2 minutes 9 seconds
0:05 Well, the implications are higher interest rate environment.
0:07 It's something we started to put our pulse on two years ago, given the forces of technology as well as rising fiscal deficits.
0:15 You know, that push-pull dynamic leads to the same conclusion, which is a generally higher interest rate environment strategically in the financial markets for bond yields.
0:25 And with that, it suggests higher, obviously, expected returns because the primary component of fixed income portfolio returns are the stated yield in the portfolio.
0:33 And so that's not a new view from our research teams, but it's something that our framework continues to underscore. And on a risk-adjusted basis, fixed income could remain attractive for the next several years.
0:47 But again, looking at the forces of technology and fiscal in particular, it really does underscore a fairly dramatic tug-of-war between those two forces, which suggests some upside risk to growth as well as some inflation volatility if AI is not as transformative as we think.
1:06 So that means, in my mind, actually a fairly strong case for active fixed income.
1:11 And why would that be?
1:12 Well, I think if AI is not as transformative as we think, we're going to have, at times, tensions between fiscal policymakers, you know, driving up fiscal deficits while at the same time monetary policymakers trying to keep some of its inflationary effects at bay.
1:27 And so, you know, talented active managers should be able to spot turning points in Fed easing cycles, Fed tightening cycles, as well as a risk premium in the market from perhaps fiscal dynamics, as well as the opportunities on credit selection, individual corporate bond selection, through the winners and losers of changes in technology, which has always had an effect on industry dynamics and corporate fundamentals.
1:53 So, again, I think in the years ahead, the case for active fixed income is very compelling.
Vanguard’s Global Chief Economist Joe Davis discusses a shift in the fixed income market as artificial intelligence (AI) progresses and highlights the potential for active risk-taking in a higher interest rate environment over the next decade.
This Q&A is one in a series featuring Davis’s research on megatrends and the future impact that AI can have on the U.S. economy and investors at large. For more insights, visit our Megatrends hub.
What insights does Vanguard’s megatrends research offer for fixed income investors?
Davis: In either a positive or a pessimistic AI scenario, the future may be ripe for active risk-taking in the fixed income market. We’re likely to see a rate environment that’s very different from what we saw from 1983 to 2020. That period provided a strong tailwind to all fixed income investors. In a higher rate environment, active risk-taking has more room to add value.
Specifically, what does your research suggest about future interest rate levels and what that could mean for fixed income investors?
Davis: Our research points to a higher neutral rate over the coming decade, relative to the low-rate environment that pervaded pre-covid, in part due to factors such as an aging population and rising structural deficits.
So, our outlook is that interest rates above pre-pandemic levels are here to stay. In both our positive and negative AI scenarios, we expect the federal funds rate to stay above 4%, but for different reasons. In the positive scenario, the 4% rate reflects higher economic growth. In this scenario, the yield curve may remain flatter than some think, creating opportunities for active risk-taking along duration. There may be similar dynamics around credit as well.
In the pessimistic scenario, it indicates growing structural deficits and financing pressures on the U.S. government. There may also be greater inflationary pressure in this scenario. This would likely be a very different environment, one in which rates may be rising and the curve is getting steeper, possibly creating an opportunity for active risk-taking.
Higher rates would mean less return would come from price appreciation, and more return would come from reinvesting at higher rates. Generally, we’d be entering an era where bonds offer greater value in a portfolio than they did in the low-rate environment that followed the global financial crisis.
How should investors be thinking about active management within their fixed income allocation?
Davis: Neither environment sounds as “easy” as it may have been during the few decades with a secular downtrend in interest rates that began in 1983. There will be many sources of volatility to navigate to either mitigate potentially adverse price effects of a rising yield environment or take advantage of price dislocations. The coming decade seems ripe for active risk-taking in the sense that there are likely to be sources of volatility to navigate or take advantage of.
It seems particularly important if AI disappoints. In this scenario, being underweight in equities and overweight in fixed income could be beneficial because in that environment, you’d expect to see lower growth, disappointing earnings growth, and higher interest rates. Within fixed income, investors may benefit from an overweight to corporate bonds (including high yield) relative to U.S. Treasuries. That’s because Treasury prices could come under pressure if investors become concerned about the sustainability of the national debt.
Takeaways
Concerns with fiscal deficits in a lower-growth future: If AI disappoints, investors could potentially benefit from an overweight to fixed income, particularly corporate bonds.
With interest rates rising, either scenario seems ripe for active risk-taking: Whether AI delivers or disappoints, we are likely to see a higher rate environment. This presents an environment ripe for active risk-taking in fixed income.
Notes:
- All investing is subject to risk, including the possible loss of the money you invest.
- Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Investments in bonds are subject to interest rate, credit, and inflation risk.
