Vanguard economic and market update: May

Key points

• US growth seen holding up despite expected rate rises and broader policy tightening by Fed.
• But recession risks rising, particularly in UK and euro area.
• ECB expected to tighten by half a percentage point in 2022.
• Policy trilemma in China due to zero-Covid policy and 5.5% growth and financial stability goals.

Economic growth

The United States economy contracted in the first three months of the year, though underlying measures of demand remained strong. GDP decreased at an annual rate of 1.4% in the first quarter, in no small part owing to a decrease in net trade. Vanguard’s forecast for full-year US growth around 3.5% is unchanged, though we’re watchful for signs of slowdown, with early indicators suggesting second-quarter activity tracking below expectations.

GDP in the euro area increased by 0.3% on a seasonally adjusted basis in the first quarter compared with the fourth quarter of 2021. We continue to expect that full-year growth will range between 2.5% and 3%. We believe that the euro area can avoid recession, though there is a narrow margin of safety in its ability to withstand further shocks, such as an abrupt cut-off in energy supplies from Russia or a sharp slowdown in US growth due to excessive monetary tightening.

The economy in the United Kingdom grew by 0.8% in the first quarter, which was less than anticipated. Wholesale and retail output fell by 2.8% in March, a sign that households are struggling to maintain consumption due to rises in the cost of living. Vanguard’s forecast for full-year growth remains a range of 3.5% to 4%. Our outlook factors in weakness in services activity and retail sales, which are partially offset by recently announced fiscal policy measures and the anticipated drawdown of household savings accumulated during the pandemic. A complete end to imports of Russian natural gas would have only a limited effect on the economy as the United Kingdom sources only 4% of its natural gas from Russia.

May data confirmed a slowdown in the economy of China in the face of zero-Covid policies that have led to weeks of lockdowns in Shanghai and beyond. The key consumer metric of retail sales of consumer goods contracted by 11.1% in April compared with a year earlier. Vanguard believes Chinese government faces a policy trilemma: how to reconcile its target of “around 5.5% growth” with its approach to Covid and desire for financial stability. Given that we expect China to maintain a zero-Covid approach, we believe aggressive policy easing beyond expected infrastructure investment will be required to hit the growth target. Should policy stimulus undershoot owing to concerns about medium-term financial stability, we believe growth in 2022 would fall well below 4%.

Emerging market economies face growing headwinds as a result of developments in the US, Europe and China as well as higher inflation and central bank tightening. Whereas at the start of the year we had expected full-year 2022 emerging markets growth around 5.5%, we now expect full-year growth of around 3%. Although higher prices for commodities do benefit some emerging economies, in more general terms they are negative.

Monetary policy

The US Federal Reserve (Fed) raised the target for its key interest rate by half a percentage point to 0.75%-1.0%, the first hike of this magnitude in more than 20 years. Fed Chairman Jerome Powell has since said that two further hikes of a similar size are likely when US central bank policymakers next meet on 15 June and 27 July. Central banks are also beginning to reverse the large-scale asset purchase programmes of the pandemic. Known as quantitative tightening, this will squeeze financial conditions further with the Fed starting to actively run-down its $8.5 trillion balance sheet in June. Vanguard expects the Fed to raise interest rates by a further 1 to 1.5 percentage points in 2022, which is less than current market expectations for a 2.75% federal funds rate at year-end.

The European Central Bank (ECB) left its main deposit rate unchanged at a negative 0.5% and reinforced expectations that it too would end asset purchases, starting in the third quarter. Vanguard now expects euro-area policy rates to rise by half a percentage point this year, up from our previous expectations for one quarter-point hike from the ECB. This is about half what the market currently expects due to the risks we see to euro-area economic growth.

The Bank of England in May raised its bank rate by a quarter percentage point to 1%, its fourth consecutive hike since December. But in doing so, the central bank’s Monetary Policy Committee (MPC) also sent signals reflecting the sheer challenge of doing enough to quell inflation while not stifling growth. Vanguard continues to expect only an additional one or two quarter-point hikes this year. The bank also said it would provide an update at its August meeting on its plans to sell assets from its £866 billion Asset Purchase Facility. With the bank rate having reached 1%, the criterion has been met for outright asset sales as opposed to only passive roll-off of assets by not reinvesting proceeds of maturing securities. In any event, the bank said sales would depend on economic circumstances and occur “in a gradual and predictable manner.”

The People’s Bank of China cut its reserve requirement ratio by a quarter percentage point, less than the half-point cut expected by the market. Given rising rates in the United States and other developed markets, the bank likely finds itself without room to cut the rate further, which would increase the prospect for capital outflows.

Inflation

The consumer price index (CPI) in the United States rose by 8.3% in April compared with April 2021, moderating from an 8.5% year-on-year gain in March. Core CPI, which excludes volatile food and energy prices, rose by 6.2% year-on-year in April, down from a 6.5% rise in March. Although the report supports Vanguard’s view that headline and core inflation are likely to peak in the second quarter, it shows that the Federal Reserve will need to remain vigilant, especially given an accelerated pace of core services price gains.

Headline inflation in the euro area remained stable in April, holding at 7.4% compared with April 2021. Energy prices were up by 37.5% year-on-year, though that was less than a 44.3% year-on-year gain in March. However, prices for food, non-energy industrial goods, and services all rose by more than they did in March. Core inflation, which excludes volatile food and energy prices, increased from a revised 3.0% to 3.5%, suggesting a broadening of inflationary pressures in the economy. We have revised our 2022 euro-area inflation forecast higher, from an average of 6.5% to an average just above 7%. We expect euro-area inflation to peak in the second quarter of 2022, with inflation falling back toward the ECB’s 2% target by the end of 2023.

Annual inflation in the United Kingdom rose to 9.0% in April, a 40-year high. Prices rose by 2.5% in the month, higher than a 1.1% increase in March, driven by the 54% increase in the nation’s energy price cap on April 1, which led to a 47.5% increase in utility prices. Core inflation, which excludes volatile food and energy prices, rose to a 30-year high of 6.2% year-on-year. Higher energy prices resulting from the war in Ukraine and, more recently, the broadening of price pressures, have led us to revise our 2022 inflation forecast to an average of 7% to 8% from a previous forecast of 5% to 6%. We expect headline inflation to breach 10% in the fourth quarter, after an anticipated October increase in the energy price cap.

Employment

The United States economy created 428,000 jobs in April, continuing to show broad-based strength. The unemployment rate remained at 3.6%, just above its 3.5% pre-pandemic level. Although wage gains moderated in the month, Vanguard expects year-on-year increases in monthly wage data to remain above 5% throughout 2022. We continue to expect the US unemployment rate to fall to around 3.2% by year-end.

Unemployment in the euro area fell to 6.8% in March. We continue to see the euro-area jobs market strengthening in the months ahead, with wage pressures continuing to build, though at a more moderate pace than in the United Kingdom or the United States.

The unemployment rate in the United Kingdom fell to 3.7% in the three months to March-end, lower than its pre-pandemic level. It is the United Kingdom’s lowest unemployment rate since 1974. For the first time since records began, job vacancies, at a record 1.3 million in April, exceeded the number of unemployed people. However, the pace of increase in vacancies has levelled off, suggesting the labour market may have less room to run going forward.

The points above represent the house view of the Investment Strategy Group’s (ISG’s) global economics and markets team as of 18 May, 2022.

Asset class return outlooks

Vanguard has updated its 10-year annualised outlooks for broad asset-class returns through the most recent running of the Vanguard Capital Markets Model® (VCMM), based on data as of 31 March, 2022. The probabilistic return assumptions depend on market conditions at the time of the running of the VCMM and, as such, can change with each running over time.

Vanguard usually updates these numbers quarterly, despite a partial advance running of the VCMM on 28 February due to the significant initial market impacts of Russia’s invasion of Ukraine. Projections based on the 30 June, 2022, running of the VCMM will be communicated in the August 2022 economic and market update.

Equity outlooks are slightly lower than in the April 2022 monthly update but higher in the case of bond outlooks. We would expect equity and bond 10-year outlooks to improve further based on a June 30 running of the VCMM, should recent market trends hold.

Our 10-year annualised nominal return projections are as follows. Please note that the figures are based on a 1-point range around the 50th percentile of the distribution of return outcomes for equities and a 0.5-point range around the 50th percentile for fixed income. Numbers in parentheses reflect median volatility.

IMPORTANT: The projections or 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. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of 31 March, 2022. Results from the model may 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 US Treasury and corporate fixed income markets, international fixed income markets, US 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. 

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