April 29, 2024:
Until recently, it had been a long time since investors were able to expect much from the non-stock side of their portfolios. The low- to no- interest rate environment over the prior decade was a nice thing for borrowers — think 3% mortgages — but it really weighed down returns for conservative and moderate/balanced investors. Now all that has changed, as a result of the sizable increase in interest rates over the past couple years. (Our prior article detailed the huge crash in the bond market and the good opportunities that have resulted).
We added significantly to bonds after the big runup in rates last year, and our bond holdings are still yielding over 5%. Our expectation for liquid alternatives (the other big non-stock part of our portfolios) is somewhat higher than for bonds, and higher still for many areas of the stock market (more on stocks below). Putting it all together, the outlook for balanced investors appears better than it has been for almost all of the past 15 years.
We only have to go back a few years to see how much things have changed. Vanguard publishes 10-year asset class forecasts using a valuation-based methodology we think is very sensible. At the beginning of 2022, Vanguard’s 10-year forecast for the classic “balanced” portfolio (60% global stocks and 40% US bonds) was just 3.8%/year. By the start of this year, thanks to vastly improved valuations, Vanguard’s forecast had risen to 6.4%/year. The table below summarizes these figures as well as showing the forecasted 10-year cumulative return to illustrate how big an impact those higher annual return rates can have over time. 1
Stocks are good too! (well, most of them)
The prospects are looking good for our more stock-focused allocations as well. The next table shows Vanguard’s forecasts for several different areas of the global stock market, again showing annualized and 10-year cumulative expected returns. 2
US growth stocks continue to be very expensive, which drags down their expected returns and to a lesser extent those of US large caps (of which growth stocks are a big part). But the forecasted returns to US value stocks and international stocks are quite good.
We are tilting our stock exposure towards the latter three categories in the table, and we believe we are getting a further potential return boost by emphasizing value in our international stock exposure as well. (Vanguard doesn’t break out growth vs. value in international stocks, but a similar forecasting methodology shows that the unusually good prospects for value vs. growth stocks are a worldwide phenomenon). 3
For a smaller part of our stock portfolios, we also have exposure to some more targeted areas. One of these is our allocation to clean energy and other companies tied to that sector. We wanted to highlight it here because, while it’s been a detractor, we think it has a lot of potential and we added exposure after the majority of the downturn last year.
Clean energy companies have rapidly grown their earnings in recent years, and this trend looks set to continue. Immense amounts of money have been earmarked for spending on decarbonization in the years to come, and the increasingly voracious power demands of generative AI are likely to even further increase the demand for renewable energy. 4
But the sector is prone to boom-bust cycles and sensitive to changes in interest rates. Recent cyclical headwinds have combined with the rise in rates to really punish clean energy stock values. What looked like growth at a reasonable price a year ago now seems to be growth at a bargain price. This is nice on its own merits, but it’s particularly appealing in combination with the substantial value-stock tilt in the rest of our stock strategy.
More generally, we see unusually good opportunities for investors all along the risk spectrum right now — be they conservative, balanced, or aggressive in their strategy.
- Source: Vanguard 2022 and 2024
- Source: Vanguard Capital Market Model Forecasts
- For example, Research Affiliates’ valuation-based forecast model predicts that international developed value stocks will outperform international stocks overall by 2.3%/year.
- This article from The Verge discusses the potential surge in data center energy usage.