Vanguard’s Aliaga-Diaz: Rate Outlook Dims View of Cash

While cash returned about 5% this year, the Federal Reserve’s signaling of interest rate cuts in 2024 points to some imperatives, experts say: Put that money to work now, and a soft landing isn't necessarily baked in. 

The outlook for cash is wholly dependent on monetary policy, says Roger Aliaga-Diaz, global head of portfolio construction at Vanguard Group, the world's second-largest ETF issuer. “The yield in the money market fund is really the Fed Fund rate,” he says. 

That means with lower rates potentially ahead, cash will earn less. Even if the Fed engineers a soft landing, which is not Vanguard’s house view, the central bank could preemptively cut interest rates to avoid an over-tightening that fumbles the landing, Aliaga-Diaz says. 

Vanguard, which manages $2.33 trillion in 84 exchange-traded funds, forecasts the neutral level of interest rates to settle around 3.5% once the Fed normalizes monetary policy. That may still entice conservative investors, but Aliaga-Diaz says Vanguard anticipates the U.S. 10-year Treasury’s fair value will hit 4%. Investors who diversify with high-quality credit or mortgage-backed securities may boost that yield to between 4.8% and 5%. 

“That's where you see the reward for taking the extra risk,” he says. 

Aliaga-Diaz says Vanguard expects at least 150 basis points in cuts, with the Fed acting quickly to reach a neutral rate. If that equals 3.5%, as Vanguard thinks, that could mean 200 basis points of cuts, he adds.

Vanguard Expects Mild Recession

Vanguard expects a mild recession in 2024; even with that forecast cash isn’t the place to be. “It’s a great time to be invested in markets,” Aliaga-Diaz says. 

The keys are to use prudent diversification and avoid unnecessary risk. A portfolio with a fixed income tilt could offer a similar return profile with less risk as the equity risk premium between stocks and bonds heads closer to flat or 1%. Typically, that premium runs closer to 4%. “That alone tells you the payoff for the extra risk of equities isn’t that great,” he contends.  

Higher rates means portfolios can achieve more balance, vindicating Vanguard’s long-held view that the 60/40 portfolio isn’t dead, despite the recent common belief. “We went through some dark times with the 60/40 portfolio,” he admits, and recommends investors stick with that weighting if they haven’t abandoned it. 

For fixed income sleeves, investors can cautiously add credit but should stick with high-quality investment grade. Aliaga-Diaz believes that given the current spreads between Treasurys and corporate bonds, the credit market is overly optimistic in general. 

“They’re priced for perfection,” he notes. “They’re price for a soft landing. [But] I don’t think they’re not weighing enough the odds for a recession,” adding that he thinks credit is expensive. 

He doesn’t recommend high yield or emerging market funds right now as those not only produce higher risk, but will also likely see more volatility. 

In equities, he favors value over growth and international over domestic stocks, based on a purely valuation basis. But he acknowledges that 2023’s tech rally and the strength of U.S. equities this year defied expectations. “Tech was supposed to be more affected by higher rates,” Aliaga-Diaz says. 

Higher Interest Rates

That said, he predicts the impact of higher rates will eventually trickle down to affect growth-oriented enterprises and the credit sector as companies move to refinance debt at higher interest rates. Refinancing may not happen next year, “but you have to invest now for that event,” he says. 

The reverberations of higher interest rates should favor value stocks in 2024, which he admits is a controversial view.  

“I do believe that in this interest rate environment, value stocks [can be] more resilient than growth,” he says, “although that's not where the excitement is right now.”