Central banks face a battle to cool inflation without provoking a hard economic landing. Nonetheless, we think the long-term outlook for markets is much improved.
By Shaan Raithatha, senior economist, and Lukas Brandl-Cheng, investment strategy analyst, Vanguard, Europe.
The past year has produced one of the fastest-evolving economic and financial market environments ever seen. Faced with the greatest inflation threat since the 1980s, central banks across the globe have responded with coordinated increases in interest rates that have outpaced anything we’ve witnessed for several decades.
As we get ready to move into 2023, we look at three key themes that we think will shape the economic and market environment in the year ahead.
1. Vigilance in fighting inflation
The chart shows where this monetary tightening cycle has got to and where we think interest rates could be headed next.
What seems clear to us is that central banks like the Bank of England and US Federal Reserve still have a difficult path ahead that will require them to raise interest rates further and maintain vigilance as the inflation situation shifts.
Globally coordinated monetary tightening
Note: Dotted lines represent market-based expectations for future policy rates as at 31 October 2022.
Sources: Thomson Reuters Datastream and Bloomberg.
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 higher rates are intended to alleviate.
However, support for further rate rises could wane in 2023, particularly if economies slow too much, prompting companies to cut costs and shed jobs on a large scale. As such, central banks have a very narrow window to aim at as they seek to cool inflation without inducing a recession.
Central banks typically seek to avoid recessions, but current inflation dynamics leave policymakers with little choice but to tighten financial conditions to try to stabilise prices.
Indeed, our base case for 2023 is one of disinflation, but at the cost of a global recession.
2. Energy challenges 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.
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. However, as in the United States, there are tentative signs now that inflation in Europe has peaked – although we still expect price pressures associated with the labour market and wage growth to be stubbornly high as we move into next year.
3. A better outlook for long-term investors
Against such a deteriorating economic backdrop, it’s little wonder that investment markets have generally had a tough time of it in 2022. We think further near-term pain is still possible for investors. On the plus side, though, we also believe the longer-term outlook has improved.
Our forecasts are based on the Vanguard Capital Markets Model® (VCMM), a modelling tool we have developed internally that simulates thousands of potential outcomes based on a statistical analysis of historical data together with forward-looking assumptions and indicators1. It’s not a crystal ball; the results are hypothetical in nature. The projections nonetheless offer a yardstick by which we can better understand the potential direction of travel.
And the good news is that our outlook for 10-year annualised returns has ticked up, having largely trended downwards since 2009. So much so, that our expectations for how markets will behave over the next 10 years has improved significantly compared with what the VCMM was projecting a year ago.
For UK-based investors, our bond-return outlooks are more than three percentage points higher than they were a year ago, as cash flows can now be reinvested at higher interest rates. The VCMM projects UK bond returns of 4.7%-5.7% per year on average over the next decade, with global bonds (excluding UK bonds, hedged into pounds) potentially delivering returns of 4.3%-5.3% per year over the same period.
This means that we expect the wealth of bond investors with a sufficiently long investment horizon to be higher 10 years from now than our year-ago forecast would have suggested – as the chart below illustrates.
We expect long-term investors to be better off because of the sell-off, not in spite of it
Past performance is not a reliable indicator of future results. Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.
Notes: The chart shows actual returns for the Bloomberg Sterling Aggregate Bond Index along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as at 31 December 2021 and 30 September 2022. The shaded areas represent the 10th and 90th percentiles of the forecasted distributions. Data as at 30 September 2022.
Source: Refinitiv and Vanguard calculations in GBP, as at 30 September 2022.
This improved outlook for long-term investors extends to shares as well, given share valuations in several parts of the world are lower than they used to be.
For UK-based investors, the VCMM calculates that global shares (ex-UK, unhedged) will likely return between 6.1% and 8.1% per year on average over the next decade, with UK shares returning between 4.6% and 6.6%. Our outlook for UK shares was similar a year ago, while our expectation for global ex-UK equity has increased by more than 3 percentage points.
In short, we believe the long-term outlook for investors is the best it has been for some time.
Our valuations and forecasting frameworks are intended to set long-term expectations, so they should not, in themselves, suggest a short-term action on the part of investors.
Our analysis, nonetheless, should give long-term investors reasons to be optimistic and assurance that a portfolio diversified across shares and bonds remains an effective way for investors to achieve long-term investment success.
1 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 modelled asset class. Simulations as at 31 December 2021 and 30 September 2022. Results from the model may vary with each use and over time. For more information, please see the “Important information” section.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
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 US 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.
This article is designed for use by, and is directed only at, persons resident in the UK.
The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.
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