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The market, which was initially slow to price higher interest rates to fight elevated and persistent inflation, now believes that most central banks will have to go well past their neutral policy rates (see “The global economy in 2023”) – the rate at which policy would be considered neither accommodative nor restrictive – to quell inflation. The eventual peak and persistence of policy rates, which will depend heavily on the path of inflation, will determine how high bond yields rise.
Although rising interest rates have created near-term pain for investors, higher starting interest rates have significantly improved our return expectations for the Canadian and international bonds.
From a Canadian investor’s perspective, we now expect the Canadian bonds to return 3.3%-4.3% per year over the next decade, compared with the 1.4%-2.4% annual returns we forecast a year ago. For international bonds ex-Canada (hedged), we expect returns of 3.1%-4.1% per year over the next decade, compared with our year-ago forecast of 1.2%-2.2% per year. This means that for investors with an adequately long time horizon, we expect their wealth to be higher by the end of the decade than our year-ago forecast would have suggested.
In credit, valuations are attractive, but the growing likelihood of recession and declining profit margins skew the near-term risks toward higher spreads. Although credit exposure can add volatility, its higher expected return than government bonds and low correlation with equities validate its inclusion in portfolios.
Rising interest rates, inflation, and geopolitical risks have forced investors to reassess their rosy expectations for the future. The silver lining is that this year’s bear market has improved our outlook for global equities, though our Vanguard Capital Markets Model® (VCMM) projections suggest there are greater opportunities outside the United States.
Stretched valuations in the U.S. equity market in 2021 were unsustainable, and our fair-value framework suggests they still don’t reflect current economic realities. We also see a high bar for continued above-average earnings growth, especially in the U.S. Although U.S. equities have continued to outperform their international peers, the primary driver of that outperformance has shifted from earnings to currency over the last year.
The 30% decline in emerging markets over the past 12 months has made valuations in those regions more attractive. We now expect similar returns to those of non-U.S. developed markets and view emerging markets as an important diversifier in equity portfolios.
From a Canadian investor’s viewpoint, our VCMM model projects higher 10-year annualized returns for both the Canadian and international equities. We now expect the Canadian equities to return 4.7%-6.7% per annum over the next decade compared with the 3.1%-5.1% annual returns we forecast a year ago. For international equities, we expect returns of 4.9%-6.9% per year over the next decade, compared with our year-ago forecast of 3.4%-5.4% per annum.
From a U.S. dollar investor’s perspective, the VCMM projects higher 10-year annualized returns for non-U.S. developed markets (7.2%-9.2%) and emerging markets (7%-9%) than for U.S. markets (4.7%-6.7%). Globally, our equity return expectations are 2.25 percentage points higher than they were at this time last year.
Within the U.S. market, value stocks are fairly valued relative to growth, and small-capitalization stocks are attractive despite our expectations for weaker near-term growth. Our outlook for the global equity risk premium is still positive at 1 to 3 percentage points, but lower than last year due to a faster increase in expected bond returns.
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 modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. For more information, please see the Disclaimer section.
Joseph H. Davis, PhD, is a Vanguard principal, global chief economist, and global head of The Vanguard Group, Inc.’s Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction and related investment topics. As Vanguard’s global chief economist, Mr. Davis is also a key member of the senior portfolio management team for Vanguard Fixed Income Group. The Vanguard Global Economics Team contributed to this report. The detailed Vanguard economic outlook for 2023 can be viewed on the Vanguard website.
Disclaimer
Content © 2022 by Vanguard Group. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Insights“ page of the Vanguard Group, Inc.’s website. Used with permission.
Publication date: November 2022
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
Certain statements contained in this material may be considered "forward-looking information" which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.
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