Our investment and economic outlook, April 2023

Our researchers believe U.S. housing activity will be driven in the next couple years by: 1) the structural undersupply of homes that’s prevailed since the 2008 global financial crisis; 2) robust demographic trends and favorable sentiment toward homeownership; and 3) strong borrower fundamentals and high equity cushions.

Since World War II, declines of greater than 10% in the annualized rate of investment in housing construction and improvements (or “residential fixed investment”) have coincided with recession on all but two, wartime occasions, when defense spending propped up the economy. In the last three quarters of 2022, declines in such investment hovered around –20%.

The housing downturn is part of the reason why we view a mild U.S. recession in 2023 as most likely.

The views below are those of the global economics and markets team of Vanguard Investment Strategy Group as of April 19, 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. 

Since the March 10 closure of Silicon Valley Bank revealed stresses in the U.S. banking system, financial markets have been pricing in Federal Reserve interest rate cuts. According to the Atlanta Fed’s market probability tracker, markets as of April 17 expected the equivalent of two quarter-point cuts this year to the Fed’s target for short-term interest rates. We do not believe those expectations will be met.

• We don’t see enough of a bank stress-induced impact on credit conditions to warrant a pause in the Fed’s inflation-fighting campaign. We’re still most closely watching the strength of the labor market, the potential for accelerated wage gains, and the stickiness of core inflation.
• We expect the Fed to raise its rate target by another 75 basis points (0.75 percentage point) this year, to a range of 5.5%–5.75%. We don’t foresee rate cuts before 2024.
• A combination of fewer job vacancies and more unemployment likely will be required to keep wage growth in check. As more restrictive financial conditions take hold, we foresee the unemployment rate rising to 4.5%–5% (from 3.5% in March) by the end of 2023.
• We continue to expect 2023 U.S. growth of around 0.75%. A recession in the second half of the year remains our base case.

The latest data portray a Chinese economy in full bounce-back mode in the months after its postpandemic reopening. Given the strength in first-quarter data, we have increased our outlook for full-year growth from 5.3% to 6.4%. With consumer confidence on the mend and credit growth accelerating, there is scope for a further pickup in activity over the coming quarters.

• We expect China’s postpandemic recovery to be uneven, however. COVID-sensitive services sectors have led the rebound since the beginning of the year, joined more recently by the housing and export sectors. Manufacturing remains sluggish and domestic demand weak.
  
• Low inflation, especially low core inflation, suggests some softness in domestic demand. Consumer prices fell on a monthly basis for the second straight month in March and were up just 0.7% compared with a year earlier.
• We expect inflation to average 2.5% in 2023, below the People’s Bank of China’s 3% target.
• We don’t expect further People’s Bank of China cuts to the reserve requirement ratio after a 25-basis-point cut for large and medium-size banks announced March 17. Any easing in the medium term is likely to be targeted, such as for the benefit of manufacturing and green investment.

Recently released inflation figures support central bank hawkishness. While falling energy prices helped slow the pace of year-over-year headline inflation to 6.9% in March, the pace of core inflation, which excludes volatile food and energy prices, increased for a fourth straight month, to 5.7%.

• We expect core inflation to peak in a range of 5.7%–6% in the next few months before fading in the second half of 2023. Core inflation is likely to average 4.5% in 2023 and end the year around 3.3%—still solidly above the European Central Bank’s (ECB’s) 2% target.
• We expect the ECB to raise its deposit rate (currently 3%) to a range of 3.75%–4%, with no rate cuts in 2023. Markets are pricing in a peak rate of 3.5%–3.75%.
• Our base case includes a recession in the second half of the year and full-year GDP growth around 0.5%. Although activity has been somewhat stronger than expected, we see a likely further tightening in financial and credit conditions as a strong opposing force. We continue to anticipate the effects of recent banking sector stress as being temporary.
• The euro area’s labor market remains historically tight and should continue to exert upward pressure on wages, which an inflation-fighting ECB will watch carefully.

Labor market and inflation data released this week did little to suggest that the Bank of England (BOE) may be able to pause its rate-hiking cycle at its next meeting. While growth in private-sector pay and job vacancies eased in the December 2022–February 2023 period and the unemployment rate edged higher, growth in public sector regular pay continued its nearly year-long rise, to 5.3% on a year-over-year basis. And while the pace of headline inflation slowed in March, it remained in double digits.

• We continue to expect core inflation, which stood at 6.2%, year-over-year, in February, to fall below 4% by the end of 2023 as the effect of higher interest rates and the benefits of lower energy prices work through the economy.
• We expect the BOE to lift the bank rate to 4.5% when it next meets, on May 11, and to leave it there for the rest of 2023.
• Our business-cycle view is unchanged. We continue to expect recession in 2023, with full-year GDP falling by about 1%. We foresee growth of about 0.6% in 2024.

Increasing business and consumer confidence, as measured by surveys that feed into Vanguard’s proprietary index of leading economic indicators, suggests continued economic resilience in emerging markets, especially emerging Asia.

• We recently raised our forecast for 2023 emerging markets GDP growth from about 3% to about 3.25%. Even faster growth could result if greater optimism translates into greater economic activity. Because we expect slower global growth later in 2023, however, our forecast remains relatively subdued. For example, the International Monetary Fund this month increased its forecast for 2023 emerging markets GDP growth to 3.9%.
• As in developed markets, core and services inflation has been persistent, even as headline inflation slows more meaningfully.
• In Mexico, for example, a second consecutive monthly decrease left the year-over-year pace of headline inflation at 6.85% in March, more than a percentage point below its rate just two months earlier. Core inflation, however, stood at 8.09%, down less than half a percentage point from its 8.51% peak four months earlier.
• Emerging-market central banks were quicker to raise interest rates in this hiking cycle than their developed-market counterparts and may lead the way in pausing rate hikes and eventually in cutting rates. Central banks in Poland, Romania, and Indonesia held rates steady this month, acknowledging slowing inflation alongside increased uncertainty in the global economy.

On April 12, the Bank of Canada (BOC) held its short-term interest rate target steady at 4.5% for a second straight month, giving itself further room to assess whether monetary policy is sufficiently restrictive to return inflation to its 2% target.

• We believe that, with home sales holding up and labor markets still strong, the policy rate will need to remain elevated for longer than some observers expect, regardless of whether the BOC further raises its key rate.
• Complicating the BOC’s calculus is that Canadian homeowners are among the most indebted in developed markets. Rising interest rates can pose challenges for household budgets in a country where variable-rate mortgages are popular, especially if the labor market softens.
• We continue to foresee 2023 GDP growth of about 1%, with risks to the downside, and a recession late in the year.

The Reserve Bank of Australia (RBA) held its target for short-term interest rates steady at 3.6% on April 4, ending a run of 10 consecutive policy meetings in which it lifted the cash rate. Noting the cost of allowing high levels of expected inflation to become entrenched, the RBA said “some further tightening of monetary policy may well be needed” to ensure that inflation returns to its 2%–3% target.

Yet the central bank’s data-dependent approach suggests the rate-hiking cycle may have peaked. Consider a variety of indicators:

• The labor market. It isn’t as tight as those of most developed-market peers, despite multidecade low unemployment. The ratio of job vacancies to the unemployed is well below that of the United States, for example. A relatively high labor force participation rate limits upward pressure on wages and, by extension, overall inflation. We expect the unemployment rate (3.5% in March) to rise this year as financial conditions tighten.
• Inflation. It appears to have peaked. The prices of goods and services stood 6.8% higher, on average, in February than a year earlier, continuing their deceleration from the 8.4% postpandemic peak of December 2022.
• Housing. Most Australian homeowners hold mortgages with variable rates or fixed rates with short terms. Inflation and growth, therefore, are likely to slow as the effects of past rate increases ripple through the economy. 

We continue to expect:

• Headline inflation to fall to about 4.25% by year-end and into the RBA’s 2%–3% target range in 2024.
  
• The economy to grow 1%–1.5% this year. We assign a 50% probability of recession over the next 12 months, up from 40% last month, as our proprietary index of leading indicators reflects below-trend growth.

• Tech sector layoffs and what they foreshadow (article, issued April 2023)
• Consumer spending could push Fed higher (article, issued April 2023)
• Advice for investors feeling anxious (3:16 video, issued March 2023)
• Personalized inflation hedging: A closer look at your true consumer price index (research paper, PDF, issued February 2023)