1. Inflation: Return to central banks targets in 2024
The key question is when inflation will return to central bank targets. We expect this to occur globally in 2024. However, the return to 2% inflation, which is the target of most major central banks, will happen at different times in different regions. We forecast the UK to return to target the earliest, in Q2, followed by the euro area and the US in Q3.
This timeline represents a positive development, as we previously anticipated stickier inflation worldwide. That said, central banks will need to strike a balance in terms of the timing and magnitude of rate cuts, given the risk of inflation re-emerging on the one hand and the risk of a downturn on the other.
The path to inflation targets
Source: Bureau of Labor Statistics, Eurostat, Office for National Statistics. Seasonally and working day adjusted data, as at 18 January 2024.
2. Interest rates: Likely cut around the middle of 2024, but won’t go back to zero
Falling inflation and weaker economic activity will allow central banks to cut interest rates from around the middle of 2024. After policy rates recede from their cyclical peaks, we expect them to settle at a higher level than we’ve seen in the past decade, in both Europe and the US. Interest rates will likely not fall to zero and will instead remain structurally higher in the years to come. This marks an important departure from the post-global financial crisis era and ushers in a “return to sound money”, the overarching theme of our Vanguard economic and market outlook for 2024.
Landing in a new world: Higher equilibrium policy rates
Notes: Monthly data from January 2000 to October 2023. Forecasts are to year-end 2025. The nominal neutral rate is the estimated level of equilibrium real interest rates that would support both full employment and stable inflation. Nominal neutral rate estimates are derived using Vanguard’s proprietary model. The policy rate is the rate used by central banks to enact monetary policy. For an analysis of the relationship between neutral and policy rates, please see What our interest rate outlook means for investors.
Source: Bloomberg, Vanguard as at January 2024.
There is a risk of policy mistakes, as history illustrates. In the US, for example, the Federal Reserve (Fed) cut interest rates in late 1966, when inflation was falling, but it proved to be too early. Inflation subsequently rose again and the Fed needed to hike even more, which led to a painful recession in 1969. The issue then was that fiscal policy was more expansionary than expected and the Fed had seen productivity changes as permanent, when in fact they were temporary.
So a key area to monitor in 2024 is whether interest rate cuts come too early or if central banks get the timing right and manage to engineer a soft landing, in which inflation returns to target without recession.
3. Growth: Expected to slow in the US and remain weak in Europe and China
The global economy proved more resilient than expected in 2023. This was partly because monetary policy was not as restrictive as initially thought – our research suggests the neutral rate of interest (also known as “r-star”) has increased by about 1% in recent years. Other factors also blunted the normal channels of monetary policy. These included a strong US fiscal impulse, healthy household and corporate balance sheets following the Covid-19 pandemic, and tighter-than-usual labour markets.
In 2024, we expect this economic resilience to fade in the US. This is because interest rates will become increasingly restrictive in real terms as inflation falls and the positive effects of fiscal stimulus and healthy balance sheets will wane, in our view. However, there are risks to this view. A soft landing remains possible, as does an economic slowdown that is further delayed.
In Europe, we expect anaemic growth as restrictive monetary and fiscal policy linger, while in China we anticipate additional policy stimulus to sustain economic recovery amid increasing external and structural headwinds. We believe that China will likely rebalance to a lower, but more sustainable, growth path in the coming years.
4. Portfolio: Bonds offer good returns, equity risk premium at historic lows
What does the macroeconomic backdrop mean for investor portfolios? In short, we believe that the return to sound money—or the persistence of positive real interest rates—is the single most important and beneficial development for long-term investors in more than 20 years. This structural shift towards higher real interest rates provides a solid foundation for long-term risk-adjusted returns. However, the transition to higher rates is not yet complete and near-term financial market volatility is likely to remain elevated.
In this environment, bond investors stand to benefit. Global fixed income markets have repriced in the past two years amid the shift to higher rates and, in our view, bond valuations now look broadly close to fair, if not undervalued. While the sharp increase in yields has driven down the prices of bonds significantly over the last few years, these higher yields today mean that the outlook for long-term investors is better than it has been in more than a decade.
There’s a somewhat mixed picture for equities. The equity risk premium has fallen to historical lows; in other words, the amount investors could be compensated for taking on the additional risk associated with equities, versus bonds or cash, looks low. This is because, in our view, equities appear broadly overvalued and could be at risk of a correction. Despite this outlook, we still see long-term opportunity in equities within a balanced portfolio given that we expect the correlation between stocks and bonds to be negative over the long term.
The case for a diversified 60/40 portfolio is alive and well. Indeed, we believe it has actually strengthened. If we look at forecasts generated by the Vanguard Capital Markets Model (VCMM), we can see that the 10-year annualised return has improved as of September 2023, compared with the end of 2021 (as shown in the lefthand chart below). We saw a relatively accurate forecast from the VCMM for the past decade, with the 10-year forecast return as of December 2013 comparing favourably with the realised returnfrom December 2013 to December 2023 (the righthand chart), which gives us confidence in the model as we move forward.
The case for 60/40 portfolio has strengthend Good performance of VCMM model
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: The LHS chart shows the VCMM forecast as at 31 December 2013 and the realised return over the subsequent 10-year period ending 31 December 2023 for a 60% equity/40% bond portfolio. The RHS chart shows the VCMM forecast as at 31 December 2021 and 30 September 2023 for a 60% equity/40% bond portfolio. Equity comprises UK equities (MSCI UK Total Return Index) and global ex-UK equities (MSCI AC World ex-UK Total Return Index). Fixed income comprises UK bonds (Bloomberg Sterling Aggregate Bond Index) and global bonds ex-UK (hedged, Bloomberg Global Aggregate ex Sterling Bond Index Sterling Hedged). UK equity home bias: 25%, UK fixed income home bias: 35%.
Source: Vanguard calculations in GBP based on data from Refinitiv as at 30 September 2023.
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 the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 31 December 2013, 31 December 2021 and 30 September 2023. Results from the model may vary with each use and over time.
There may yet be further volatility in markets in 2024, given the transition to a higher interest rate environment is not yet complete. But patient multi-asset investors, who maintain discipline with a strategic allocation to global equities and bonds, are likely to be rewarded over the long term. Furthermore, because it is challenging to time financial markets, we believe investors should stay the course and maintain a long-term perspective to have the best chance of investment success.
