- As we move into 2023, we believe central banks will remain vigilant in the fight against inflation.
- We believe that the challenges posed by the energy crisis in Europe are likely to continue.
- As China relaxes its zero-Covid policy, we expect the reopening of China’s economy to be bumpy.
- Our longer-term outlook for developed markets is significantly improved from just a year ago.
As we move into 2023, our economists have identified four key themes that they believe will shape the economic environment next year: central banks’ vigilance in the fight against inflation, the economic effects of the energy crisis in Europe, China’s long-term structural challenges as it aims to end its zero-Covid policy and a more positive outlook for long-term investors.
Fighting inflation: Central banks maintain vigilance
The last year has proven to be one of the most rapidly evolving economic and financial market environments in history. Across the globe, central banks have responded with coordinated monetary policy changes that have outpaced anything we’ve seen for several decades.
A globally coordinated monetary tightening regime
Note: Dotted lines represent market-based expectations for future policy rates as at 31 October 2022.
Sources: Thomson Reuters Datastream and Bloomberg.
As the inflation situation shifts, central banks face a difficult path ahead that will require being more aggressive with policy, making additional interest rate hikes and maintaining vigilance. In the US, the Federal Reserve (Fed) has adopted the position that more work is still needed to control inflation, and it appears resolved to take all necessary measures to do so.
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 restrictive monetary policy is intended to alleviate.
Yet support for policy tightening could wane in 2023 and the available window for the Fed to raise interest rates enough to cool inflation but not enough to induce a recession is very narrow.
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. In 2023 our base case is one of disinflation, but at a cost of a global recession.
Energy crisis in Europe: Challenges are likely to continue
The war in Ukraine added to financial 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.
We’re encouraged by Europe’s nimble adaptation to a sharp reduction in Russian gas imports. As the chart below shows, substitutions to supply in 2022 came from a combination of other fuels, renewables, supply from other sources and existing storage. Even as those options soften the blow, we expect that gas demand will have to contract by about 15% this winter relative to last year.
European gas imports: How the gap will be plugged
Sources: International Energy Agency, European Commission, and Vanguard estimates, as at 31 October 2022.
Looking ahead to 2023, the European gas supply will be starting from a much lower base than in 2022, which could present a challenge in the middle or later part of next year. In the longer term, the extent of European gas shortages will be determined by the ability of countries to secure alternative energy supplies at a reasonable price.
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 continue to impact consumer confidence.
China’s economy in 2023: A cyclical bounce amid structural challenges
China’s zero-Covid policy and a contraction in the real estate sector have been significant drags on growth in 2022.
Looking ahead to 2023, we expect the reopening of China’s economy to be bumpy and it could be several months before we see a meaningful relaxation of restrictions. Meanwhile, we expect a protracted downturn in housing investment over the next five to 10 years. Despite easing government regulation, the housing market is unlikely to rebound due to a structural downturn in demand.
Housing remains oversupplied in China, with increased demand providing only a slight offset to supply growth.
Source: Vanguard calculations, based on data from Bloomberg, as at 31 October 2022.
A more sanguine outlook for long-term investors
Our longer-term outlook for developed markets is significantly improved from just a year ago. Fixed income investors felt the near-term pain of rising interest rates, but higher interest rates at which cash flows can be reinvested have considerably raised our return expectations for global bonds. For global equity investors, lower valuations are much more conducive to higher long-term returns compared with this time last year. Our annualised projections for the next decade have increased by more than two percentage points for global bonds and global equity.
For euro investors, we now expect euro area aggregate bonds to return 2.2%-3.2% per year over the next decade, compared with the -0.5%-0.5% annual returns we forecast a year ago. For global bonds (excluding euro-area bonds, hedged to euros), we expect returns of 2.1%-3.1% per year over the next decade, compared with our year-ago forecast of -0.5%-0.5% per year. This means that for investors with an adequately long time horizon, we expect their wealth to be higher by the end of the decade than our year-ago forecast would have suggested.
The chart below reflects Vanguard’s forecasts for the euro area bond market; however, similar trajectories hold true across the developed world.
We expect investors to be better off because, not in spite, of the sell-off
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 Euro-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 ranges from the 10th to the 90th percentiles of the forecasted distributions. Data as at 30 September 2022.
Source: Refinitiv and Vanguard calculations in EUR, as at 30 September 2022.
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 are as at 31 December 2021 and 30 September 2022. Results from the model may vary with each use and over time.
In terms of equity returns, euro area equities are likely to return between 4.9% and 6.9% per year over the next decade, and global equities (ex-euro area, unhedged) between 3.7% and 5.7%. With that, our equity return outlook is more than two percentage points higher than at this time last year. After several strong years for the US dollar, our capital markets model suggests it is now above what fundamental, long-term drivers suggest. Going forward, we believe it will depreciate over the next decade, explaining why our global equity outlook is below our outlook for euro area equity.
Of notable mention were the simultaneous declines of stock and bond markets in 2022. Although not unusual, periods of concurrent negative returns are infrequent—and painful to experience. Our research finds that such correlations can move aggressively over shorter time horizons but that it would take long periods of consistently high inflation for long-term correlation measures—those that more meaningfully affect portfolio outcomes for a long-term investor—to turn positive. In short, a portfolio diversified across asset classes remains an effective tool to manage risk tolerance across a long-term investment horizon.