Key points

  • Interest rates seen close to peaking in US but have more upside in Europe. 
  • Growing potential for recessions to be delayed until 2024 in euro area and UK.
  • Strong first quarter may well represent peak activity in China in 2023.
  • Return outlook for equities reduced after first-quarter rise in valuations.

A pause in US interest rate hikes may now not be far away, our experts believe, but it’s a different story in Europe where economic resilience and ‘sticky’ inflation could mean even higher rates for longer.

United States – With inflation still too high and the labour market still tight, we expect the Federal Reserve (Fed) to raise interest rates again at its 14 June policy meeting. But in a change to our previous forecast, we expect it to pause after this next hike. As such, we now see the key ‘federal funds rate target’ peaking at 5.25% to 5.5% – a quarter percentage point higher than it is now.

The reason for that is that we perceive a shift in the Fed towards greater risk management, owing to recent banking system stresses and debt ceiling concerns. Indeed, the Fed’s most recent quarterly survey on bank lending practices noted tighter lending standards and weaker loan demand.

That said, we don’t expect the Fed to cut its key rate target before 2024. In addition, we have increased our forecast for year-end ‘core’ inflation, which strips out volatile food and energy prices, to 3.3% from 3%. This is after data in April showed core consumer price inflation (CPI) unchanged on the month at 5.5% year on year.

Worker compensation is also rising too fast for the Fed’s comfort, with the unemployment rate falling to 3.4% – matching the January 2023 low last seen in 1969. We expect US unemployment to be around 4.5% at year-end 2023, down from our previous projection of 4.5% to 5%.

GDP data suggests a softening in the broader economy, with annual growth slowing to 1.1% in the first quarter compared with 2.6% in the final quarter of 2022. We continue to expect a recession in the second half of 2023, though the odds of the US avoiding one have risen.

Euro area – The European Central Bank’s (ECB’s) stance on interest rates is more unequivocal. After its seventh consecutive hike – a 25 basis-point hike to 3.25% in its deposit facility rate on 4 May – ECB President Christine Lagarde made clear that the rate-hike cycle wasn’t over. We expect the ECB to raise its main policy rate to a range of 3.75%–4% over the next several months.

The latest inflation data illustrates the ECB’s challenge, with the headline rate climbing to 7.0% year-on-year in April from 6.9% in March and core inflation edging down to 5.6% from 5.7% in March. Just as persistently high inflation can become “sticky” by manifesting itself in wage growth, the ECB has identified “sticky profits” as a risk. We continue to expect core inflation to peak at 5.5% to 6% before fading in the second half of the year as the effects of higher interest rates work their way through the economy. But we also expect it to end the year at around 3.3% – still solidly above the ECB’s 2% target.

The euro area economy returned to growth in the first quarter, with GDP growing by 1.3% compared with the previous year. The bloc’s largest economy, Germany, stagnated though and shrunk by 0.1% year on year. We continue to expect 0.5% euro-area growth for all of 2023, with a mild recession later in the year, but we recognise that the need for higher central bank interest rates for longer to tame inflation may yet push a recession further back into 2024.

United Kingdom – The risk of a delayed, and potentially deeper, recession is also rising in the UK, with higher-than-anticipated interest rates now seen as necessary to counter stickier inflation due to the unexpected strength of the economy.

We’ve revised our forecast for GDP in 2023 to no growth having previously anticipated a contraction this year of around 1%. For now, we still expect a recession to happen later this year, but it will be shallower than previously thought. Whilst revising up our forecast for UK inflation and interest rates, we’ve also ratcheted down our 2024 growth forecast to 0.2% from 0.6%.

Based on the accrued inflation data and our revised growth forecast, we’ve increased our year-end forecast for headline inflation to 3.7% from 3.4% and for core inflation to 3.6% from 2.8%. We’ve raised our monetary policy forecast as well and now expect the Bank of England to raise its main policy rate to 4.75%–5% and to keep it there until at least 2024. This was after interest rates were raised to 4.5% on 11 May. 

China – A strong first quarter may well represent peak activity in China in 2023. A 4.5% increase in GDP growth compared with a year earlier outstripped expectations, powered by consumers tapping into excess savings after Covid-19-related lockdowns in 2022.

Although strong tourism and hospitality data from the May holidays show pent-up demand carrying over into the second quarter, other recent developments cast doubt on the sustainability of the recovery.

This includes the fact that activity in the services sector has been greater than that in the goods sector and that public investment has outpaced private investment. And although housing completions have increased, housing starts have declined. Meanwhile, youth unemployment is rising even as the overall unemployment rate has fallen.

We expect full-year GDP growth in the range of 6% to 6.5%, higher than the government’s official 2023 growth target of “around 5%” but decelerating toward trend in coming quarters.

The points above represent the house view of the Vanguard Investment Strategy Group’s (ISG’s) global economics and markets team as of 17 May, 2023.

Asset-class return outlook

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 2023. Outlooks for equities are mostly down globally as valuations rose with equity prices in the first quarter, especially in the US. Fixed income outlooks are marginally lower as yields fell in the quarter at the longer end of the curve.

The probabilistic return assumptions depend on market conditions at the time of the running of the Vanguard Capital Markets Model® (VCMM) and, as such, can change with each running over time.

ISG updates these numbers quarterly. The projections listed above are based on a running of the VCMM based on data as of 31 March 2023.  Please note that the 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. 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, 2023. Results from the model may vary with each use and over time. For more information, please see the ‘Investment risk 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.

Important information

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