Valuations in focus
Bonds remain in favor in time-varying model portfolio
April 25, 2025
The U.S. equity market fell by 4.8% in the first quarter amid uncertainty related to tariffs and trade negotiations. Meanwhile, developed markets outside the U.S., led by Europe, rallied, returning 5.8%, driven by expectations for increased defense spending and prospects of a deal to end the war in Ukraine. Emerging markets returned 1.2% as China increased domestic stimulus amid renewed business confidence and improved investment prospects.1
With the mixed results, global equity valuations remained elevated. Our time-varying asset allocation (TVAA) for March remained risk-off, with an overall 36% equity allocation, given a historically low global equity risk premium. Still, that’s an increase of 5 percentage points over our year-end 2024 portfolio, with most of the increase going to U.S. value-oriented equities.
Within fixed income, the TVAA portfolio maintained most of its positioning from year-end 2024, with the notable change of an allocation away from intermediate-term credit bonds and into U.S. aggregate bonds. The reallocation was primarily the result of three factors: 1) historically tight credit spreads; 2) the longer average maturity of the Bloomberg U.S. Aggregate Bond Index, better insulating it from reinvestment risk associated with expectations for generally declining interest rates in the coming years; and 3) more favorable correlations relative to the portfolio’s equity asset classes given a similar return outlook.
On the equity side, value and developed markets remained more attractive than growth and emerging markets even as they outperformed their counterparts by a sizable margin in the quarter.
Surprises that affected our outlook in the first quarter were larger- and earlier-than-expected tariff increases and more elevated and widespread policy uncertainty. At quarter-end, the market was expecting three Federal Reserve interest rate cuts this year as the growth outlook softened, up from 1.75 cuts at year-end 2024.
The TVAA strategy is built on the framework of the Vanguard Asset Allocation Model (VAAM), driven by forecasts generated by the Vanguard Capital Markets Model® (VCMM). The TVAA provides a model portfolio that optimizes for higher expected risk-adjusted returns over the next decade. The TVAA is not intended to be a tactical tool used in pursuit of short-term gains. It is better thought of as a dynamic allocation based on long-term risk-return relationships, driven by current market conditions.
Further, the TVAA portfolio is intended to be informational, free from real-world constraints such as trading costs and tax consequences of recalibrating the portfolio. An investor’s goals, risk tolerance, tax situation, and preferences are important factors in determining whether the TVAA portfolio is suitable for implementation.
The TVAA strategy is also geared toward those who are comfortable with model risk—a form of active risk in which the forecasts generated by the model may not be fully realized. Nevertheless, the TVAA portfolio is useful in helping investors make informed decisions about portfolio construction and will differ from quarter to quarter as our capital market forecasts evolve over time.
For valuation-aware investors with the requisite risk tolerance, our model points to bonds
Notes: Time-varying portfolio allocations were determined by the Vanguard Asset Allocation Model (VAAM). The assets under consideration were U.S. and non-U.S. equities and fixed income, as well as real estate investment trusts (REITs), U.S. high-yield corporate bonds, and emerging markets equities, which were used to illustrate time-varying allocation not only within equities versus fixed income but also within sub-asset classes. See the notes that accompany VCMM forecasts for additional details on asset class indexes. A minimum home-bias constraint of 60% was applied for U.S. equities, and 70% was applied for U.S. fixed income. VCMM 10-year projections as of March 31, 2025, were used. The sum of individual sub-asset class allocations may not total 100% because of rounding.
Source: Vanguard calculations, as of March 31, 2025.
Portfolio characteristics
Notes: Vanguard calculations are based on portfolios optimized by the VAAM, using return projections from the VCMM. Sharpe ratio is a measure of return above the risk-free rate that adjusts for volatility. A higher Sharpe ratio indicates a higher expected risk-adjusted return. Expected maximum drawdown is the median peak-to-trough drop in the portfolio’s value in 10,000 VCMM simulations. The probability of underperforming the benchmark is in any given year.
Source: Vanguard calculations, as of March 31, 2025.
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 VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of March 31, 2025. Results from the model may vary with each use and over time. For more information, please see the Notes section below.
1 First-quarter returns for the U.S., developed markets outside the U.S., and emerging markets are based on the CRSP US Total Market Index, the FTSE Developed All Cap ex US Index, and the FTSE Emerging Markets All Cap China A Inclusion Index, respectively.
Notes: All investing is subject to risk, including the possible loss of the money you invest.
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.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (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. 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 importantly, 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 U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, U.S. municipal bonds, 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 time. Forecasts represent the distribution of geometric returns over different time horizons. Results produced by the tool will vary with each use and over time.