Brighter prospects for fixed income ahead

Commentary by Roger Aliaga-Díaz, Vanguard’s Global Head of Portfolio Construction and Chief Economist, Americas.

• There could be brighter prospects for fixed income ahead.
• The US Federal Reserve’s monetary tightening is having an impact on balanced portfolios.
• For investors with portfolios balanced between equities and bonds, return expectations have improved.

The US Federal Reserve (Fed) has made it clear in recent months, in both words and action, that reining in runaway inflation is its top priority. Unfortunately, the Fed’s series of interest rate hikes have not been helpful for the traditional balanced portfolio, hurting both equities and bonds - a rare occurrence historically. And rates will not only go higher, but may stay elevated for a while.

Inevitably, given these developments, my portfolio construction team and I have been fielding questions from clients that fall under one of two themes:

• 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 fixed income

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 at the longer end of the maturity spectrum. The unusually positive return correlation we’ve seen this year between equities and bonds may fall, and the lockstep downward spiral of the two asset classes could end. This leads me to answer the second question: No, the balanced portfolio is far from obsolete.

When all this comes to pass, fixed income will resume its role as a buffer for equities. 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 (inflation-adjusted) rates in fixed income. We’re on the verge of entering a period of positive real rates, strengthening the case for fixed income.

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 equities and bonds. We don’t yet know where the bottom is, but investors who get out now will miss the rebound.

Equities 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 trajectory of fixed income, if not necessarily its exact timing. Projections for equities 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 Shiller price-earnings ratio 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 stock 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 equities 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. Our models project 10-year annualised returns that are almost 2 percentage points higher than a year ago for both US and non-US equities, though still below long-term historical averages¹. In bonds, projected 10-year annualised returns for US aggregate bonds and global bonds ex-US (hedged) have both risen by 1.8 percentage points over the past year.

For UK investors, projected 10-year annualised returns for UK equities are down just over half a percentage point relative to a year ago, although return expectations for non-UK equities are up by 1.6 percentage points. In fixed income, projected 10-year annualised returns for UK aggregate bonds have risen by 1.8 percentage points, as have return expectations for global bonds ex-UK (hedged).

For euro area investors, return expectations for euro area equities are up 1.5 percentage relative to a year ago while non-euro area equity return projections are up 1.7 percentage points. In bonds, projected 10-year annualised returns for euro area aggregate bonds and global bonds ex-euro area have increased by 1.8 and 1.9 percentage points respectively.

The recent strengthening of the US dollar—driven by the Fed’s aggressive rate hikes relative to other central banks, on top of the natural flight to US Treasuries during times of global crisis—means that returns for non-US investments will be muted over the short term relative to US investments. Long term, however, we expect these two drivers of US dollar strength to reverse, which would help non-US equities.

Overall, with improved outlooks for fixed income and equity 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 Notes: Indices used in VCCM simulations: US equities = MSCI US Broad Market Index; Global ex-US equities = MSCI All Country World ex-USA Index; US aggregate bonds = Bloomberg US Aggregate Bond Index; Bloomberg Global Aggregate ex-USD Index; UK shares = MSCI UK Index; global ex-UK shares = MSCI AC World Index ex UK; UK aggregate bonds = Bloomberg Sterling Aggregate Bond Index; global ex-UK bonds = Bloomberg Global Aggregate ex GBP Index; euro-area equities = MSCI European Economic and Monetary Union (EMU) Index; global ex-euro-area equities = MSCI AC World ex EMU Index; euro-area aggregate bonds = Bloomberg Euro-Aggregate Bond Index; global ex-euro-area bonds = Bloomberg Global Aggregate ex Euro Index.

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 modeled 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.