Higher interest rates are here to stay. Even after policy rates recede from their cyclical peaks, in decades ahead we expect rates will settle at a higher level than we’ve grown accustomed to since the 2008 global financial crisis (GFC). This development could usher in a return to sound money, and the implications for the global economy and financial markets may be profound. We expect that borrowing and savings behaviour will be reset, capital will be allocated more judiciously, and asset class return expectations will be recalibrated.

A higher interest rate environment may serve investors well in achieving their long- term financial goals, but the transition may be bumpy. The global economy has proven more resilient than some expected in 2023. This is partly because monetary policy has not been as restrictive as initially thought. Various other factors have blunted the impact of monetary policy, including the U.S. fiscal impulse from debt-financed pandemic support and industrial policies, improved household and corporate balance sheets, and tight labour markets that have resulted in real wage growth.

Outside the U.S., this dynamic is less pronounced. Europe’s predominantly bank- based economy is already flirting with recession, and China’s rebound from the end of COVID-19-related shutdowns has been weaker than expected. In Australia economic activity has slowed, but strong population growth and strong levels of public and private investment have helped keep the economy afloat.

The U.S. exceptionalism is set to fade in 2024. Monetary policy may become increasingly restrictive as inflation falls and offsetting forces wane. The economy will experience a mild downturn as a result. This is necessary to finish the job of returning inflation to target. However, there are risks to this view. A ’soft landing’, in which inflation returns to target without recession, remains possible, as does a recession that is further delayed. In Europe and Australia, growth may weaken as restrictive monetary and fiscal policy lingers, while in China, additional policy stimulus may sustain economic recovery amid increasing external and structural headwinds.

Barring an immediate 1990s-style productivity boom, a U.S. recession is likely a necessary condition to bring down the rate of inflation, through weakening demand for labour and slower wage growth. As central banks feel more confident in inflation’s path toward targets, they may start to cut policy rates in the second half of 2024 (Figure 3).

For well-diversified investors, the permanence of higher real interest rates is a welcome development. It provides a solid foundation for long-term risk-adjusted returns. However, as the transition to higher rates is not yet complete, near-term financial market volatility is likely to remain elevated.

Global bond markets have repriced significantly over the last two years because of the transition to the new era of higher rates. In our view, bond valuations are now close to fair. Despite the potential for near-term volatility, this rise in interest rates may be the best economic and financial development in 20 years for long-term investors. Similarly, the case for the 60/40 portfolio is stronger than in recent history. According to Vanguard, long- term investors in diversified portfolios see a dramatic rise in the probability of achieving a nominal 7% return, from 11% in 2021 to 38% today.

Valuations are most stretched in the U.S. Despite some expected rate relief, the prospect that the higher interest rate environment will last for years may be underappreciated (Figure 4). Within the U.S. market, value stocks are more attractive than they have been since late 2021 and small-capitalisation stocks also appear attractive for the long term. Australian valuations appear more fair, however globally earnings may come under pressure as rate rises weigh on economic output and profit margins ease.