Market Perspectives
Our global survey of economic conditions features a look at divergent expectations for the key U.S. interest rate.
Key highlights
Vanguard believes that the Fed has more work to do to bring inflation to acceptable levels and keep it there.
With each month of labor market resilience, we see increasing risks that wage growth could become stuck at current levels.
Vanguard has lowered our forecast for full-year economic growth in China to 5.5%–6.0%.
Vanguard’s outlook for financial markets
Our 10-year annualized nominal return and volatility forecasts are shown below. They are based on the March 31, 2023, running of the Vanguard Capital Markets Model® (VCMM). Equity returns reflect a 2-point range around the 50th percentile of the distribution of probable outcomes. Fixed income returns reflect a 1-point range around the 50th percentile. More extreme returns are possible.
Notes: These probabilistic return assumptions depend on current market conditions and, as such, may change over time.
Source: Vanguard Investment Strategy Group.
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. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of March 31, 2023. Results from the model may vary with each use and over time. For more information, see the Notes section at the end of this article.
Region-by-region outlook
UNITED STATES
Federal Reserve policymakers have put their interest rate hiking cycle on pause, leaving their target for short-term interest rates at a range of 5.00%–5.25%. But the Fed suggested that it could still hike interest rates by an additional 50 basis points before the end of the year. The Fed’s updated views are consistent with Vanguard’s own view that the Fed has more work to do to bring inflation to acceptable levels and keep it there.
The Consumer Price Index report for May revealed an easing of price pressures. Headline inflation rose by just 0.1% in the month on a seasonally adjusted basis, and by 4.0% compared with a year earlier. Although core CPI (which excludes volatile food and energy prices) rose by a greater-than expected 0.4% and was up by 5.3% year-on-year, private data suggest that prices for used cars and trucks, a leading contributor to core inflation’s gain, are set to fall in the months ahead.
The U.S. labor market sent mixed signals in May. The economy created far more jobs than expected, but the unemployment rate rose from 3.4% to 3.7%. Average hourly earnings growth of 0.3% in May and 4.3% year-on-year was considerably higher than the Fed’s comfort level. With each month of labor market resilience, we see risks increasing that wage growth could become stuck at current levels.
GDP grew at an annualized rate of 1.3% in the first quarter, according to a second estimate from the Bureau of Economic Analysis, higher than its first estimate of 1.1% but lower than the 2.6% growth in the fourth quarter.
EURO AREA
The euro area tipped into recession in the first quarter, based on downward revisions to GDP data for the first quarter of 2023 and the fourth quarter of 2022. Leading indicators suggest that the euro zone will grow modestly in the second quarter, making its energy-induced recession both shallow and short-lived.
We expect a double dip—a second recession following the first—later this year, though risks are rising that it could be pushed into 2024. The second dip would be driven by more restrictive monetary policy, namely the European Central Bank’s interest-rate tightening to quell inflation.
The European Central Bank (ECB) raised the deposit facility rate by 25 basis points to 3.50%, reflecting its “updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission.” We foresee the ECB raising its rate target by an additional 25 to 50 basis points in coming months for a terminal rate of 3.75%–4.00% and no rate cuts until mid-2024.
There is tentative evidence that core inflation has peaked. We expect core inflation to average 4.5% in 2023, ending the year around 3.3%, still well above the ECB’s 2.0% target.
The unemployment rate fell to a record low of 6.5% in the euro area in April and remained at 2.9% in Germany, Europe’s largest economy.
UNITED KINGDOM
Persistent inflation underscores our view that the Bank of England (BOE) will need to raise the bank rate by another 25 or even 50 basis points, to 4.75%–5.00%, before ending the current hiking cycle that began in December 2021.
Although headline inflation fell into single digits in April for the first time since August 2022, the 8.7% year-on-year increase exceeded expectations. The pace of core inflation accelerated to 6.8%, the highest annual increase since March 1992.
Inflation in the U.K. has been stickier than expected. Vanguard expects both headline and core inflation to fall to just above 3.5% by the end of 2023 as more restrictive monetary policy takes hold. Risks have increased that core inflation could stay higher.
We recently revised our forecast for 2023 GDP to no growth—from a previous forecast for a contraction of around 1%—as services demand and wage growth remain resilient.
Our base case remains that a recession will take hold later this year, though the likelihood that it could be delayed in 2024 has risen substantially.
CHINA
Recovery is losing its steam after a strong first quarter driven by the economy’s reopening after COVID-19-related lockdowns. Vanguard has therefore lowered its forecast for full-year economic growth in China to 5.5%–6.0%, from our previous view of 6.0%–6.5%. The recovery has been skewed toward services, and we believe it has been front-loaded.
GDP increased by 4.5% in the first quarter compared with a year earlier, powered by consumers tapping into excess savings after COVID-19 lockdowns in 2022 and outstripping expectations.
As pent-up demand fades and external headwinds intensify, growth will be contingent upon improvement in the labor market and income growth and a gradual recovery of household and business confidence, as well as additional policy support.
With a clearer picture of China’s challenging fundamentals, the People’s Bank of China lowered the one-year medium-term lending facility rate from 2.75% to 2.65%. We expect further mild rate cuts plus targeted easing measures in the coming quarters, though we expect the magnitude of stimulus to be smaller than in previous easing cycles.
Retail sales and industrial production data for May were below expectations.
We have lowered our forecasts for both headline and core inflation for 2023 following a series of weak inflation prints driven by lower energy and pork prices and slowing economic growth. We foresee full-year headline inflation in a range of 1.0%–1.5%, down from our previous forecast of 2.5%, and core inflation of 1.0%, down from our previous forecast of 1.5%.
Chinese households’ appetite for both short- and long-term loans has dried up. It’s a reflection of waning confidence that will heal only gradually.
The decline in credit in 2022 and thus far in 2023 has little to do with credit supply. Rather, it reveals the effect of three years of COVID-19 restrictions and policy uncertainties on China’s psyche.
While businesses’ appetites for long-term loans has surpassed levels of two years ago, we would expect even greater demand if the economy were healthy.
As pent-up demand that fueled a strong first quarter fades and external headwinds intensify, China will depend on improved household and business confidence to spur growth. And that may take time.
Recent weakness in net loan issuance illustrates China’s challenges
Notes: Negative numbers reflect periods when loan repayments exceeded loan issuance. Figures are as of April 30 for each year displayed.
Sources: Vanguard calculations, using People’s Bank of China data as of April 30, 2023, accessed through CEIC. A billion yuan equals about USD 140 million.
Emerging markets
The patterns and risks we’ve seen in developed markets over 2023 are like those we’re seeing in emerging markets. Economies have been resilient, and though inflation is slowing, it’s showing signs of stickiness in the services sector.
Emerging markets led the global rate-hiking cycle, in no small part to defend currencies in anticipation of developed market rate hikes. We would expect emerging markets to lead a global rate-cutting cycle too, but rate cuts may not be set in stone while inflation remains sticky.
We think inflation has peaked in Latin America and possibly in emerging Europe too, but we expect only a gradual decline to levels that will give central banks confidence that they can begin to cut interest rates.
We recently upgraded our forecast for 2023 emerging markets growth from 3.25% to 3.90%, given China’s strong first-quarter growth and resilient activity globally.
We foresee emerging Asia leading the way with 2023 growth of around 5.25%. We anticipate growth in Latin America of about 1.50% and in central Europe, the Middle East, and Africa of around 1.00%. As in many developed markets, the chances are increasing that economic slowdowns could be delayed until 2024.