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While the traditional 60/40 balanced portfolio has suffered its worst year in decades, and Recession is likely in 2023, the Vanguard Group is optimistic that balanced portfolios will thrive beyond 2023 and over the rest of the decade.
“A balanced portfolio still offers the best chance of success,” is one of the top conclusions that will be unveiled Monday: Vanguard Canada is hosting its Economic and Market Outlook for 2023, with a global virtual press conference scheduled at 11 AM [Dec. 12]. It includes Vanguard economists such as Global Chief Economist Joe Davis.
Below, received last week under embargo, are highlights of a report titled Vanguard Economic and Market Outlook for 2023: Beating back inflation. It runs about 60 pages, including numerous charts.
The text below consists mostly of excerpts from the Vanguard report, with the use of an ellipsis to indicate excisions, so there are no passages in quotation marks. Subheads are also taken from the original document. Apart from a handful of charts reproduced below, references to numerous other charts or graphs have been removed in the excerpts selected below.
Base case for 2023 is Disinflation
Our base case for 2023 is one of disinflation, but at a cost of a global recession. 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. As such, our base case has government bond yields generally peaking in 2023. Although rising interest rates have created near-term pain for investors, higher starting rates have raised our return expectations for U.S. and international bonds. We now expect U.S. and international bonds to return 4%–5% 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 2.25 percentage points higher than last year. From a U.S. dollar investor’s perspective, our Vanguard Capital Markets Model projects higher 10-year annualized returns for non-U.S. developed markets (7.2%–9.2%) and emerging markets (7%–9%) than for U.S. markets (4.7%–6.7%).
Global inflation: Persistently surprising
Our base case is a global recession in 2023 brought about by the efforts to return inflation to target … growth is likely to end 2023 flat or slightly negative in most major economies outside of China. Unemployment is likely to rise over the year 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 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.
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.
Rising interest rates and higher interest rate expectations have lowered bond returns in 2022, creating near-term pain for investors. However the bright side of higher rates is higher interest payments. These have led our return expectations for U.S. and international bonds to increase by more than twofold. We now expect U.S. bonds to return 4.1%–5.1% per year over the next decade, compared with the 1.4%–2.4% annual returns we forecast a year ago. For international bonds, we expect returns of 4%–5% per year over the next decade, compared with our year-ago forecast of 1.3%–2.3% per year.
Global equities: Resetting expectations
The silver lining is that this year’s bear market has improved our outlook for global equities, though our Vanguard Capital Markets Model (VCMM) projections suggest there are greater opportunities outside the United States.
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.
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.
Within the U.S. market, value stocks are fairly valued relative to growth, and small-capitalization 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 because of a faster increase in expected bond returns
