Ruth Saldanha: As the New Year begins, the one thing investors want to know is what we can expect going ahead. Now, it's impossible for anyone to know for sure, but based on the information at hand, asset managers make some predictions on what they think might happen. Vanguard, for example, thinks that in 2024, the case for the 60/40 portfolios has strengthened, and these are estimated to deliver about 6% to 7% returns. They also think stock returns will be lower over the next decade, but bonds will stay higher. Sal D'Angelo is the Head of Product for Vanguard Canada, and he is here today to talk about his expectations. Sal, thank you so much for being here today.
Sal D'Angelo: Thanks for having me, Ruth. Great to see you.
Saldanha: So, let's start by talking about some of the assumptions that you made for these expectations. Walk us through those.
D'Angelo: Sure. So, this year, our annual economic and market outlook is actually titled the return of sound money, which is really talking about the persistence of real interest rates, which marks the very sharp change from the previous few years. In fact, we actually believe this is the single best economic development over the last 20 years for investors. So, the days of zero interest rates are actually gone, and a higher interest rate environment is here to stay. And why this is important is because higher interest rates actually provide a solid foundation for long-term risk-adjusted return, and a particularly attractive opportunity for fixed income investors, which is ultimately leading to better returns for balanced or diversified clients. And last, our market outlook in general, it's important to note that it's actually powered by our Vanguard Capital Markets Model, which is our financial simulation tool developed in-house by our global investment strategy group. And it's important to note that these are actually time-varying capital market outlooks that are based on a 10-year forecast and are probabilistic in nature, and they're not point-in-time or short-term tactical estimates.
Balanced Portfolios Will Do Well Again
Saldanha: Yeah, that makes sense. Now, you said that the balanced portfolios are something that will do well in the next year. In fact, Vanguard anticipates that the 60/40 portfolio should get between 6% and 7% returns. What are some of the Canadian as well as global stock and bond returns you're expecting to drive these potential returns?
D'Angelo: Yeah, a good question. So, that's correct. We do estimate around 6% to 7% returns. And it's interesting because many pundits actually completely disregarded the 60/40 in 2022 due to a really challenging year from a sharp rise in interest rates that challenged both the fixed income and equity side of the portfolio. But the balanced portfolios actually rebounded quite nicely in 2023 with about 10% year-to-date returns for a 60/40 Canadian home-biased portfolio. So, looking ahead, we do see about a 7% return is very likely. And actually, to be more specific, our probabilities have increased the potentially of achieving at least a 7% return over the next 10 years from about a 7% likelihood in 2021 to a 32% likelihood today. And that's really driven from both mainly the fixed income side of the portfolio where return expectations have increased substantially. So, we now expect on the fixed income side Canadian bond to achieve about a 4.3% to 5.3% annually over the next decade, and that compares to just about 1.4% to 2.4% annualized just at the end of 2021. So, about a 300-basis-point increase over the last few years. And similarly for ex-Canada bonds or global bonds ex-Canada, we expect a similar return of about 4% to 5% annually over the next decade. And again, about a similar 300-basis-point increase since the end of 2021.
Now, on the equity side, though, a higher rate environment actually depresses asset price valuation across global markets while squeezing profit margins as corporations will now find it more expensive to refinance and issue debt. And actually, we see the global equity risk premium now at the lowest level since the 1999 to 2009 loss decade, and we expect that to be the global equity risk premium about 0% to 2% for the next decade going forward. And where valuations are most stressed are in the U.S. equity market. And we've actually downgraded our return expectations there to about 3.5% to 5.5% over the next decade. And in the U.S., we see more value in value stocks than small caps. And we similarly see more attractive opportunities outside the U.S. where we see about a 6.3% to 8.3% annualized return for ex-U.S. developed markets.
Expect 1% GDP Growth in 2024
Saldanha: Yeah, that makes sense. Can you also tell us one of the things that investors care about quite strongly, especially over the past couple years, is inflation. What are your expectations for the Canadian economy, especially around GDP growth and inflation?
D'Angelo: So, for the Canadian economy, we expect the period of weak growth that we saw now in late 2023 to actually extend into a mild recession in early 2024. But we do expect to end the year with a full year GDP growth of about 1% year-over-year. And we expect inflation to continue to decelerate toward the Bank of Canada's target of 1% to 3%. Housing-related inflation, which has really been a key driver of overall inflation in the economy, should soften as house prices moderate in response to declining affordability. Also loosening in the labor market and the resulting easing of wage pressures should slow price increases for the services unrelated to the shelter side of the economy.
Highly Leveraged Households Pose a Risk
Saldanha: And what does all of this mean for interest rates?
D'Angelo: Yes. So, for interest rates, it's interesting. The Bank of Canada actually led the developed markets in pausing its interest rate hiking cycle. And we could very well see the Bank of Canada lead the rate cutting cycle as well. And we forced a reduction in the overnight rate by up to half from its current 5% level by the end of 2024. Although we anticipate a recovery in late 2024 in response to the Bank of Canada rate cut as inflation does start to moderate, highly leveraged Canadian households do pose a risk to greater slowdown and that will bear watching as the year unfolds.
Expect Volatility Over the Short-Term
Saldanha: So much like Morningstar, Vanguard has a long-term outlook. In fact, you said at the start that your outlook looks over the next 10 years going ahead. So, for 2024, what would your advice be for investors?
D'Angelo: Yeah, our advice would be, as we alluded to earlier, the permanence of higher real interest rates is a very welcome development and really provides a solid foundation for long-term risk-adjusted returns for investors, particularly on the fixed income side. However, as the transition to higher rate is not yet complete, arguably this last part of the inflation battle could prove to be the most difficult. Near term financial market volatility is likely to remain elevated in 2024. So, for those with an appropriate risk tolerance, a more defensive risk exposure may be appropriate given the higher expected fixed income returns and an equity market that is yet to fully reflect the implications of higher rates. And finally, we always encourage investors to stay focused on the long-term goals, remain disciplined during periods of elevated volatility and build diversified low-cost portfolios to achieve long-term success. So, really in short, stay the course with a proper long-term investing plan.
Saldanha: Yeah, that makes sense. Thank you so much for being here today, Sal.
D'Angelo: Thank you, Ruth.
Saldanha: For Morningstar, I'm Ruth Saldanha.
