The last mile to target inflation may take some time
There’s progress in the fight against inflation. But it’s too early to declare victory. Vanguard foresees developed market core inflation (which excludes food and energy prices) continuing to fall through the end of 2023 from recent generational highs. But we expect it will be late 2024 or even 2025 before inflation falls back to central banks’ targets, which are mostly around 2%.
“We believe central banks have more work to do,” said Andrew Patterson, Vanguard senior international economist. “We’ve always said inflation wouldn’t come down magically, even as post-pandemic supply chain issues were resolved. The pandemic accelerated demographics-driven changes to labor markets. Strong demand for workers who can command higher pay than historical standards requires monetary policy that is clearly restrictive. The last leg of inflation reduction to central bank targets may be the most challenging.”
That last leg is also likely to vary by region, said Rhea Thomas, a Vanguard economist. “The initial catalysts for the surge in inflation were global in nature,” Thomas said. “The pace at which inflation travels that last mile to target will depend more heavily on local drivers: how restrictive policy tightening is in each country or region, and local demand, labor market, and housing dynamics.”
Thomas noted that central banks in Australia, Canada, and now the United States have paused in what had been a relentless cycle of rate hikes. Hikes have since resumed in Australia and Canada, and the Federal Reserve policymakers have hinted they will resume lifting rates as well.
Inflation, policy elevate the risk of recession
In the United States, the recovery from the shortest recession in more than 150 years—a two-month downturn in early 2020—has endured one of the most aggressive interest rate-hiking cycles in Federal Reserve history. Recent growth has been stable at about 2%, annualized. We still assign a high probability to a recession, though the odds have risen that it could be delayed from 2023 to 2024. Shelter inflation should slow in the second half of 2023 and return to its pre-pandemic pace by 2024. Slowing momentum in labor markets should also lower ex-shelter services inflation later this year.
In our initial outlook for 2023, we described a weakening of the labor market (along with slowing growth) as a necessary condition for falling rates of inflation. The labor market has had its own idea, remaining resilient even as disinflation has continued. Unemployment remains below 4%, where it stood when the Fed started its current rate-hiking cycle. We continue to expect some softening.
Given the long and variable lags between monetary policy shifts and discernible changes in economic activity, Federal Reserve policymakers could decide that the 500 basis points (5 percentage points) of interest rate hikes they’ve enacted since March 2022 are enough to knock inflation down to their 2% target. But we view at least one more rate increase as probable.
Notes: The figure shows year-over-year changes in the core consumer price index (CPI) for all locations except Australia, where it shows trimmed mean CPI. Year-end 2023 figures are Vanguard forecasts.
Source: Vanguard calculations, using data from the U.S. Bureau of Labor Statistics, Statistics Canada, Eurostat, the U.K. Office for National Statistics, and the Australian Bureau of Statistics, accessed through Macrobond on June 15, 2023.
*Inflation forecasts are for core inflation, which excludes volatile energy and food prices, except for Australia, where we measure headline inflation, which includes food and energy.
**Our forecast for the United States year-end monetary policy rate reflects the low end of the Federal Reserve's federal funds target range.
Notes: Figures related to economic growth, inflation, monetary policy, and unemployment rate are Vanguard forecasts for the end of 2023. Growth and inflation are comparisons with the end of the preceding year; monetary policy and unemployment rates are absolute levels.
Source: Vanguard, as of June 26, 2023.
Expected 10-year asset class returns
Equity markets around the world generally have rallied strongly—with the notable exception of China, the dominant emerging market by total value—since we issued Vanguard Economic and Market Outlook for 2023: Beating Back Inflation. For most investors around the world, the gains have reduced the expected returns of global equities, excluding local markets.
Bond markets worldwide also generally have recorded solid gains—if only in nominal, not inflation-adjusted terms—since late 2022. Relative to our initial forecast, expected returns generally declined slightly.
Our forecasts are derived from a May 31, 2023, running of the Vanguard Capital Markets Model®. Figures are based on a 2-point range around the 50th percentile of the distribution of return outcomes for equities and a 1-point range around the 50th percentile for fixed income.
Following are our 10-year annualized return forecasts. Forecasts are from the perspective of local investors in local currencies.
U.S. stocks: 4.1% to 6.1%; ex-U.S. stocks: 6.5% to 8.5%.
U.S. bonds: 3.8% to 4.8%; ex-U.S. bonds: 3.7% to 4.7% when hedged in U.S. dollars.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss in a declining market. 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. Past performance is no guarantee of future results.
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.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
About the Vanguard Capital Markets Model
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 Investment Strategy Group. 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. 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.
The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk–return trade-offs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered, such as the data presented in this paper, is the most effective way to use VCMM output.
The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognize that the VCMM does not impose “normality” on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths. Indeed, this is a key reason why we approach asset-return outlooks in a distributional framework.
Indexes used in Vanguard Capital Markets Model simulations
The long-term returns of our hypothetical portfolios are based on data for the appropriate market indexes as of December 31, 2021; December 31, 2022; and May 31, 2023. We chose these benchmarks to provide the most complete history possible, and we apportioned the global allocations to align with Vanguard’s guidance in constructing diversified portfolios. Asset classes and their representative forecast indexes are as follows:
U.S. equities: MSCI US Broad Market Index.
Global ex-U.S. equities: MSCI All Country World ex USA Index.
U.S. aggregate bonds: Bloomberg U.S. Aggregate Bond Index.
Global ex-U.S. bonds: Bloomberg Global Aggregate ex-USD Index.
Canadian equities: MSCI Canada Total Return Index.
Global ex-Canada equities: MSCI All Country World Index ex-Canada in CAD.
Canadian aggregate bonds: Bloomberg Canadian Issues 300MM Index.
Global ex-Canada bonds: Bloomberg Global Aggregate ex-Canada Index (CAD Hedged).
Euro area equities: MSCI European Economic and Monetary Union (EMU) Index.
Global ex-euro area equities: MSCI AC World ex EMU Index.
Euro area aggregate bonds: Bloomberg Euro-Aggregate Bond Index.
Global ex-euro area bonds: Bloomberg Global Aggregate ex Euro Index.
UK equities: Bloomberg Equity Gilt Study from 1900 through 1964, Thomson Reuters Datastream UK Market Index from 1965 through 1969; MSCI UK thereafter.
Global ex-UK equities: S&P 90 Index from January 1926 through March 3, 1957; S&P 500 Index from March 4, 1957 through 1969; MSCI World ex UK Index from 1970 through 1987; MSCI AC World ex UK thereafter.
UK aggregate bonds: Bloomberg Sterling Aggregate Bond Index.
Global ex-UK bonds: Standard & Poor’s High Grade Corporate Index from 1926 through 1968, Citigroup High Grade Index from 1969 through 1972, Lehman Brothers US Long Credit AA Index from 1973 through 1975, Bloomberg US Aggregate Bond Index from 1976 through 1990, Bloomberg Global Aggregate Index from 1990 through 2001; Bloomberg Global Aggregate ex GBP Index thereafter.
Australian equities: MSCI Australia Index.
Global ex-Australia equities: MSCI All Country World ex-Australia Index.
Australian bonds: Bloomberg Australian Aggregate Bond Index.
Global ex-Australia bonds: Bloomberg Global Aggregate ex-AUS Bond Index.
Mexico equities: MSCI Mexico Index.
Global ex-U.S. developed market equities: MSCI World ex US Index.
Mexico sovereign bonds: S&P/BMV Sovereign MBONOS Bond Index.
Global bonds ex-Mexico: Bloomberg Global Aggregate Index.