Due to elevated interest rates and high starting equity valuations, Vanguard is overweight bonds relative to stocks when compared to a traditional 60/40 portfolio.
In its 2025 outlook report, the world’s second largest asset manager revealed it is wary of the narrow equity risk-premium implied by current equity valuations.
The firm said it is overweight US credit despite stretched valuations “given its more favourable expected returns”. It is also overweight US long-term bonds.
Currently high starting yields cushion bond returns while still allowing for investors to take advantage of falling rates, according to Vanguard.
“This development, which we refer to as the “coupon wall,” creates an asymmetric and favourable risk/return environment,” the report said. “The long-term case for bonds remains solid.”
However Vanguard warned that bonds are still at risk of inflation outpacing productivity gains, which would cause yields across the curve to rise and for the stock/bond correlation to turn positive again.
But due to a strong growth outlook, its base case is for yields to remain above 4% and for any negative demand shock to allow bonds to become a hedge in multi-asset portfolios.
A mixed equity outlook
On the equity side, Vanguard is overweight US value, US small cap and developed markets ex-US equities “due to their more appealing valuations and higher anticipated returns”.
However, the firm reduced its exposure to emerging market equities due to lower earnings growth and reduced investor sentiment.
“A soft earnings profile, driven by our underwhelming outlook for Chinese growth and coupled with our expectations for limited upside valuation potential, suggests muted return prospects,” Vanguard said in its report.
“In our assessment, emerging markets equity valuations are now fair rather than undervalued, and even approaching overvalued when China is excluded.”
“Continued U.S. dollar strength and additional trade policy uncertainty could further limit the upside in emerging markets returns in the near term,” it continued.
Vanguard did note that a China policy “bazooka” could have the potential to significantly and sustainably raise earnings growth prospect for both itself and the broader emerging market region.
But despite the recent policy pivot a few months ago by Chinese authorities, Vanguard said “a more decisive fiscal push will be needed to engineer a meaningful recovery in private confidence and spending”.
