-grade space but relatively rich in high-yield. What’s more, the growing likelihood of recession and declining profit margins skew the risks toward wider spreads.

Higher rates leave equities overvalued

A higher-rate environment depresses asset price valuations across global markets while squeezing profit margins as corporations find it more expensive to issue and refinance debt.

Valuations are most stretched in the U.S. As a result, we have downgraded our U.S. equity expectations to an annualised 4.0%-6.0% over the next 10 years from 4.6%-6.6% heading into 2023. Within the U.S. market, value stocks are more attractive than they have been since late 2021 and small-capitalisation stocks also appear attractive for the long term.

U.S. equities have continued to outperform their international peers. The key drivers of this performance gap over the last two years have been valuation expansion and dollar strength beyond our fair-value estimates, but these are likely to reverse. Indeed,  projections suggest an increasing likelihood of greater opportunities outside the U.S. We project 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 global equity risk premium that emerges from current stock and bond market valuations is the lowest since the 1999–2009 “lost decade.” The spread between global equity and global bond returns is expected to be 0 to 2 percentage points annualised over the next 10 years. In contrast to the last decade, we expect return outcomes for diversified investors to be more balanced. For those with an appropriate risk tolerance, a more defensive risk posture may be appropriate given higher expected fixed income returns and an equity market that is yet to fully reflect the implications of the return to sound money.

Notes:

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.

Vanguard
November 2023
vanguard.com.au