Vanguard’s international economic outlook – second-quarter 2023

Recession risks

Last time, I updated Vanguard’s outlook for the Canadian economy, and showed how central banks in major economies are still emphasizing the importance of adhering to a tight monetary policy to meet their inflation targets. This, along with stress in the banking sector will likely constrain global growth through 2023 and the first half of 2024. However, growth is expected to increase in 2025 as the effects of policy tightening fade.

With this backdrop, Vanguard expects slower growth across all major economies and regions, except emerging markets, particularly, China. We foresee 2023 U.S. growth of around 0.75% during 2023 with risk of declines in consumption driven by lower purchasing power, coupled with labor and non-labor supply side constraints keeping inflation elevated.

For the Euro area economy, our base case remains a recession in the second half of the year and full-year GDP growth around 0.5%. The Chinese economy is in full bounce-back mode in the months after its post-pandemic reopening, based on the latest data. Given the strength in Q1 data released, we have improved our outlook for China’s full-year economic growth from 5.3% to 6.4%. We have upgraded our outlook from emerging markets, particularly emerging Asia, upgrading our forecast for 2023 emerging markets GDP growth from about 3% to about 3.25%.

Since stresses in the U.S. banking system became apparent with the closure of Silicon Valley Bank on March 10, financial markets have been pricing in Federal Reserve interest rate cuts. According to Atlanta Fed’s market probability tracker, markets as of April 13 expected the equivalent of two quarter-point cuts to the Fed’s federal funds rate target this year. On May 3, the U.S. Fed raised its target for the federal funds rate by 25 basis points to a range of 5%-5.25%. and on June 8 decided to maintain the target range at that level.

We believe that the data will lead the Fed to raise rates by at least an additional 25 basis points. We continue to closely monitor the same indicators that we were observing prior to the onset of banking stresses, i.e., the strength of the labour market, the potential for accelerated wage gains, and the stickiness of core inflation. Given continued resilience in all these areas, we expect the Fed to remain hawkish. We believe the Fed will hold its terminal rate for at-least the remainder of 2023. We do not foresee rate cuts before 2024.

Headline inflation, as measured by the Consumer Price Index, continued to decelerate, registering 4.9% in April 5.0%, year over year versus a 5% expectation. This is down from 5% in March and 5.5% in February.

Gross domestic product (GDP) grew at an annual rate of 2.6% in the fourth quarter of 2022, according to the third estimate by the Bureau of Economic Analysis, down from 3.2% growth in the third quarter. Advance estimate for first-quarter 2023 by the bureau suggests an annualized growth rate of 1.1%. We continue to foresee 2023 U.S. growth of around 0.75%. A recession in the second half of the year remains our base case.

Labour market remains strong as the economy created 253,000 non-farm jobs in April, and the unemployment rate decreased to 3.4%.

Key risks

1. Declines in purchasing power of the US consumer continue to present a significant threat to the economic activity

2. Labor and non-labor supply side constraints last through 2023 keeping inflation elevated and dual mandate in conflict

3. Geopolitical risks, ensuing high energy prices and a Fed policy misstep resulting in a recession and/or stagflation also remain as key risk factors for the economy

Rest of the world

Europe. Our base case for the Euro area economy remains a recession in the second half of the year and full-year GDP growth around 0.5%. Although activity data have been stronger than expected, we see a further tightening in both financial and credit conditions as a strong opposing force.

Headline inflation slowed to 6.9% in March compared with a year earlier, far lower than an 8.5% year-over-year reading in February, primarily due to falling energy prices. Vanguard continues to expect core inflation to peak in a range of 5.5%-6% in the next few months before fading in the second half of the year as the effects of higher interest rates work their way through the economy. We foresee core inflation averaging 4.5% in 2023 and ending the year around 3.3% - still solidly above the European Central Bank’s (ECB’s) 2% target.

China. The latest data on GDP, retail sales, and exports portray a Chinese economy in full bounce-back mode in the months after its post-pandemic reopening. Given the strength in Q1 data released, we have improved our outlook for China’s full-year economic growth from 5.3% to 6.4%. With consumer confidence on the mend and credit growth accelerating, there is scope for a further pickup in activity over the coming quarters. China’s official target is for the economy to grow “around 5%” in 2023.

Emerging markets. Increasing business and consumer confidence, as measured by Vanguard’s proprietary index of leading economic indicators, suggests continued economic resilience in emerging markets, especially emerging Asia. We recently improved our forecast for 2023 emerging markets GDP growth from about 3% to about 3.25% and see risks skewed toward further upside, especially if measures of optimism translate into real economic data.

Future expected returns¹

Looking ahead, our fair-value projections reveal a global equity market that has gone through a significant price correction since November 2021 and is still likely to produce healthy returns, over the next 10 years. With market anticipation of lower interest rates across the yield curve, however, our total return expectations for bonds have slightly decreased compared to the last quarter.

Canadian and global equities. With sizable reductions in equity values across the Canadian and global markets since last year, we maintain a positive long-term outlook for equity returns. Our median 10-year returns expectations for Canadian equities at the end of March 2023 are in a range of 4.6% to 6.6%, about 1.10% higher than our mid-year 2022 estimate and unchanged from the fourth-quarter 2022 levels. For global stocks (ex-Canada, unhedged) our forecasts have slightly reduced, by nearly 10 basis points to a 4.3%-6.3% range, compared to mid-year 2022 and by around 30 basis points compared to end of 2022. This is attributable to higher valuation of international equity prices due to market expectations of lower interest rates (as discussed in the next section).

Canadian and global bonds. With headline inflation declining in major economies from historically high levels in 2022, market participants are increasingly expecting lower interest rates in the near term, despite central banks stressing the importance of adhering to a tight monetary policy to meet their inflation targets. This anticipation has resulted in a downward parallel shift in yields at both short and long ends (2-year and 10-year) of the yield curve by 30 to 40 basis points in Canada and the U.S. As a result, at the end of March 2023, we anticipate that median 10-year returns for Canadian bonds will range from 3% to 4%, around 40 basis points lower than our forecast at the end of December 2022 and almost unchanged from mid-year 2022.

Likewise, for global aggregate bonds (ex-Canada, hedged), we now anticipate median 10-year returns of 2.8%-3.8%, about 35 basis points lower than our estimate at the year-end, 2022, but around 20 basis points higher than our mid-year forecast, last year.

Notes

1. All returns are annualized median expected returns over the next 10 years, as of March 31, 2023, using Vanguard Capital Markets Model.

Bilal Hasanjee, CFA, MBA, MSc Finance, is Senior Investment Strategist at Vanguard Investments Canada.

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