• Tariffs usher in and accelerate longer-term trends across the global economy.
  
  
• The era of sound money—the persistence of positive real interest rates—remains well supported by short- and long-term forces.
  
  
• The case for global diversification is strengthening, even with the prospect of transformative AI.
   

Three themes are worth emphasising as we reach the midpoint of 2025: (1) Tariffs are likely to produce both an unmistakable signal and unremitting noise for the global economy; (2) Interest rates above the rate of inflation are here to stay; and (3) The case for global diversification is strengthening. We emphasise these themes even amid recent heightened geopolitical tensions.

1. Tariff developments could muddy the waters and hasten trends

Tariffs have been used to a much larger extent as a policy tool than we had anticipated at the start of the year. Our 2025 economic outlook put supply-side forces and their potential stagflationary effects — downward pressure on growth and upward pressure on prices—at the centre of our short-term economic assessments. Meanwhile, high policy uncertainty and the anticipation of slowing global trade have accelerated imports and fostered inventory buildup ahead of tariff announcements. This dynamic adaptation is clouding macroeconomic data, necessitating care in distinguishing signal from noise. Thanks to the substantial frontloading of imports in the US during the first quarter of 2025, the realised effective tariff rate, which is the weighted average tariff actually paid by importers, has remained well under 10% so far. However, tariff frontloading and policy uncertainty will eventually subside, and we expect the effective tariff rate to climb to around 13% by the end of 2025.

Tariff rates hold the key for our economic outlook

Notes: The figure shows the estimated impact of effective tariff rates on our 2025 year-end forecasts for US GDP growth and inflation as of three different points in time: at the beginning of 2025, current and when tariffs were announced in early April. These estimates hold all other drivers constant and assume that the effective tariff rate will remain in effect throughout 2025.

Source: Vanguard calculations, as at 13 June 2025.

Yet tariffs and related global policy discussions may prove to be a catalyst for longer-term trends. For example, the European Union’s commitment to increase defence spending could boost the region’s economy for the next few years and become a kernel of homegrown productivity in the longer term. In China, efforts to shift from an export- and investment-driven economy to a consumer-driven economy will be crucial. And in the US, a spotlight is being shone anew on the importance of fiscal discipline. Whether via tariffs, growth or any other means, the US needs to put its fiscal deficit back on a sustainable path. 

2. Higher interest rates are here to stay

As we discussed in our 2025 outlook, the era of sound money continues. This means that the neutral rate—the theoretical rate that keeps the supply and demand of capital in balance—is far higher than it was before the Covid-19 pandemic. US inflation is expected to remain above the US Federal Reserve’s (Fed’s) 2% target in the short term. However, of more enduring relevance is the US fiscal deficit. At 6%–7% of GDP, it is historically high for a peacetime and non-recessionary environment. Worse yet, the deficit picture is likely to deteriorate over time given ageing demographics. If left unchecked, those persistent deficits become a source of excess demand and inflationary pressures. However, if the Fed is to remain committed to its price stability goal, then we’re likely entering a period of persistently higher real interest rates. The bond market has taken note of this tension, demanding greater compensation for risk. The term “bond vigilantes” may become more commonplace going forward. 

With yields on corporate bonds within the 5%–6% range—a level not seen since before the 2008 global financial crisis—two significant observations are worth highlighting for investors. First, spreads have remained surprisingly compressed through the policy turmoil, and they’ll likely stay rangebound absent an unforeseen event or tail risk. Second, bond investors may need to adjust their mindset from the pre-Covid-19 era, when bond holdings appreciated due to declining rates. In the years ahead, the source of return is more likely to be collecting a healthy level of interest income and reinvesting it at a high rate.

3. The case for equity market diversification is strengthening

Our 2025 outlook noted a continued equity market dichotomy. There are a handful of US firms, representing the “new economy”, that grow earnings around 20% year-on-year and have valuations that are stretched. Meanwhile, the rest (representing the “old economy” – both US and non-US firms) have less impressive earnings growth and more reasonable valuations. This valuation tension has persisted even following a volatility spike in the first half of the year that first, exposed the vulnerability of high valuations and second, demonstrated US-based tech firms’ continuing ability to generate earnings growth against this backdrop. 

Beyond valuations, there is an additional consideration that strengthens the case for a globally diversified portfolio. That is, even if AI transforms the economy – and this is implicit in current valuations – the history of technology-based transformations suggests that the benefits of such advancement accrue beyond those companies that lay down the infrastructure. The next winners in the AI race could be those value companies that benefit from the technology breakthroughs, as opposed to the growth companies that created the technology in the first place. From a US historical perspective, railroads in the 19th century and technology, media and telecommunications companies in the 1990s provide some of the most salient examples of this concept.

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. 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, 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.

The primary value of the VCMM is in its application to analysing 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 recognise 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 modelled 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.

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.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Important information 

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained herein 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 does not constitute legal, tax, or investment advice. You must not, therefore, rely on it when making any investment decisions. 

The information contained herein is for educational purposes only and is not a recommendation or solicitation to buy or sell investments. 

Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.

Issued in Switzerland by Vanguard Investments Switzerland GmbH.

Issued by Vanguard Asset Management Limited which is authorised and regulated in the UK by the Financial Conduct Authority. 

© 2025 Vanguard Group (Ireland) Limited. All rights reserved.

© 2025 Vanguard Investments Switzerland GmbH. All rights reserved.

© 2025 Vanguard Asset Management, Limited. All rights reserved.