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Vanguard Market perspectives: September 2022

| September 09, 2022
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Key highlights

We place the likelihood of a U.S. recession in the next 12 months at about 25% and in the next 24 months at about 65%.
Vanguard is downgrading our China growth forecast for full-year 2022 from 3.0%–4.0% to 2.5%–3.5%.
We expect the Federal Reserve to increase its federal funds rate target to a range of 3.25%–3.75% by the end of the year.

Asset-class return outlooks

Our 10-year, annualized, nominal return projections, as of June 30, 2022, are shown below. Please note that the figures are based on a 1.0-point range around the rounded 50th percentile of the distribution of return outcomes for equities and a 0.5-point range around the rounded 50th percentile for fixed income.

Equities                                                                        Return projection and Median volatility
U.S. equities                                                                    4.1%–6.1%    17.2%
U.S. value                                                                       4.4%–6.4%     19.5%
U.S. growth                                                                     1.6%–3.6%     18.2%
U.S. large-cap                                                                 4.0%–6.0%    16.8%
U.S. small-cap                                                                 4.3%–6.3%    22.5%
U.S. real estate investment trusts                                    3.9%–5.9%   20.2%
Global equities ex-U.S. (unhedged)                                 6.6%–8.6%   18.6%
Global ex-U.S. developed markets equities (unhedged) 6.5%–8.5%   16.7%
Emerging markets equities (unhedged)                           5.9%–7.9%   26.5%

Fixed income                                                            Return projection and Median volatility
U.S. aggregate bonds                                                  3.1%–4.1%      5.1%
U.S. Treasury bonds                                                    2.7%–3.7%      5.4%
U.S. credit bonds                                                         3.7%–4.7%      5.0%
U.S. high-yield corporate bonds                                  5.7%–6.7%      10.2%
U.S. Treasury Inflation-Protected Securities               2.3%–3.3%       4.9%
U.S. cash                                                                    2.6%–3.6%       1.3%
Global bonds ex-U.S. (hedged)                                  3.0%–4.0%       4.1%
Emerging markets sovereign bonds                           5.4%–6.4%      11.9%
U.S. inflation                                                               2.0%–3.0%        2.4%
These probabilistic return assumptions depend on current market conditions and, as such, may change over time.

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 June 30, 2022. Results from the model may vary with each use and over time. For more information, see the Notes section.

Source: Vanguard Investment Strategy Group.

Region-by-region outlook
United States

Vanguard has downgraded our forecast for 2022 growth in the United States on the back of a second consecutive quarter of economic contraction.

GDP decreased at an annual rate of 0.9% in the second quarter, according to an advance estimate by the Bureau of Economic Analysis. The report fell short across key categories, and we see it as softer than the headline number would suggest.
We believe it likely that the United States will struggle to regain above-trend growth in the quarters ahead. Vanguard now expects full-year 2022 U.S. economic growth of 0.25%–0.75%, down from the estimate last month of about 1.50%.
We place the likelihood of a U.S. recession in the next 12 months at about 25% and in the next 24 months at about 65%. (Whereas in some countries two consecutive quarters of contraction constitute a recession, U.S. recessions are determined by the private National Bureau of Economic Research (NBER). Key NBER recession drivers including the labor market and industrial production remain strong; we believe it unlikely that the NBER will declare a recession in the near term.)
We're also watching the yield curve for signs of recession. The spread between 10-year and 2-year Treasuries has been inverted—with the shorter-term yield higher than the longer-term yield—since early July; the spread was –43 basis points as of August 16. Vanguard would need to see the inversion continue in the weeks ahead to view it as a recession signal.
We believe that the 10-year/3-month Treasury spread is a more reliable recession indicator.
When a recession occurs, we don't know how long it will last or precisely when equity markets will recover, making it virtually impossible to time the markets. But equity prices have frequently begun to fall prior to the start of a recession and hit their low point sometime during the recession. They have typically started to recover before the end of the recession (see chart).
Stocks start to recover before recessions end
This chart shows the performance of the S&P 500 from 1973 through 2021, including its performance during seven recessions.
Equity prices have frequently begun to fall prior to the start of a recession and hit their lows during the recession.
During the recession that began in November 1973 and ended in February 1975, the S&P 500 reached its low toward the end of this period, in September 1974.
The next recession was much shorter, from January through June of 1980. During this six‐month period, the S&P reached its low in March, slightly earlier than in the previous recession.
The recession that began in July 1981 lasted until October 1982. The low point of the S&P 500 occurred relatively late in the period, in July 1982.
During the recession that began in July 1990 and extended through February 1991, the S&P 500 hit its low in the middle of the period, in
October 1990.
For the recession that occurred from March through October 2001, the S&P low occurred late in the period, in September.
The next recession started in December 2007 and lasted through May 2009. The low for the S&P 500 during this period occurred near the end of the period, in February 2009.
During the 2020 recession, which lasted only two months, the low for the S&P 500 occurred during the latter half of the period, in March.
Notes: This chart shows the one-year annualized returns for the S&P 500 Index from 1973 through 2021. The shaded areas represent months where the U.S. economy was in recession as defined by the National Bureau of Economic Research.

Sources: Vanguard calculations as of December 31, 2021, using data from Refinitiv.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Euro area

Vanguard maintains its estimate of full-year 2022 euro area economic growth of 2% to 3%, and our outlook for 2023 growth of 0.5% to 1.5%. But risks are skewed to the downside.

Leading economic indicators suggest sharp downturns in Germany and Italy, and a European Commission reading of economic sentiment hit a 17-month low amid fears of energy shortages and concerns that a recession is nearing.
In our base case, Vanguard sees a 50% chance of euro area recession in the next 12 months, growing to 60% over the next 24 months.
Economic data published for July showed a weaker-than-expected recovery from the second-quarter slump in China. Consumer spending remained particularly subdued. These data, in addition to the broadening property market downturn, lead us to downgrade our GDP call for full-year 2022 from 3%–4% to 2.5%–3.5%.

Weakness is driven by a crisis in confidence, stemming from declining house prices (an important asset in Chinese household balance sheets) as well as continued "zero Covid-19" measures.
Stimulus measures such as investment in infrastructure and credit easing are losing effectiveness as weak consumer demand weighs on the economy—a challenge not addressed by current stimulus measures.

Emerging markets

For the emerging markets, we maintain our full-year 2022 economic growth estimate of about 3.0%, down from around 5.5% at the start of the year. Our current view is below consensus; the International Monetary Fund, for example, projects growth of 3.6%.

The primary headwinds faced by emerging economies are widespread central bank tightening and the simultaneous slowing of growth in the United States, the euro area, and China.
Emerging Europe is most at risk of recession.
Further out, markets are pricing interest rate cuts to counter slowed economies—most aggressively in emerging Europe but in Latin America as well.
Although higher commodities prices do benefit some emerging economies, they're a negative in the aggregate.

Big Fed rate hike coming in September?

The Fed raised the target for its federal funds rate by 75 basis points on July 27, to a range of 2.25% to 2.50%, and said such an "unusually large" rate increase may be appropriate again in September to bring inflation under control.

Vanguard expects the Fed to increase its federal funds rate target to a range of 3.25% to 3.75% by the end of the year, from a target of 0% to 0.25% at the start of the year.
We continue to expect a terminal rate of at least 4% in 2023 to get inflation under control. That would put the policy rate well above the Fed's assessment of the neutral rate, which Fed Chair Jerome Powell said was around the Fed’s new rate target. (The neutral rate is the theoretical monetary policy rate that would neither stimulate nor restrict economic activity.)

Inflation continues at high levels

Consumer prices in the United States, as measured by the Consumer Price Index (CPI), were unchanged on a seasonally adjusted basis in July. On a year-over-year basis, prices were up 8.5% in July, down from 9.1% the month before.

Core CPI, which excludes food and energy prices, was 5.9% higher than in July 2021, matching its pace in June and 0.5 percentage point below its March peak.
Core personal consumption expenditures (PCE), the Fed's preferred inflation indicator in considering monetary policy, rose 0.6% in June, ending a fourth-month run of 0.3% readings. It rose 4.8% compared with a year earlier, ending three straight months of deceleration.
We expect core PCE to ease toward 4% by year-end.

Job numbers exceed expectations

The labor market in the United States crushed expectations, adding 528,000 jobs in July.

The unemployment rate edged 0.1 percentage point lower, matching the 3.5% pre-pandemic rate of February 2020.
Vanguard believes that structural constraints on labor supply (such as an increased rate of retirements, decreased immigration, and changing job preferences) limit near-term risks to the labor market.

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