Why investors are firmly focused on interest rates

2024 is very much a story of how quickly and how sharply rates will start coming down.

Around the world, just like in 2023, financial markets, investors, and borrowers are firmly focused on what will happen to official interest rates.

But unlike last year, when rates were on the way up, 2024 is very much a story about how quickly and how sharply interest rates will start coming down.

Rising expectations around looming cuts to interest rates – a signal that central banks believe surging inflation levels are being brought back under control – provided a strong tailwind for share markets in December.

The Australian share market, when measured by the S&P/ASX 300, rose more than 7% over the final weeks of 2023. 

Higher for longer

The course of interest rates will remain a firm focus for most investors in 2024.

While the United States’ Federal Reserve Bank has indicated it expects to start cutting interest rates during this year, its December policy meeting minutes shed little light on when that process will begin. This will largely depend on the pace at which inflation levels continue to decline.

The Reserve Bank of Australia is in a similar boat. The RBA board will announce its next decision on interest rates when it meets for the third time this year on 7 May.

Vanguard’s just-released economic and market outlook for 2024 notes that “the persistence of positive real interest rates” will provide a solid foundation for long-term risk-adjusted investment returns over the next decade.

Vanguard forecasts that the spread between global equity and global bond returns is expected to be 0 to 2 percentage points annualised over the next 10 years. As such, we expect return outcomes for diversified investors to be more balanced over the next decade.

For those with an appropriate risk tolerance, a more defensive risk posture may be appropriate given higher expected fixed income returns and an equity market that is yet to fully reflect the implications of the return to sound money.

In the decade ahead, our forecast is for annualised earnings growth of 1.5% for Australian equities and 4.1% for global ex-Australia equities, supported by an expected growth rate in the U.S. that is well below that of past years but still higher than elsewhere.

Our bond return expectations have increased substantially. We now expect Australian bonds to return an annualised 4.3%-5.3% over the next decade, compared with the 1.3%-2.3% 10-year annualised returns we expected before the rate-hiking cycle began.

Similarly, for global bonds, we expect annualised returns of 4.5%–5.5% over the next decade, compared with a forecast of 1.6%-2.6% when policy rates were low or, in some cases, negative.

Diversification remains key

As always, having a diversified portfolio of investments is key because the returns from different asset classes and market segments vary from year to year.

Making tactical adjustments to a portfolio based on what’s happening on investment markets at any point in time, particularly when there’s a high level of turbulence, may seem logical.

Rather than making tactical changes, investors who stay aligned to their goals, who are well diversified, who minimise their costs, and who have the discipline to stay invested, even during periods of heightened volatility, have the best chance of investment success over the long term.

Source: Vanguard January 2024

This article has been reprinted with the permission of Vanguard Investments Australia Ltd. Copyright Smart Investing™

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