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Vanguard CIO: Another Rate Hike, Then a ‘Permanent Pause’

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Greg Davis, the chief investment officer of Vanguard, says 2019 will be a challenging year for financial markets because growth is slowing, rates are rising and uncertainty about geopolitics  is increasing.

Speaking at the Inside ETFs conference in Hollywood, Florida, Davis said Vanguard is not expecting a U.S. recession this year but has raised the odds from 30% previously to 35% in 2019 and to 40% to 50% for 2020, depending on “how high rates go and how muted global growth” is.

Vanguard does expect the Federal Reserve will raise interest rates one more time this year, in June.

“We believe there’s enough strength in growth and employment data to justify another rate hike, then a permanent pause,” Davis said.

Vanguard’s outlook calls for growth of 2% in the U.S., 1% in Europe and 6% in China this year — all slower than last year — with inflation also muted, at 2% in the U.S., 1.5% in Europe and 1% in Japan.

Longer term, the mega-fund company is forecasting annualized average returns over the next 10 years  of 5% for U.S. equities, 3% for U.S. bonds and 7.5% for international equities.

Given this lackluster outlook and the return of volatility in the markets — 20 days of 2% or more movement in the S&P 500 in 2018, with 60% occurring in the fourth quarter — Davis said that an advisor’s role “as behavior coach will become exceedingly important in months to come. They can add 150% in value by helping clients stick to their plan.”

The former chief investment officer for fixed income at Vanguard said that while cash returns are currently competitive with bonds with no risk, bonds serve a purpose in clients’ portfolios as a hedge against equity losses and as a “powerful diversifier.”

Compared to the worst decile of equity returns during the 1988-2018 period, high-quality bonds eked out small returns while equities lost 7%, said Davis.

He offered several considerations that bond investors should keep in mind currently:

  • The 2-year Treasury yields 95% of what the 10-year Treasury yields with about one-quarter of the risk
  • Valuations in credit markets are elevated, richer than historical levels, in an environment where global growth is slowing
  • High costs will significantly erode bond fund returns, which can be an issue with actively managed bond funds
  • Consider the risk that an active bond fund is taking in terms of duration and credit risk relative to a benchmark because underperformance in the bond market can result in losses of hundreds of basis points while outperformance results in gains of about 50 basis points
  • Having an investment time horizon longer than the duration of a bond fund is desirable because if rates rise afterward you can reinvest into a higher yield.

Davis expects the yield curve will steepen because the market will price in a Fed cut at the end of a rate hike cycle. Vanguard is currently neutral on duration and more defensive on credit.

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