Over the past decade, US equities have continued to outperform their international peers. The key drivers of this performance gap have been increasing equity valuations, faster corporate earnings growth and US dollar strength beyond the level we think is justified by fundamentals¹. This development leaves the US dollar overvalued and valuations stretched in the US but fair in most other regions. As such, we think there is an increasing likelihood of greater investment opportunities outside the US equity market over the coming years.

The likely prospect of downside pressure on US equity valuations combined with slower corporate earnings growth due to a compression of profit margins has led us to modestly lower our forecast for long-term US equity returns compared to last year and, consequently, also the forecast for global ex-UK equities. The chart below shows our 10-year annualised return expectations for different equity markets and how they compare with our forecasts from the end of 2022.

Expected 10-year annualised asset class returns for UK investors

Notes: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualised nominal returns in British pounds for the asset classes highlighted here. The median 10-year annualised nominal returns as at the end of last year (green bars). Median volatility is the 50th percentile of an assets class's distribution of annualised standard deviation of returns. Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect the reinvestment of income and capital gains. Indices are unmanaged; therefore, direct investment is not possible. Benchmarks used for asset classes: UK equities: MSCI UK Index; Global ex-UK equities: MSCI AC World ex-UK Index; US equities: MSCI US Broad Market Index; Emerging market equities: MSCI EM Index.

Source: Vanguard calculations in British pounds, as at 30 September 2023.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as at 30 September 2023 and 31 December 2022. Results from the model may vary with each use and over time. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Below-trend earnings growth could suppress equity returns

In the coming years, we expect profit margins—which globally have increased beyond the high levels reached in the run-up to the global financial crisis (GFC) of 2008—to weaken as the impact of government stimulus following the Covid-19 pandemic fades. This increase helped to cushion earnings in recent years – for a fixed amount of revenue, companies could retain a large share as profits – but also sets the stage for lower earnings growth going forward.

Consequently, in the decade ahead, our forecast is for annualised earnings growth of 2.2% for UK equities and 4.1% for global ex-UK equities, supported by an expected growth rate in the US that is well below that of recent years but still higher than elsewhere.

Weakening of profit margins likely to weigh on earnings growth

Past performance is not a reliable indicator of future results.

Notes: The chart shows the profit margins (calculated as earnings divided by net revenue) of the MSCI UK and the MSCI USA indices (solid lines) and the historical average since 31 December 1999 (dotted lines).

Source: Vanguard calculations based on data from Refinitiv and Bloomberg, as at 31 October 2023.

UK equities overvalued in current environment

Over the long term, our analysis shows that equity prices trade within a fair-value range that depends in part on the macroeconomic environment. Lower rates of interest and inflation increase the level of justifiable valuations; higher rates of interest and inflation have the opposite effect.

More than a decade of low rates and low inflation followed the GFC, boosting our fair-value estimates for equities. But the rapid monetary tightening aimed at bringing down inflation has more than reversed the valuation support provided by an era of easy money.

Looking ahead, we believe that the Bank of England and other central banks will win the fight against inflation. We expect short- and long-term interest rates to recede from their peaks but settle at higher levels than we’ve become accustomed to. As a result, our estimates of equities’ fair value will increase and, for UK equities specifically, almost reach their fair-value levels from the past decade again.

Our views are reflected in increasing expected valuations in our annualised 10-year euro area equity return forecast. Reasonable price/earnings ratios today, coupled with some level of expected rate relief, imply that equity valuations could increase by 0.8% per year, on average, and still remain in our median fair value range.

Fair value of UK equities expected to recover

Notes: The chart shows the cyclically adjusted price/earnings (CAPE) ratio for UK equities, measured by the MSCI UK Index. CAPE reflects contemporaneous real equity prices and 10-year average historical real earnings. The chart also shows our estimates of fair value, considering inflation and interest rates. Our historical fair-value estimates are based on actual levels of inflation and interest rates and reflect underlying data since 31 December 1969, while our 10-year fair-value forecast considers our expectations for inflation and rates.

Source: Vanguard calculations, based on data from Refinitiv and Global Financial Data, as at 30 September 2023.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

A solid foundation for diversified long-term investors

Despite the mixed picture for different equity markets, Vanguard believes that a higher interest rate environment will serve long-term investors well, but the transition may be bumpy. For those with an appropriate risk tolerance, a more defensive risk posture may make sense given increased expected fixed income returns and global equity markets that are yet to fully reflect the implications of the return to sound money. 

Due to the long-term nature of our valuations and forecasting frameworks, over- or undervaluation should not, in itself, suggest a short-term action on the part of investors. This underscores the challenges facing investors who tilt their portfolios heavily in one direction. We believe that a rigorous investment approach, combined with the principles of broad diversification aligned with the investor’s goals and constraints, offers the best chance of success.

Read the full report to find out how our long-term asset return expectations have changed, including for multi-asset portfolios.

Watch the Vanguard economic and market outlook for 2024 webinar for further insights, including a Q&A with Vanguard economists.

¹ From 30 November 2013 to 30 November 2023, the price/earnings ratio increased by 2.8% (annualised) for the MSCI USA Index and decreased by 0.8% (annualised) for the MSCI All Country World ex USA Index; annualised earnings growth was 6.7% for the MSCI USA Index and 1.6% for the MSCI All Country World ex USA Index; the US dollar appreciated by close to 3% (annualised) against a basket of the currencies of the largest constituent regions of the MSCI All Country World ex USA Index.

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Important information

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The information contained herein is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

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