January 29, 2024
January 29, 2024
Each month, you'll have access to the latest insights from our Portfolio Solutions experts to help you address evolving issues that may affect your clients' portfolios.
Vanguard Portfolio Solutions
Vanguard Portfolio Solutions
Vanguard Portfolio Solutions
The fight to reduce inflation is succeeding, with the Consumer Price Index having fallen from its high of 9% in June 2022 to its most recent print of 3.4% for the 12 months ending December 2023, according to the U. S. Bureau of Labor Statistics. However, some components of inflation are still too high and remain a concern for the Fed. In line with falling inflation, bond markets have already begun adjusting to reflect a lower-rate environment, where the Fed seeks to return its funds rate to a neutral policy setting.
A key role of global central banks, such as the Federal Reserve, is to achieve price stability in the economy. However, the target inflation rate of 2% has only been considered by central banks since the early 1990s, and it wasn’t until 2012 under the leadership of Chair Ben Bernanke that the Fed officially adopted this target.
An inflation rate that is too high creates uncertainty for businesses and individuals. Household budgets become strained as purchasing power is eroded. Businesses are uncertain as to whether to invest to grow now or save for the future. A 2% inflation rate creates confidence in markets and the economy, which is what central banks are hoping to achieve.
Source: Vanguard and YCharts, as of December 31, 2023.
Since inflation targeting became part of global central bank mandates, annual inflation rates have reduced meaningfully. Figure 1 above represents year-on-year U.S. inflation and the U.S. fed funds rate. While goods inflation has been deflationary year-on-year, services inflation (which is much stickier) such as shelter (e.g., rent) and transportation services are still running at an annualized rate above 4%.
The Vanguard economic and market outlook for 2024 points to the impact of rising rates becoming increasingly restrictive to the U.S. economy through this year. We believe the economy will experience a mild downturn, which is necessary to return inflation to its 2% target. We also expect policy rates to remain higher than those encountered after the most recent shocks, being the Global Financial Crisis and during the COVID-19 pandemic. The implications on portfolios can vary depending on your view on inflation (and interest rates).
Inflation returns to target: With interest rates at restrictive levels, as inflation approaches its 2% target, investors can expect a normalization to the Fed’s terminal rate—the long-term target interest rate where prices are stable and full employment is achieved—which Vanguard believes to be around 3.0–3.5% (source: Vanguard economic and market outlook for 2024: A return to sound money). This expected decline provides an opportunity to extend bond duration to not only capture higher yields, but also to provide stronger diversification to equity risk. Investors should be mindful, however, that the path to “normalization” is not linear: There will likely be some bumps along the road. As such a diversified approach to bond exposure is a prudent way to spread risk and capture the higher yields that are currently available.
Higher inflation: Investors who believe that the fight against inflation has not been won just yet, who expect inflation to be stickier and remain higher than the market’s expectations, may wish to consider including exposures that are more effective to hedge against inflation. Figure 2 below highlights the effectiveness of various asset classes against unexpected inflation. These include commodities, short-term TIPS, and intermediate-term TIPS. Inflation hedging can be particularly beneficial for retirees or those about to transition to retirement, where real returns are important to maintaining their desired lifestyle. Vanguard’s own Target Retirement Funds introduce TIPS into the portfolio allocation when investors reach the age of 60.
Investors may also consider high real return assets such as equities to increase purchasing power over longer time horizons. Of course, additional investments into equities will increase the risk in a portfolio with respect to other asset classes. Any decision to adjust the risk profile of a portfolio should be considered in light of the investor’s goals, time horizon, and overall tolerance to risk.
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, 2023. Results from the model may vary with each use and over time. For more information, please see the Notes section at the end of the article.
Notes: The chart compares real (inflation-adjusted) return projections over the next 10 years to the inflation beta for various asset classes. Inflation beta is the linear regression coefficient between the 30-year inflation forecast and the 30-year portfolio return forecast. The size of the bubble represents the median annualized volatility. The indexes used are: U.S. equities: MSCI US Broad Market Index; global ex-U.S. equities: MSCI All Country World ex USA Index; U.S. bonds: Bloomberg U.S. Aggregate Bond Index; global ex-U.S. bonds: Bloomberg Global Aggregate ex-USD Index; commodities: Bloomberg Commodities Total Return Index; U.S. TIPS: Bloomberg U.S. Treasury Inflation Protected Securities Index; U.S. short-term TIPS: Bloomberg U.S. 1–5 Year Treasury Inflation Protected Securities Index; and U.S. REITs: FTSE/NAREIT US Real Estate Index.
Source: Vanguard calculations, as of September 30, 2023.
Vanguard’s latest economic and markets outlook for 2024 provides greater details on our views for inflation, interest rates, and the broader U.S. and global economy. Further to this outlook, our team of senior portfolio specialists and investment consultants can provide further insights into your portfolio’s expected return under different inflation and broader economic scenarios. With inflation falling and interest rates at elevated levels, now is an opportune time to reevaluate your bond allocation and its ability to provide portfolio diversification throughout the market cycle.
In recent years, there’s been significant growth in the use of private credit by financial advisors. Private credit funds are funds that lend money to businesses or individuals that cannot get loans from traditional sources, such as banks or issuing bonds. These funds can potentially offer a higher yield than other types of investments, but they also come with higher risk and costs. Here are some things to consider before investing in private credit funds:
Sources: S&P Global and LCD, an offering of S&P Global Market Intelligence, as of October 12, 2021.
Private credit funds may not be suitable for every client. They require a high level of risk tolerance, patience, and due diligence. When fixed income yields were close to zero, many advisors looked to private credit to provide a replacement for the yield that they weren't getting in fixed income. But with Treasury and investment grade public credit funds yielding in excess of 4% and a potential recession looming, more intensive due diligence is required to understand the underlying investments and structure in private credit funds. Private credit should be used as a diversification tool and not as a replacement for traditional fixed income. If private credit doesn’t align with your clients’ needs, consider high-yielding fixed income products such as high yield (VWEAX) or core-plus (VCPAX) to create more liquidity and transparency in your client portfolios.
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