Our investment and economic outlook, February 2023

To be sure, however, the interplay of numerous factors determines the course of the economy. A resilient consumer could extend a growth cycle but also spur persistent inflation that could lead the Federal Reserve to raise interest rates further than anticipated. 

The views below are those of the global economics and markets team of Vanguard Investment Strategy Group as of February 15, 2023.

Our 10-year annualized nominal return and volatility forecasts are shown below. They are based on the December 31, 2022, running of the Vanguard Capital Markets Model® (VCMM). Equity returns reflect a 2-point range around the 50th percentile of the distribution of probable outcomes. Fixed income returns reflect a 1-point range around the 50th percentile. More extreme returns are possible. 

Clearly, the nearly year-long, 450-basis-point cycle of interest rate hikes by the Federal Reserve hasn’t materially affected the labor market. Consider year-end Bureau of Labor Statistics’ adjustments that suggested an even stronger labor market in 2022 than initially reported. Or the reported creation of 517,000 jobs in January and the fall in unemployment rate to a 54-year low of 3.4%.

• Changes in monetary policy take time to work through an economy, however, and we expect higher interest rates to cool the labor market in the second quarter. We anticipate job losses in the second half of 2023 and an unemployment rate near 5% by year-end.
• We continue to expect the Fed to increase its rate target by a total of 50 basis points over its next two meetings (in March and May), to a range of 5%–5.25%, and to keep it there through year-end.
• The Consumer Price Index stood 6.4% higher in January than a year earlier, down modestly from December’s 6.5% year-over-year rise. We expect inflation to subside gradually through 2023, with higher shelter prices in the first half of the year offset to a degree by faster deceleration in goods prices.
• We expect the Fed’s favored inflation gauge, the core Personal Consumption Expenditures Index, to fall below 3% by year-end 2023 and to 2% by year-end 2024.
• We continue to assign a high probability to a mild recession in 2023, though the odds of continuing economic growth—a “soft landing” from the Fed’s efforts to quell inflation—have risen.

China has rapidly moved away from its zero-COVID policy. As in developed markets, though to a lesser degree, consumers are poised to spend excess savings built during two years of widespread lockdowns. The effect likely will be a boost to domestic growth if not a reduced likelihood of global recession, according to Vanguard’s Asia-Pacific chief economist, Qian Wang. 

• We expect China’s GDP to grow by an above-consensus 5.3% in 2023. Increased service-sector activity related to the economy’s reopening should especially boost the first two quarters. But growth likely will slow to just below 5% in 2024, as we remain pessimistic about China’s structural outlook.
• The expected recovery in consumption this year is likely to accelerate inflation, though not beyond China’s 3% target. We foresee 2023 headline inflation around 2.5%, held back by moderating food prices and appreciation in China’s currency. We expect core inflation to average 1.5% in 2023.
• We expect broad policy settings to shift from somewhat accommodative to more neutral late in the first quarter. Targeted growth support remains likely, however, such as in the property market to revive demand and limit developer defaults. But we expect continued deleveraging in the sector.

Fast-falling natural-gas prices, a resilient industrial sector, and the reopening of China’s economy are mitigating an otherwise challenging euro area outlook. We continue to expect a recession, beginning this quarter, though we believe it will last just two quarters. We now forecast 0% change in regional economic output in 2023, an upgrade from our previous expectation of a 0.5%–1% contraction. We foresee euro area growth of about 0.7% in 2024.

• We’ve lowered our forecast for headline inflation in 2023—to an average of 4.5%, down from 6.1%—largely because of an almost 85% decline in natural-gas prices since their August 2022 peak. Our view is well below a consensus view of 5.7%, which we expect will come down in the weeks ahead.
• We continue to foresee core inflation, which excludes volatile food and energy, averaging 4% in 2023. Service-sector wage pressures are likely to remain strong, given a historically tight labor market.
• On February 2, the European Central Bank (ECB) increased its deposit facility rate by 50 basis points, to 2.5%, and said it intends to raise the rate to 3.0% on March 16. We expect the ECB to raise the key rate to 3.5% in the second quarter of 2023, with two more, 25-basis-point rate hikes. Rate cuts are likely to arrive in the second half of 2024 at the earliest.
• The energy shock from Russia’s 2022 invasion of Ukraine, meanwhile, appears milder than initially feared. Natural-gas prices are down, and the region has adapted well to significantly lower Russian energy imports. But Europe’s energy crisis isn't over, according to Shaan Raithatha, a London-based Vanguard senior economist.

To see the effect of tighter monetary policy on the U.K. economy, look no further than the housing market. Mortgage approvals fell in December for a fourth straight month to the lowest level since May 2020, as the effective interest rate on new mortgages rose by 32 basis points, to 3.67%. More than 750,000 homeowners are at risk of defaulting on their mortgages in the next two years, the country’s main financial regulator has warned.

• We expect the Bank of England (BOE) to lift its bank rate to 4.5% in May and keep it there until the second half of 2024. Our view is contrary to that of markets pricing in rate cuts in the second half of 2023.
• Rising wages likely will continue to play into the BOE’s decision-making. In the private sector, which accounts for more than 80% of total employment, average regular pay grew by 7.3% in the fourth quarter.
• Goods and services prices were 10.1% higher in January than a year earlier, continuing to ease from their October 2022 peak but still far above the BOE’s target. We expect headline inflation to average 6%–6.5% in 2023.
• We believe that a recession likely has begun this quarter in the United Kingdom and will persist through the third quarter of 2023. We continue to expect GDP to contract by 1% in 2023 before growing about 0.6% in 2024.

The reopening of China’s economy and the increased consumption we expect it to engender will likely benefit Asian emerging markets through tourism and trade. 

• We haven’t changed our below-consensus forecast for emerging markets GDP growth of 3% in 2023. Our proprietary leading indicators index signals an upside growth risk for emerging markets, however; this would be felt most in emerging Asia and somewhat in Latin America, though likely not at all in emerging Europe, given broader economic challenges there.
• Inflation likely has peaked in Latin America and neared its peak in emerging Asia, but inflation-related challenges haven’t gone away. The Bank of Mexico on February 9 cited a “slower-than-foreseen disinflationary process” in raising the target for its overnight interbank rate by 50 basis points to 11%. The bank said it expects inflation to fall to its 3% target only in the fourth quarter of 2024.
• Headline inflation was 7.9% in January in Mexico compared with a year earlier, higher than in both November and December though considerably lower than its 8.7% September 2022 peak. Core inflation, at 8.45% compared with a year earlier, was up from December’s level and near its November peak. 

When the Bank of Canada (BOC) announced January 25 that it was increasing its target for the overnight rate by 25 basis points, to 4.5%, it hinted it would keep rates at that level for a time to reassess the impact of its more restrictive monetary policy on an economy that was showing signs of slowing. 

• Labor market data released February 10 suggests that a pause at the BOC’s March 8 policy meeting isn’t a foregone conclusion. Canada’s economy created 150,000 jobs in January—10 times the 15,000 expected by economists surveyed by Bloomberg—a development reminiscent of a similarly strong U.S. January labor market report a week earlier that would seem to ensure further Federal Reserve tightening. 
• The most recent government inflation data appear to support our view that headline inflation most likely has peaked. Headline inflation was 6.3% compared with a year earlier in December, down from 6.8% year-over-year in November. The pace of core inflation, which excludes volatile food and energy, eased to 5.3% in December.
• We continue to foresee 2023 GDP growth below 1%, a view that the February 28 fourth-quarter GDP report will help inform.

“Given the importance of avoiding a prices-wage spiral, the board will continue to pay close attention to both the evolution of labor costs and the price-setting behavior of firms in the period ahead.” So said the Reserve Bank of Australia (RBA) on February 7, when it increased its target for the cash rate by 25 basis points, to 3.35%. 

• Given rising wage pressures, we believe the RBA will raise the cash rate to 3.85%, extending the hiking cycle that began in May 2022 and has resulted in 325 basis points of increases. The consensus forecast of the terminal rate is 3.55%.
• We expect 1.0%–1.5% economic growth in 2023—less than the 1.8% consensus estimate—with higher interest rates dampening Australia’s growth.
• Just as it took longer for inflation to take hold in Australia, the timing of the disinflation process trails that of developed-market peers. Headline inflation accelerated to 7.8%, annualized, in the fourth quarter. If it does not prove to be the peak, however, the fastest rate of price increases since 1990 should be close to it.
• By year-end 2023, headline inflation likely will fall to around 4.5%, as higher interest rates dampen demand. Price rises should then fall back to the RBA’s 2%–3% target band in 2024, though this hinges on wage growth. 

• Assessing your personalized inflation risk (research summary, issued February 2023)
• China’s economic rebound lowers the odds of a global recession (article, issud February 2023)
• One year on, Europe's energy crisis is far from over  (article, issued February 2023)