Vanguard economic and market outlook: Midyear 2022 update

From

Andrew Patterson

This update highlights some of the major developments and changes since we released our 2022 economic and market outlook in December 2021.

Inflation, policy elevate the risk of recession

A lot has changed since Vanguard published its economic and market outlook for 2022, Striking a Better Balance. At the start of the year, we expected global economies to continue to recover from the effects of the COVID-19 pandemic but at a more modest pace than in 2021. While that holds true, the pace of change in macroeconomic fundamentals such as inflation, growth, and monetary policy has failed to live up to expectations.

Labour and supply-chain constraints were already fueling inflation before the year began, but Russia’s invasion of Ukraine and China’s zero-COVID policy exacerbated the situation. Central banks have been forced to play catchup in the fight against inflation, ratcheting up interest rates more rapidly and possibly higher than previously expected. But those actions risk cooling economies to the point that they enter recession.

“Global economic growth will likely stay positive this year, but some economies are flirting with recession, if not this year, then in 2023,” said Andrew Patterson, Vanguard senior international economist.

Compared with the start of the year, Vanguard has downgraded its 2022 GDP growth forecasts for all the major regions, increased its inflation forecasts, and become more hawkish about monetary policy.

United States

In the United States, inflation has reached 40-year highs, eroding consumers’ purchasing power and driving the Federal Reserve to aggressively raise interest rates. We expect the equivalent of 12 to 14 rate hikes of 25 basis points for the full year, with the target federal funds rate landing in the 3.25%–3.75% range by year-end. We expect a terminal rate of at least 4% in 2023—higher than what we consider to be the neutral rate (2.5%) and above what’s currently being priced into the market. (The neutral rate is the theoretical rate at which monetary policy neither stimulates nor restricts an economy.)

We have downgraded expected U.S. GDP growth from about 3.5% at the start of the year to about 1.5%. The factors that led to our downgrade will likely continue through 2022—namely, tightening financial conditions, wages not keeping up with inflation, and lack of demand for U.S. exports. Labor market trends are likely to keep downward pressure on the unemployment rate through year-end, though increases in 2023 are likely as the impacts of Fed policy and slowing demand take hold. We assess the probability of recession at about 25% over the next 12 months and 65% over 24 months. We believe that a period of high inflation and stagnating growth is more likely than an economic “soft landing” of growth and unemployment rates around or above longer-term equilibrium levels (about 2% for growth and 4% for unemployment).

Australia

Australia’s status as a commodities exporter has partly insulated it from the some of the economic woes elsewhere, but global factors and rising inflation still have an impact. Broad-based and persistent inflation has the Reserve Bank of Australia on course to raise its target rate by more than 2 percentage points in 2022. The labour market is robust, with the unemployment rate falling to a historical low. It should stabilise as growth slows, but upward pressure on wages is likely to persist for a while. A recession isn’t likely in Australia unless major developed markets fall into recession first. We’ve reduced our growth forecast by a percentage point from the start of the year, to 3%–3.5%.

China

China will fall far short of policymakers’ growth target of about 5.5%, given that it’s a challenge to achieve all three of their goals: the growth target, financial stability, and a zero-COVID policy. (The latter affects not just China’s economy, but the global economy as well.) We believe the actual 2022 GDP growth rate will be just above 3%, far below China’s pace for many years. Given China’s zero-COVID policy, additional outbreaks resulting in renewed lockdowns could further detract from growth. That said, recession is unlikely, with probability at 30% over 12 months and 35% over 24 months.

Euro area

In the euro area, headline inflation driven by high energy prices may spike to above 10% in the third quarter. Inflation has become widespread, spurring the European Central Bank into what it expects will be a “sustained path” of interest rate increases. In September, rates will likely be out of negative territory for the first time in a decade. We forecast economic growth to be about 2% to 3% for the full year. However, Europe’s dependence on Russian natural gas and the challenges of managing monetary policy for 19 countries put the euro area at a higher risk of recession than the United States in the next 12 months. A complete cutoff from Russian gas would likely lead to rationing and recession. We assess the probability of recession around 50% over 12 months and 60% over 24 months.

United Kingdom

In the United Kingdom, energy prices will likely drive the headline inflation rate to roughly 10% late in the year. We expect the Bank of England to raise the bank rate by an additional 1.25 percentage points over the next 12 months to reach our estimate of a 2.5% neutral rate. The bank has signaled that it’s prepared to enact larger than 25-basis-point rate hikes, depending on the economic and inflation outlook.

Even with rising inflation and a slowing economy, the labor market will likely stay strong, given record job vacancies and unemployment near a 50-year low. But a drop in real wages, combined with diminished consumer and business confidence and tightening financial conditions, could push the United Kingdom into recession. Vanguard sees the probability of recession at about 50% over the next 12 months and 60% over 24 months. For 2022, we’ve downgraded our 5.5% forecast at the start of the year to 3.5%–4%. Further out, the pending leadership change in the U.K. may bring some policy uncertainty.

Emerging markets

We recently downgraded our forecast for fullyear 2022 growth in emerging markets, from about 5.5% at the start of the year to about 3%. Emerging markets continue to face headwinds from slowing growth in the United States, the euro area, and China, as well as from developed markets’ central bank tightening and from domestic and global inflation. Although higher commodities prices do benefit some emerging economies, they’re a negative in the aggregate.

Expected 10-year asset class returns have risen

Stock and bond markets have been hit hard so far in 2022. But there is an upside to down markets: Because of lower current equity valuations and higher interest rates, our model suggests higher expected long-term returns than our forecasts as of year-end. For U.S.-based investors, our latest 10-year annualised return forecasts are in the 3.4% to 5.4% range for U.S. stocks, 6.1% to 8.1% for international stocks, 3% to 4% for U.S. bonds, and 2.9% to 3.9% for international bonds (hedged in U.S. dollars). The figures are based on a 1-point range around the 50th percentile of the distribution of VCMM return outcomes for equities and a 0.5-point range around the 50th percentile for bonds.

For Australian investors, our 10-year annualised return forecasts are 3.5% to 5.5% for Australian stocks and 4.8% to 6.8% for international (exAustralia) stocks; 3.1% to 4.1% for Australian bonds and 3.3% to 4.3% for international (ex-Australia) bonds when hedged in Australian dollars.

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