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2023 focus: Central banks, energy, inflation, markets

Vanguard Economic and Market Outlook for 2023: Beating Back Inflation is scheduled to be released in the United States on December 12.


The report examines four key themes that we expect will shape the economic environment as we move into 2023: central banks’ vigilance in the fight against inflation, the economic effects of the energy crisis in Europe, China’s long-term structural challenges as it aims to end its zero-COVID policy, and a more positive outlook for long-term investors.


Fighting inflation: Central banks maintain vigilance

The last year has proven to be one of the most rapidly evolving economic and financial market environments in history. Across the globe, central banks have responded with coordinated monetary policy changes that have outpaced anything we’ve seen for several decades.


A globally coordinated monetary tightening regime

Note: Dotted lines represent market-based expectations for future policy rates as of October 31, 2022.

Sources: Thomson Reuters Datastream and Bloomberg.


“This is the greatest inflation threat we’ve seen since the 1980s,” said Josh Hirt, a Vanguard U.S. senior economist. “Central banks have a difficult path ahead that will require being more aggressive with policy, making additional rate hikes, and maintaining vigilance as the inflation situation shifts. In the U.S., the Federal Reserve has adopted the position that there is still work to be done, and it appears to have the resolve to stick with it.”


Vanguard estimates that about half of the upward pressures on inflation globally are the result of supply, brought on by the lingering effects of pandemic-era impacts on supply chains and the war in Ukraine. The other half is caused by demand, which restrictive monetary policy is intended to alleviate. Support for policy tightening could wane in 2023, however, particularly if economies slow to the extent that corporate belt tightening leads to large-scale layoffs, Hirt said. 


“To solve the inflation issue, the Fed really does need to slow economic activity,” he said. “We think the available window for the Fed to raise rates enough to cool inflation but not enough to induce a recession is very narrow.” 


Central banks typically seek to avoid recessions, but current inflation dynamics leave policymakers with little choice but to tighten financial conditions to try to stabilize prices. In 2023 our base case is one of disinflation, but at a cost of a global recession. 


Canada’s economy: Energy prices, real estate, and global spillovers


The housing market will remain a vulnerability for economic growth in Canada in 2023. We expect Canada to experience a mild recession, with full-year growth around 0.7%. Global economic and geopolitical developments, especially those in the U.S., will help define Canada’s economic outcomes. 


Key downside risks to our view are the spillovers of global recession to Canada’s export economy. Energy price volatility or supply chain shocks may delay a normalization of inflation, causing financial conditions to remain tight for longer. This alongside monetary policy tightening may lead to a deeper recession than we expect now, given Canada’s record household leverage and declining housing price fundamentals and household wealth. We see a soft landing as unlikely but continue to watch Canada’s labor and real estate markets as economic conditions evolve.



Energy crisis in Europe: Challenges are likely to continue


The war in Ukraine added to European uncertainty, market volatility, and price pressures in 2022. Sharply higher natural gas prices contributed to the tighter financial conditions and depressed sentiment that we believe will have pushed the euro area into recession in the fourth quarter. 


We’re encouraged by Europe’s nimble adaptation to a sharp reduction in Russian gas imports. As the chart below shows, substitutions to supply in 2022 came from a combination of other fuels, renewables, supply from other sources, and existing storage. Even as those options soften the blow, we expect that gas demand will have to contract by about 15% this winter relative to last year. 


European gas imports: How the gap will be plugged

Sources: International Energy Agency, European Commission, and Vanguard estimates, as of October 31, 2022.


“A large reason why the 2022 European gas supply is more comfortable than expected is that many nations were able to fill gas storage facilities ahead of time, while Russian gas was still flowing,” said Shaan Raithatha, U.K./Europe senior economist at Vanguard. “Next year they’ll be starting from a much lower base, which could present a challenge in the middle or later part of 2023.” In the longer term, the extent of European gas shortages will be determined by the ability of countries to secure alternative energy supplies at a reasonable price. 


In the shorter term, high energy and food prices will continue to weigh on real household disposable incomes, while uncertainty about the war in Ukraine will impact consumer confidence. “As in the United States, there are tentative signs now that inflation in Europe has peaked,” Raithatha said. “But we still expect price pressures associated with the labor market and wage growth to be stubbornly high as we move into next year.” 


We project that inflation will have peaked around 11% and remain well above the European Central Bank’s 2% target in 2023. In response, we expect the ECB to continue to increase its deposit rate through the first quarter of 2023 to reach 2.5%. 



China’s economy in 2023: A cyclical bounce amid structural challenges


China’s zero-COVID policy and a contraction in the real estate sector have been significant drags on growth in 2022. We forecast GDP growth to end 2022 around 3%, well below the historical average and the official “around 5.5%” target. For 2023, we foresee GDP growth accelerating to around 4.5%, driven by a modest loosening in the zero-COVID policy and a stabilizing real estate sector.


“COVID is one of the factors that’s going to dominate the economy in the coming months,” said Qian Wang, Vanguard Asia-Pacific chief economist. “The Chinese exit from zero-COVID is going to be bumpy, as witnessed by the recent lockdowns in big cities like Chongqing, Guangzhou, and Beijing. China needs to prepare for reopening by promoting vaccine and drug development, improving hospital facilities, and changing the mass perception of COVID. It cannot afford to abolish its zero-COVID policy outright, and it could be several months before it can relax it meaningfully.” 


Meanwhile, we expect a protracted downturn in housing investment over the next five to 10 years. 

“Declining affordability, an aging population, reduced urbanization, and a policy stance that ‘housing is for living in, not for speculation’ will push real estate demand structurally lower,” Wang said. Supportive fiscal and monetary policy will help boost demand, she said, but “even as the government relaxes regulations on the housing market, we don’t expect a rebound to be sharp.”


Despite easing regulation, the housing market is unlikely to rebound because of a structural downturn


Housing remains oversupplied in China, with increased demand providing only a slight offset to supply growth.


Cyclical factors will provide near-term support to housing, but structural factors will lower demand over the next 5 years.


Source: Vanguard calculations, based on data from Bloomberg, as of October 31, 2022.


Finally, China is on the wrong side of a global supply chain restructuring. Multinational firms are looking to reduce dependence on strategic competitors, which threatens China’s long-term export dominance. “This will challenge China’s ability to attract and retain top talent, and could crimp innovation,” Wang said. “To compensate, China is turning its focus to ‘indigenous innovation’ and ‘internal circulation’ so it can continue to grow domestically.” 


A more sanguine outlook for long-term investors


Late in 2021 we emphasized that high equity valuations and low interest rates had not yet reflected the seriousness of growing inflationary pressures, which created a fragile backdrop for markets. It wasn’t until mid-2022 that markets were forced to accept a new economic reality of persistently rising inflation. A resulting combination of rising discount rates, geopolitical shocks, and slowing growth led to a stubborn global sell-off that spanned asset classes.


Our longer-term outlook for developed markets is significantly improved from just a year ago. Fixed income investors felt the near-term pain of rising interest rates, but higher starting interest rates have considerably raised our return expectations for global bonds. For global equity investors, lower valuations are much more conducive to higher long-term returns compared with this time last year. Our annualized projections for the next decade have increased by around 2 percentage points for both global bonds and global equities. 


In response to a persistently strong inflation environment in the U.S., “we’ve seen extraordinary hawkishness from the Federal Reserve that has increased the nominal U.S. yield curve to a level not seen since 2011,” said Kevin DiCiurcio, research team lead for the Vanguard Capital Markets Model. Over the next decade, we expect an annualized return of 4%–5% for global bonds ex-U.S. and 4.1%–5.1% for U.S. bonds. That’s a 2.7-percentage-point increase over last year’s projection for each bond category. This means that for investors with an adequately long time horizon, we expect their wealth to be higher by the end of the decade than our year-ago forecast would have suggested.


The chart below reflects Vanguard’s forecasts for the U.S. bond market; however, similar trajectories hold true across the developed world.


We expect investors to be better off because, not in spite, of the sell-off

Notes: The chart shows actual returns for the Bloomberg U.S. Aggregate Bond Index along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as of December 31, 2021, and September 30, 2022. The dotted lines represent the 10th and 90th percentiles of the forecasted distribution. Data are as of September 30, 2022. 

Sources: Vanguard calculations, using September 30, 2022, VCMM simulation, and Bloomberg. 

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 December 31, 2021 and September 30, 2022. Results from the model may vary with each use and over time. For more information, please see the “Important information” section. 

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. 


On the U.S. equity side, the stretched valuations we’ve seen in recent years were unsustainable in the context of the domestic inflation and interest rate environment. U.S. market equity indexes all posted losses greater than 20% in the first nine months of 2022, as did developed international and emerging-market equity indexes. Current U.S. valuations are more attractive than they were last year, but some near-term caution for U.S. equities may still be warranted. “U.S. equity valuations are still above our estimates of fair value, and long-term return expectations are somewhat below historical averages in the U.S.,” DiCiurcio said. “We’d have to see valuations come down a little further to push expectations closer to historical average ranges.” Even so, we expect U.S. equities to return 4.7%–6.7% over the next 10 years, a 2.4-point increase over last year’s projection. 


Of notable mention were the simultaneous declines of stock and bond markets in 2022. Although not unusual, periods of concurrent negative returns are infrequent—and painful to experience. Our research finds that such correlations can move aggressively over shorter time horizons but that it would take long periods of consistently high inflation for long-term correlation measures—those that more meaningfully affect portfolio outcomes for a long-term investor—to turn positive. In short, a portfolio diversified across asset classes remains an effective tool to manage risk tolerance across a long-term time horizon. 


  • Notes: 

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. 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. Diversification does not ensure a profit or protect against a loss. 

Investments in bonds are subject to interest rate, credit, and inflation risk. 

Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets. 

IMPORTANT: The projections and 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 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, 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. 


Publication date: December 2022  

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