Vanguard economic and market outlook for 2023
● Generationally high inflation has led to a marked slowing in global economic activity. Rapid monetary tightening aimed at bringing down inflation will ultimately succeed, but at a cost of a global recession in 2023.
● Current and expected conditions are like those that have signaled past global recessions. Significantly deteriorated financial conditions, increased policy rates, energy concerns, and declining trade volumes indicate the global economy will likely enter a recession in the coming year. Job losses should be most concentrated in the technology and real estate sectors, which were among the strongest beneficiaries of the zero-rate environment.
● Inflation continued to trend higher in 2022 across most economies as supply chains had yet to fully recover from pandemic-related distortions and as demand was buoyed by strong household and business balance sheets. Inflation has likely already peaked in most markets, but reducing price pressures tied to labor markets and wage growth will take longer. As such, central banks may reasonably achieve their 2% inflation targets only in 2024 or 2025.
● Consistent with our investment outlook for 2022, which focused on the need for higher short-term interest rates, central banks will continue their aggressive tightening cycle into early 2023 before pausing as inflation falls and job losses mount. Importantly, we see most central banks reluctant to cut rates in 2023 given the need to cool wage growth.
● Although rising interest rates have created near-term pain for investors, higher starting rates have raised our return expectations for both global bonds, which we now expect to return roughly 3.9%–4.9% over the next decade.
● Equity markets have yet to drop materially below their fair-value range, which they have historically done during recessions. Longer term, however, our global equity outlook is improving because of lower valuations and higher interest rates. Our return expectations are 2.5 percentage points higher than last year. From an Australian dollar investor’s perspective, our Vanguard Capital Markets Model projects higher 10-year annualised returns for ex-Australia markets (5.6%–7.6%) than for Australian equities (4.5%–6.5%).
The global economy in 2023: Beating back inflation
In our 2022 economic and market outlook, we outlined how we believed the removal of policy accommodation would shape the economic and financial market landscape. Policy has in fact driven conditions globally in 2022, one of the most rapidly evolving economic and financial market environments in history. But one fact has been made abundantly clear: So long as financial markets function as intended, policymakers are willing to accept asset price volatility and a deterioration in macroeconomic fundamentals as a consequence of fighting inflation. The stabilisation of global consumer behaviour, cyclical acceleration in demographic and geopolitical trends, and rapid monetary tightening suggest a more challenging macroeconomic environment in 2023 that, in our view, will help bring down the rate of inflation.
Global inflation: Persistently surprising
Inflation has continued to trend higher across most economies, in many cases setting multi-decade highs. The action taken, and likely to be taken in the months ahead, by central banks reflects a promising effort to combat elevated inflation that has proven more persistent and broad-based. Supply-demand imbalances linger in many sectors as global supply chains have yet to fully recover from the COVID-19 pandemic and as demand is supported by strong household and business balance sheets buoyed by pandemic-era stimulus. The war in Ukraine continues, threatening another surge in energy and food commodities prices. Effective monetary policy requires good decision-making, good communication, and good luck. The current backdrop is missing the good-luck component, posing a challenge for policymakers whose fiscal and monetary tools are less effective combating supply shocks.
A recession by any other name
Global conditions today and those anticipated in the coming months are similar to those that have signalled global recessions in the past. Energy supply-and-demand concerns, diminishing capital flows, declining trade volumes, and falling output per person mean that, in all likelihood, the global economy will enter a recession in the coming year. Although central banks generally seek to avoid recessions, inflation dynamics mean that supply-side pressures must continue to ease and that policymakers must tighten financial conditions to lessen the inflationary push from elevated demand. That said, households, businesses, and financial institutions are in a much better position to handle an eventual downturn, to the extent that drawing recent historical parallels seems misplaced. Although all recessions are painful, this one is unlikely to be historic.
Our base case is a global recession in 2023 brought about by the efforts to reduce inflation. At a regional level, we place the odds of a recession in Australia around 40%, far lower than the 90% odds placed on U.S., U.K., and Euro area recessions. This is because wage and inflation pressures are more muted in Australia, meaning interest rates will not need to rise as much. Australia also stands to benefit from a cyclical rebound in China, and as a net exporter of commodities given elevated commodity prices. Whether history views the global recession as mild or significant matters little for those affected by the downturn. But failing to act aggressively to combat inflation risks harming households and businesses through entrenched inflationary pressures that last longer than the pain associated with any one recession.
Growth is likely to end 2023 very weak or slightly negative in most major economies outside of China. Unemployment is likely to rise over the year, including in Australia, but nowhere near as high as during the 2008 and 2020 downturns. Through job losses and slowing consumer demand, a downtrend in inflation is likely to persist through 2023. We don’t believe that central banks, including the RBA, will achieve their targets of 2% inflation in 2023, but they will maintain those targets and look to achieve them through 2024 and into 2025 or reassess them when the time is right. That time isn’t now; reassessing inflation targets in a high-inflation environment could have deleterious effects on central bank credibility and inflation expectations.
Global fixed income: Brighter days ahead
The market, which was initially slow to price higher interest rates to fight elevated and persistent inflation, now believes that most central banks will have to go well past their neutral policy rates—the rate at which policy would be considered neither accommodative nor restrictive—to quell inflation. In Australia, we expect the cash rate to reach 4.35% by mid-2023, higher than currently anticipated by markets and economists, given the RBA’s strong desire to quash inflation. This is based on the historical observation that the longer inflation is above target, the more painful it will be to bring it back down.
The eventual peak and persistence of policy rates, which will depend heavily on the path of inflation, will determine how high bond yields rise. Although rising interest rates have created near-term pain for investors, higher starting interest rates have raised our return expectations significantly for global bonds. We now expect Australian bonds to return 3.7%–4.7% per year over the next decade, compared with the 0.9%–1.9% annual returns forecast a year ago. For global bonds, we anticipate returns of 3.9%–4.9% per year over the next decade, compared with our year-ago forecast of 1.3%–2.3% per year. In credit, valuations are more fairly valued, but the growing likelihood of recession and declining profit margins skew the risks toward higher spreads. Although credit exposure can add volatility, its higher expected return than government bonds and low correlation with equities validate its inclusion in portfolios.
Global equities: Resetting expectations
Rising interest rates, inflation, and geopolitical risks have forced investors to reassess their rosy expectations for the future. The silver lining is that 2022's bear market has improved our outlook for global equities.
Stretched valuations in the U.S. equity market in 2021 were unsustainable, and our fair-value framework suggests they still don’t reflect current economic realities in certain regions. We also see a high bar for continued above-average earnings growth, especially in the U.S. Although U.S. equities have continued to outperform their international peers, the primary driver of that outperformance has shifted from earnings to currency over the last year. The 30% decline in emerging markets over the past 12 months has made valuations in those regions more attractive. We now expect similar returns to those of non U.S. developed markets and view emerging markets as an important diversifier in equity portfolios.
From an Australian dollar investor’s perspective, the research projects higher 10-year annualised returns for ex-Australia markets (5.6%–7.6%) than for Australian equities (4.5%–6.5%). Globally, our equity return expectations are 2.5 percentage points higher than they were at this time last year. Value stocks are fairly-valued relative to growth, and small-capitalisation stocks are attractive despite our expectations for weaker near-term growth. Our outlook for the global equity risk premium is still positive at 1 to 3 percentage points, but lower than last year due to a faster increase in expected bond returns.
What this means for Australian investors
The stormy weather experienced by financial markets this year has likely unmoored even the most seasoned of investors but the break in the clouds is that both equities and fixed income are now a lot more attractively priced than where we were at the end of 2021.
Investors considering portfolio changes in the face of a possible recession in Australia and indeed other regions around the globe, should maintain a focus on the plan and objectives they have set.
For some, forecasts about possible recessions could interrupt nearer term financial goals and plans, and decisions on asset allocations should be made accordingly. But for others with a long-term horizon, Vanguard’s rolling 10-year asset class return outlooks are to help set realistic expectations and to inform a long-term plan, rather than spur tactical decisions over the short-term.
Regardless of whether we land in recession territory or not, reacting to current events and using short-term portfolio performance as a focal point to make investment strategy decisions can be detrimental for investors, and result in long term impacts on an investor’s overall wealth building journey.
Based on history, investors with a well-diversified portfolio and the mettle to stick to the plan and goals set in less turbulent times are often rewarded when the volatility ebbs.
Read the full Vanguard report here.