2023 economy and markets: 4 things to know

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2023 economy and markets: 4 things to know

Vanguard Perspective


December 12, 2022

This article was updated on January 26, 2023.

Vanguard Economic and Market Outlook for 2023: Beating Back Inflation examines four key themes that we expect will shape the economic environment as we move into 2023:

1. Central banks' vigilance in the fight against inflation.
2. The economic effects of the energy crisis in Europe.
3. China's long-term structural challenges as it aims to end its zero-COVID policy.
4. A more positive outlook for long-term investors.

Want more insights? Watch a replay of our recent webcast, Investing in 2023: The economic and market outlook.

1. 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

central bank policy rates graph

Note: Dotted lines represent market-based expectations for future policy rates as of October 31, 2022.

Sources: Thomson Reuters Datastream and Bloomberg.


“This is the greatest inflation threat we’ve seen since the 1980s,” said Josh Hirt, a Vanguard U.S. senior economist. “Central banks have a difficult path ahead that will require being more aggressive with policy, making additional rate hikes, and maintaining vigilance as the inflation situation shifts. In the U.S., the Federal Reserve has adopted the position that there is still work to be done, and it appears to have the resolve to stick with it.”

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. Support for policy tightening could wane in 2023, however, particularly if economies slow to the extent that corporate belt-tightening leads to large-scale layoffs, Hirt said.

“To solve the inflation issue, the Fed really does need to slow economic activity,” he said. “We think the available window for the Fed to raise 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 stabilize prices. In 2023 our base case is one of disinflation, but at a cost of a global recession.

2. Energy crisis in Europe: Challenges are likely to continue

The war in Ukraine added to European uncertainty, 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

eu gas imports bar graph

Sources: International Energy Agency, European Commission, and Vanguard estimates, as of October 31, 2022.

“A large reason why the 2022 European gas supply is more comfortable than expected is that many nations were able to fill gas storage facilities ahead of time, while Russian gas was still flowing,” said Shaan Raithatha, U.K./Europe senior economist at Vanguard. “Next year they’ll be starting from a much lower base, which could present a challenge in the middle or later part of 2023.” 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 impact consumer confidence. “As in the United States, there are tentative signs now that inflation in Europe has peaked,” Raithatha said. “But we still expect price pressures associated with the labor market and wage growth to be stubbornly high as we move into next year.”

We project that inflation will have peaked around 11.0% and remain well above the European Central Bank’s 2.0% target in 2023. In response, we expect the ECB to continue to increase its deposit rate through the first quarter of 2023 to reach 2.5%.

3. 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. We forecast GDP growth to end 2022 around 3.0%, well below the historical average and the official “around 5.5%” target. For 2023, we foresee GDP growth accelerating to around 4.5%, driven by a modest loosening in the zero-COVID policy and a stabilizing real estate sector.

“COVID is one of the factors that’s going to dominate the economy in the coming months,” said Qian Wang, Vanguard Asia-Pacific chief economist. “The Chinese exit from zero-COVID is going to be bumpy, as witnessed by the recent lockdowns in big cities like Chongqing, Guangzhou, and Beijing. China needs to prepare for reopening by promoting vaccine and drug development, improving hospital facilities, and changing the mass perception of COVID. It cannot afford to abolish its zero-COVID policy outright, and it could be several months before it can relax it meaningfully.” 

Meanwhile, we expect a protracted downturn in housing investment over the next 5 to 10 years. “Declining affordability, an aging population, reduced urbanization, and a policy stance that ‘housing is for living in, not for speculation’ will push real estate demand structurally lower,” Wang said. Supportive fiscal and monetary policy will help boost demand, she said, but “even as the government relaxes regulations on the housing market, we don’t expect a rebound to be sharp.”

Despite easing regulation, the housing market is unlikely to rebound because of a structural downturn.


Housing remains oversupplied in China, with increased demand providing only a slight offset to supply growth.

housing supply and demand for China

Cyclical factors will provide near-term support to housing, but structural factors will lower demand over the next 5 years.

real estate demand and age

Source: Vanguard calculations, based on data from Bloomberg, as of October 31, 2022.

Finally, China is on the wrong side of a global supply chain restructuring. Multinational firms are looking to reduce dependence on strategic competitors, which threatens China’s long-term export dominance. “This will challenge China’s ability to attract and retain top talent, and could crimp innovation,” Wang said. “To compensate, China is turning its focus to ‘indigenous innovation’ and ‘internal circulation’ so it can continue to grow domestically.”

4. A more sanguine outlook for long-term investors

Late in 2021 we emphasized that high equity valuations and low interest rates had not yet reflected the seriousness of growing inflationary pressures, which created a fragile backdrop for markets. It wasn’t until mid-2022 that markets were forced to accept a new economic reality of persistently rising inflation. A resulting combination of rising discount rates, geopolitical shocks, and slowing growth led to a stubborn global sell-off that spanned asset classes.

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 starting interest rates 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 annualized projections for the next decade have increased by around two percentage points for both global bonds and global equities.  

In response to a persistently strong inflation environment in the U.S., “we’ve seen extraordinary hawkishness from the Federal Reserve that has increased the nominal U.S. yield curve to a level not seen since 2011,” said Kevin DiCiurcio, research team lead for the Vanguard Capital Markets Model. Over the next decade, we expect an annualized return of 4.0%–5.0% for global bonds ex-U.S. and 4.1%–5.1% for U.S. bonds. That’s a 2.7-percentage-point increase over last year’s projection for each bond category. 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 U.S. bond market; however, similar trajectories hold true across the developed world.

We expect investors to be better off because of, not in spite of, the sell-off

value and year comparison of 100 investment

Notes: The chart shows actual returns for the Bloomberg U.S. Aggregate Bond Index along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as of December 31, 2021, and September 30, 2022. The dotted lines represent the 10th and 90th percentiles of the forecasted distribution. Data are as of September 30, 2022.

Sources: Vanguard calculations, using September 30, 2022, VCMM simulations, and Bloomberg.

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 modeled asset class. Simulations as of December 31, 2021, and September 30, 2022. Results from the model may vary with each use and over time. For more information, please see the “Notes” section.

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.

On the U.S. equity side, the stretched valuations we’ve seen in recent years were unsustainable in the context of the domestic inflation and interest rate environment. U.S. market equity indexes all posted losses greater than 20% in the first nine months of 2022, as did developed international and emerging-market equity indexes. Current U.S. valuations are more attractive than they were last year, but some near-term caution for U.S. equities may still be warranted. “U.S. equity valuations are still above our estimates of fair value, and long-term return expectations are somewhat below historical averages in the U.S.,” DiCiurcio said. “We’d have to see valuations come down a little further to push expectations closer to historical average ranges.” Even so, we expect U.S. equities to return 4.7%–6.7% over the next 10 years, a 2.4-point increase over last year’s projection. 

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 time horizon.

Webcast replay—Investing in 2023: The economic and market outlook

Get the latest insights from Joe Davis, Vanguard global chief economist, and Sara Devereux, global head of Vanguard Fixed Income Group, on key economic issues and the forces shaping the markets, with a special focus on fixed income.

Investing in 2023: The economic and market outlook

Jill DeBerardinis:Hi, I'm Jill DeBerardinis, and you're watching a replay of a recent webcast on our 2023 economic and market outlook. We hope you enjoy it.

Jill DeBerardinis: Hi, I'm Jill DeBerardinis, and I'm a sales executive in Vanguard Financial Advisor Services™ division. Today I'm live from Vanguard's studio in beautiful Valley Forge, Pennsylvania. I'm delighted to be sitting down with Vanguard® global chief economist and Head of our Investment Strategy Group, Joe Davis, and our global head of fixed income, Sara Devereux.

As we embark on a conversation on the markets and economy, these two experts are perfectly positioned to help us navigate 2023 and beyond. Joe's Investment Strategy Group serves as our in-house think tank and produces industry-leading research that shapes our viewpoints here at Vanguard. And Sara leads our deep and credentialed team of fixed income experts all around the globe, managing over $2 trillion in assets under management.

Now, a few housekeeping items before we get started. First, many of you submitted questions during registration, and we shaped today's agenda based on your questions. Please submit additional ones, and we'll aim to address as many as we can.

Second, if you experience technical difficulties at any time, please click the Question icon at the bottom of your screen. We have staff ready and available to help you. Be sure to check out the Resources icon on your screen for additional content.

Finally, and I promise this is the last thing, we are excited to offer continuing education for today's event. If you requested continuing education credits during registration, please make sure to stay online for the entire session. There will be three unannounced poll questions that appear on your screen during the event, and you'll need to respond to all of them in order to receive CE credit.

All right, Joe and Sara, are you ready to get started?

Joe Davis: Yes.

Sara Devereux:Yes.

Jill DeBerardinis: Great. Right, so I wanted to give the audience a chance to get to know both of you a little better. Joe, I'm going to start with you. You're a bit of a fixture here at Vanguard.

Joe Davis:  That means I'm getting old.

Jill DeBerardinis: Yes. What's it been, 20+ years?

Joe Davis:  20 years.

Jill DeBerardinis: 20 years now at Vanguard. I want to ask you what's your proudest accomplishment here at Vanguard so far?

Joe Davis: Proudest accomplishment, well, maybe I can sneak in two. One is just assembling the research team, being part of that research team. Much like Sara, [I'm] just really proud of the team we have at Vanguard Investment Strategy Group.

The second one is just bringing tools to help investors think through investment problems, over 20 years. It's the frameworks we've tried to operationalize, economics, markets. We'll hear [about] that Capital Markets Model, probably the first project I worked on 20 years ago, and even frameworks for asset allocation. So, again, these are tools that we hope professional investors can use to make the decisions and the portfolios that they wish to make for their clients. So, I'm really proud to have operationalized that, being rigorous but yet being relevant in the real world.

Jill DeBerardinis: Yes, that's great. Well, we're so excited to hear more about what your team has brought to light in recent times. But I wanted to move over to Sara because Joe may seem like a bit of a household name around here and maybe our audience doesn't know you quite as well.

So, I'm here to change that. I know you've spent a lot of time being maybe a bit loud and proud about how much alpha can be added in fixed income. It's interesting to see you now here at Vanguard, a place that's really known for our indexing reputation. So what kind of inspired you to come join us here at Vanguard?

Sara Devereux: Well, sure. It's great to be here, first of all, hi everyone. Well, obviously, yes, Vanguard is very well known for being an index shop with a trillion in assets under management and a number one market position. And sometimes people are surprised to hear that we also have nearly a trillion in assets under our management in active—across active taxable, municipals, and our money market franchises. And in terms of market share, we're number one in munis and we're number two in active taxable.

So this didn't happen overnight. You know, we've been in active fixed income for over 40 years. But, more recently, we really have been investing in growing our active fixed income franchise to meet client demand. So we've been growing our capabilities in mortgages, emerging markets, and high yield. And we've been able to add new funds as well—Core, Core-Plus, and Emerging Markets. I'm proud to say the performance has been very strong. On a five-year trail, 80% of our active funds are beating their Lipper peer averages, so something to be proud of.

Now, to answer your question of what inspired me to come here to Vanguard, I'll say, you know, I got a call from Vanguard. Of course, I took the call. Like, who wouldn't take a call from Vanguard? Phenomenal reputation as a firm. But I really took the job because of the people, the culture, and the mission, you know, our mission to help investors with their best chance of investment success. I will tell you, we live and breathe it every day, right? To me that's really inspiring and I'm super proud to be a part of the team.

Jill DeBerardinis: Yes, what an inspiring message and a good reminder to all of us why we're here. Yes, that's great.

So I want to just dive right in to the markets and economy, and I think we have to start with inflation.

Sara Devereux: Here we go.

Jill DeBerardinis: I think we have to start with inflation. I don't think we could host any economic outlook today without touching on the subject of inflation. And I'll reference also that our paper this year was called Beating back inflation, meaning, Joe, I think you're going to have a ton to say on the topic.

But I first want to think about the fact that inflation remained a little stickier through 2022 than maybe some had been expecting prior to that. There were some shifts and, of course, categories where we felt inflation. But my real question for you here, and I think the one that's burning on our audience's minds, is when, if ever, will we get back to what we would call quote/unquote a “normal” inflation rate?

Joe Davis: Normal inflation. Well, great. And again, you know, the viewers may not know, Sara and I have spent a great deal of time, our teams, together. We meet every week, in terms of investment strategy for her great active funds, in the process. We've been talking about it for a long time, Jill, to your point: inflation. The bottom line is inflation, very likely, and with very high odds, will be lower over the course of this year. There's simple arithmetic reasons for that but, more importantly, the drivers for that.

So, about this time last year, our analysis indicated that roughly 50% of the rise, you know, higher-than-expected rise in inflation, was supply related, which I think gets to your point, Jill, a little bit stickier initially and higher than expected. But [it's] also something that we zeroed in on. We may have underestimated [the] supply side; we did not underestimate the demand side. And that is tied to the strength of the labor market, which we've seen the Federal Reserve increasingly start to talk about.

So inflation will come down. Sara and I, we talk about that last mile of inflation. So, if it's closer to 6%, depending upon the measure you're using, it'll get down to 3% or so over the course of this year, plus or minus. It's that last percent. If central banks target 2%, which is really tied to—which we'll get into, I think, later in this webcast in terms of do we see a deceleration in wage growth in the tightness of labor markets. If we don't, that's going to be much stickier or the Fed's going to have to go further. But, you know, at the end of the day, history clearly shows across any country and across long periods of time, that if a central bank wants to bring down inflation, it's actually pretty easy to do. You just have to raise rates above the rate of inflation and keep at it.

And I think we're seeing the rhetoric from the Federal Reserve, the bond market, and that was a pain point last year.

Sara Devereux: Oh, yes.

Joe Davis: So, I'm not concerned that we're going to have inflation at this rate this time a year from now. It's more the concerns of how much, sort of, collateral damage or headwinds [will we have] during this process. So, I think that's how it'll play out this year.

Jill DeBerardinis: So I guess maybe a follow-up to that, are we getting the right signals that the Fed is doing enough or that other things are materializing to bring inflation down right now? Are you feeling kind of confident there? And, I guess, what do you think needs to continue to happen with Fed or not Fed in order to get us back to where we need to be?

Joe Davis: Well, and again, and Sara, please jump in, I mean we had a framework for over two years, right? Look at what are the drivers, which is not easy to do, because you have movements in supply as well as demand. We've seen an incredible improvement on the supply side, which was on the good side, which was really the intro to COVID, and that was the first hard, expected inflation.

So we're seeing indicators of that, but what we were concerned about is the Federal Reserve and central banks were underestimating what I would call the demand and the wage-based fluctuation, which made it easier for companies to pass on prices. That was why we were very adamant that central banks, particularly the Fed, were behind the curve this time last year.

Now we've had to revise our forecast. Well, full transparency, I wasn't here last year saying the Fed was going to go to 5%. But we were saying it was higher than what the bond market expected, and that was the active conversation with Sara and the team.

So I'll turn it over to Sara. I think we're starting to see evidence of that with deceleration, but we're not out of the woods yet because inflation is still elevated. That is why Beating back inflation is the theme. We were intentional on the theme, Jill, because it's not going to just magically come down.

Part of that, we'll, we will have some good tailwinds to that, but there's some headwinds in terms of—what you need to see is a little bit of demand destruction on the labor market if you're really going to bend the inflation curve.

Sara Devereux: Yes, one of the things I think your team has highlighted from the beginning was all the supply shocks. Right, like he talked about the good supply shock with supply chain disruption. We talked about the energy supply shock, right? And those two seem to be resolving, but the third shock that you guys identified really early was labor supply. The labor force participation rate, and that really has come to be the one that's still kind of out there that we're keeping a close eye on. I mean your team was very early to highlight that, and we're still keeping an eye on it.

Jill DeBerardinis: Yes, great.

So, Sara, I think, actually, just before the session today, we were talking about how these higher rates actually paint a pretty rosy picture for fixed income. So just thinking in that same realm, do you think that some of the pain we experienced through 2022 might be in the rearview mirror for us now?

Sara Devereux: Well, certainly there was a lot of pain in the markets last year, and not just in fixed income. As Joe said, inflation surprise to the upside, right, forcing central banks into a very steep hiking cycle.

We started the year at 0% on Fed funds. We ended the year at 4.5%, right? That is the fastest pace of monetary policy tightening in the U.S. since the 1980s. So rapidly rising rates, tightening financial conditions, that drives volatility and fears of recession. Not good for risk assets, not good for equities, and not good for credit spreads either.

And then, finally, we had a lot of event risk. Russia was invading the Ukraine. We had the U.K. pensions struggling and the Bank of England had to come in to help them. So none of these things were good for the markets.

And I just want to highlight that this was a very unusual year. Incredibly unusual for all of those things to happen. Not a single major asset class had a positive return last year, except for cash and commodities. Like, 10-year U.S. Treasuries [had a] total rate of return, –17%. S&P 500, –18%. Just to give you an idea of how unusual that is, the last time both stocks and bonds were down more than 10% at the same time was in the 1800s. Right, so incredibly unusual year.

Joe Davis: Early 1800s.

Sara Devereux: Yes, early 1800s, exactly. Now, the good news is that really sets us up for better returns looking forward and I'll highlight a few aspects just related to fixed income specifically.

First of all, valuations are materially better than they have been. In fact, we haven't seen yields like this in a decade. And secondly, income is back in fixed income. That might sound obvious because yields are higher, but think about it for a second. It's been a long time since we've had a coupon that we can clip. And I bring your attention to that because that component of the return is very stable. That's a real buffer to price volatility, so that's incredibly valuable in fixed income.

The third thing I'll highlight is diversification benefits are back. Last year was a bit of a struggle, a highly unusual year. This year we expect bonds to behave more normally and, over the long term, bonds are a great diversifier of equity stress.

And finally, if there is a recession this year, which many people are forecasting, bonds tend to outperform in a recession. So shaping up to be a pretty good outlook right now.

Jill DeBerardinis: Yes, lots to look forward to in bonds. I would love to be the head of fixed income right now. But I will say you did use the R word there, Sara.

Sara Devereux: I did.

Jill DeBerardinis: So that is where I'm going to take you next, Joe, and that should be no surprise at all. I do want to start addressing, kind of, potential future recession.

We are, obviously, in a more challenging environment as it pertains to a recession in this year and the economy does seem to be slowing down. But, you know, where do you put that probability? Are we headed for a recession in the U.S.? Is this a foregone conclusion?

Joe Davis:  Yes, Jill, and again it's something Sara and I talk a lot about. I mean, when we look at our framework, if you ask the official “what is our baseline?, we do have a recession. But I'll add caveats to that, Jill, and it's not because I'm avoiding the question or economists try to hedge their comments just because the nature of what our projections—our simulations are projecting. In fact, I would say that this is also shared, not widespread across the financial markets, but it's the central tendency.

And that is our growth outlook for this year is effectively zero. Now, someone may hear zero, and there's some out there saying, “Oh, then that means they're going to have a soft landing because they have the same economic forecast.” There's others that have the same economic forecast, and they're saying recession.

Now I think part of that is interpretation, right? Like, if I'm an investor, I hear recession, I look at the past few recessions. They have not been, I mean they've been deep. One was very short, one was debt-deleveraging cycle, the [global financial crisis] (GFC). They're pretty—they're in the tails of the long-run distribution. So I understand when someone says recession as if there's like, it's either going to be a good year or a really bad year. I don't think that's going to be the case, because the projections, even within a fairly wide range or in, like, the close to zero-like growth.

Now I think what a surprise would be, we either have a deep recession or we have, like, growth doesn't decelerate at all. I mean our baseline's effectively—the closest analogy would be 2001, which at the time economists actually debated if there was a recession or not. We had a sell-off in the Nasdaq and the tech markets. Job losses were modest, and we have a similar phrase, what we've called "job-full recession.”"It sounds like we're being cute; we're not. I think it's the genuineness of the tight of the labor market, number of vacancies, but we do have modest negative growth for a time. But it's not like the last two recessions, and so that's our baseline forecast. And then we'll evaluate the odds to that as we go through the course of the year.

Jill DeBerardinis: Yes. I am going to jump us ahead really quickly to our first poll question for our audience, because you went there with the shape of the recession and kind of what that future recession looks like. So I do want to bring up our first poll question for our audience, and that poll question, which should pop up on your screens at any moment, is, “What is the likely path of a recession in the U.S.?” And what we're really looking at here is shapes of potential paths.

So we have three options here for you. The first is a sharp decline, then a strong recovery. The second being a shallow recession and the third being a slow decline and a long recovery.

So we'll take a look at what our audience thinks, and we can do a bit more comparing and contrasting of what this particular market would look like. But before we get there, and we'll give our audience a chance to get back to us with their responses, I want to quickly take us globally. So you are the global chief economist, and so before we jump back into the U.S. path of recovery and what that might look like, let's go global.

What is the chance of a recession globally? What does that look like in some of the big markets that we watch around the world?

Joe Davis: Well, if you take a weighted average, Jill, we talk a lot with Sara's team, I mean Europe is extremely high. I mean, I can't legally say 100% because that implies no probability of it not happening, but it's as high as you can generate within reason. China certainly coming out of their COVID lockdown and so will not have that experience by this time next year, but we're projecting actually negative growth this quarter. So it's really a mixed bag and there [are] crosscurrents.

You know, I think there [are] downside surprises in parts of the markets outside of the U.S. The U.S., I'd say they're evenly balanced when you look over the next year in terms of our baseline forecast. I don't know, Sara, if you'd alter anything like that.

Sara Devereux: No, I totally agree. I think what's fascinating is kind of the whole world went into COVID at the same time and is emerging at different paces. So it does create risks, but it also creates opportunity.

Joe Davis: Well, it also goes at a policy thrust that we would talk internally about in the United States. One of the reasons why that rebound was so strong was we had a fiscal policy response plus monetary policy response that was well over two sigma, two standard deviations.

And, you know, we were modeling that and even we still underestimated the fiscal thrust. So part of that is wearing off in the monetary side. It is not wearing off on the fiscal side, which we'll get into our rates, our longer-term rate discussions and market outlook probably in a little bit.

Jill DeBerardinis: Great. While we wait for those poll results to come in, I do want to also just spend a little extra time on the path of the Fed, what we're thinking there. What can we expect from Jerome and friends? I mean this is one of the big questions that I think is going to dictate how we think about the markets this year.

Joe Davis: Well, I will still refer to the Chairman as the Chairman. Right? As an economist, I've got to respect Chairman Powell.

Jill DeBerardinis: Jerome and friends doesn't work for you?

Joe Davis:  Yes, I say Chairman, but I mean—I think the Fed has finally triangulated. And I don't mean to imply that I was being critical this time a year ago, but they were underestimating the vigor of the labor side, as Sara mentioned.

Sara Devereux: Yes, yes.

Joe Davis: And that's why we see them now focusing on, like, even measures of core inflation that are really zeroing in on wage growth. Right, that hasn't been a surprise to us.

So I think they're calibrating it accordingly. I think what history will show, I think the Federal Reserve early on was, like many economists, I think they were looking too strongly in the very recent memory and accepting low rates. Like there was this natural, artificial speed limit that you could not generate higher rates.

And we were somewhat skeptical of that. We didn't know the timing though, Jill, and it was one of the basis for our capital market projections. We were never assuming extended-forever zero-negative real rates.

So I think they're calibrated on the right thing. Where do they stop? I mean we're closer. I mean the ISG outlook is closer to where I think the forward curve is, the 5 percentage range. But it's something, right, Sara, you and I and your team—

Sara Devereux: We talk about it all the time.

Joe Davis: We talk about it all the time, maybe even the scenarios, where the scenarios could be, up and downside to that.

Sara Devereux: Yes, I mean, I think we do talk about this all the time. In fact, it's hotly debated, but most of the time we agree.

But, no, I'll just add a few things. I think, look, the Fed has made it really clear that they are going to be vigilant on inflation. They are going to prioritize inflation over growth. They're okay with a little bit of softer growth to kill inflation. They have said they are going to be data dependent. Right, they're going to feel their way. They've started to step down, but they are going to keep going until they get what they're looking for.

They have indicated they may go higher and stay there for longer, right? I think at the last meeting, we just got the minutes last week, they said, "not a single member of the FOMC thought they would be cutting rates this year."

Joe Davis: And that's the biggest debate that we have, right?

Sara Devereux: Yes, and the market's pricing it in, cut. So I think that's super interesting.

And also, we talk a lot about their sensitivity to financial conditions, right? Like if the market gets ahead of itself and gets excited about a Fed pivot and the bonds rally and stocks rally, that unwinds some of their good works. We think they're going to keep a really close eye on that.

So our base case, talk about our scenarios, our base case is what we're calling the “hawkish hold.” They go to 5%. They have stepped down their pace. They go to 5% by the first quarter, and they hold there for the year. That puts us through a shallow recession. That cools the labor market, which would cool inflation, and that's our central scenario.

Now, we also talk a lot about monetary policy having long and variable lags, right? They put a ton of timing into the market in a short amount of time. So they're now going to feel their way. Every data release is going to become increasingly important, and the range of outcomes is pretty wide. Like we're talking about downside scenarios where, you know, it's a deeper recession and upside scenarios which could be the economy's resilient and—

Joe Davis: And when they're still tightening it in, yes.

Sara Devereux: And they keep going, and they keep going. They slow down to 25 and it keeps going. It's not our base case.

Joe Davis: But not cutting this year, yes.

Sara Devereux: But not cutting, but we are talking a lot about—

Joe Davis: And we talk about these probabilities every week, in fact, much like a super forecasting approach, much like our longer-term capital markets projections and those range of outcomes. We're updating what we call our priors, updating our information. We're not changing frequently, but as you update information and our research from all of our teams, that may inform our thinking subtly because the market is reacting at the same time, particularly for an active process.

And again, I think that's where your question before, Jill, “Is it going to be a recession or not?” I'm just trying not to put it in. Hopefully investors—it's a zero-one variable because the Fed's baseline forecast is a recession, even though they don't say that.

Sara Devereux: They don't call it that, yes.

Joe Davis: Because now you'd say, “Well, their GDP is modestly positive, but they have the unemployment rate rise.” It would be historically unprecedented, let's put it this way, if they're even closely right and are right that we have unemployment rate rising modestly and we have the yield curve inverted.

But, you know, just because it has happened in the past, the leading indicators are consistent, with a deceleration and growth [in the] back half of the year. I think the debate we have is how much weakness before the Federal Reserve is cutting rates? And that's where we will debate. I'm of the view that I think they will be very reluctant. But that comes to the wage numbers. They are a little bit concerned of the 1970s and letting their foot off the gas.

Jill DeBerardinis: Yes, perfect.

So you mentioned the Capital Markets Model, and I want to take you there for a moment. But just before we do that, I want to apologize to our audience. You went through all that work to answer our poll question, and our results are not coming up in our system at the moment. So my apologies to you. We're going to move on to a couple of other questions, and we may loop back to that one when we have a moment.

But we are in a perfect place to talk about the Capital Markets Model and talk about all the “running the numbers” that your team has been doing, Joe. So what is our Capital Markets Model saying right now about [the] long-term projected fixed income outlook? What are some of the numbers that you're seeing there that our audience can look at and say, “Hey, I have a little bit of an idea of where we're going long term”?

And I think you did bring me a visual for this one that should pop up on the screen for our audience in terms of fixed income securities and where they're valued right now.

Joe Davis: Well, and again, I'll just give a little sense in terms of where these projections are coming from at a high level, Jill. So, it's looking at the drivers of real rates, which means taking out the inflation rate, which is expected, as well as what is in the market, as well as the drivers of inflation. And we tie that in with also the equity market drivers, which are the same factors, as well as things such as multiples or valuations. Then there [are] statistical techniques that you can use that give us decent return predictability at five to ten years out. That's certainly better than looking at the market today or looking at the forward curve.

And so what they're saying is Sara's point. It's like when you get real, positive real rates. So the TIPS yield being positive and so forth, you start generating much more significant risk premia for fixed income. But I'll turn to you, Sara, right, because there [are] various components on that, like in the near-term: credit versus Treasuries, inflation protection. But it's definitely more positive. It's one of the reasons we've been guarded for two or three years, Jill, on our capital markets outlook. We had zero, significantly, deeply negative real rates; and we had [a] high valuations equity market. That combination, even if you don't bet on mean reversion, which we don't say is just because they're low, they have to go back up to average. We do research to say, "What is the conditional long-run average?" because that could differ from the past.

But when you do all that, it's still at such high odds that we're going to have a period of transition. Sara mentioned that was squished in one year. We didn't know if it would be squished in one year, but it was high odds that we were going to have this period. But now, since that's squished, the projections are now looking much more forward because there's much less of that correction, so this fair value concept, which is a range, so that's generally a much more positive outlook for fixed income. And we don't see material, principal losses unless you get, like, deep, sort of bear market, sort of stuff like that.

Jill DeBerardinis: Yes, which is a perfect place, Sara, for you to add a bit of commentary there.

So, I mean, obviously not all fixed income will perform equally in any environment, but I know that your portfolio managers here at Vanguard are laser-focused on finding out where those opportunities are. So what are some of the parts of the fixed income market that we would expect to do well in 2023?

Sara Devereux: Well, sure. So as I mentioned earlier, as Joe alluded to, 2023 is setting up to be a great year for fixed income. Income is back. Projected returns are higher. However, waters are going to be pretty choppy, we think. All boats may not rise with the tide. Our central scenario is one of a shallow recession. In a recession, typically bonds outperform. However, also in a shallow recession, riskier credits can underperform because the risk of default rises. Right, so we're keeping a laser focus on that.

And, you know, currently in credit we are defensive, and we prefer to be up in quality. We have taken down overweights in our riskier parts of the credit market, and we're holding dry powder there to deploy at more attractive levels. We're also leaning heavily into security selection because in environments like this, avoiding the losers can be just as important as picking the winners.

Now, when we look into higher quality parts of fixed income, there's a lot of opportunity. Look at Treasuries. U.S. Treasuries get 3.5%, 4.0% yield. I mean, this time last year if you wanted a 4.0% yield, you had to go to high yield to get that kind of yield, right?

So starting with Treasuries, very attractive. We also like other, I call it high-quality, risk-premium sectors, for example, “agency mortgages” has an agency label, less default risk, lower credit risk if you will, but still a spread over Treasuries. We also like agency mortgages because valuations are pretty attractive right now, and we have a view that as the Fed gets closer to their terminal rate volatility, rates will go down, which will also buoy mortgage returns.

And then finally, we also like munis. Munis look really attractive, and we think that recession is more than priced in there, so high quality.

Joe Davis: All across the muni curve? Short duration, long duration?

Sara Devereux: Especially in the long end of the curve, in the higher quality parts of munis, yes. But we could talk about munis more. I think we'll touch on that later.

Jill DeBerardinis: Yes, I hope we have time to get to some more muni-related stuff because it is a particularly, surprisingly, exciting part of the market right now as well. Never did I think I'd be talking about munis in that way.

Jill DeBerardinis: But lots of areas to look forward to, lots of areas where we can potentially see opportunity in the future and where our investment professionals that we work with here at Vanguard, our clients can look for opportunity as well. So thanks for the work that your team is doing, and that's great information for our folks as well.

So I just want to spend a little bit more time digging in on active management. So I started there at the very beginning. You came from the active world, and you came to join us over here at Vanguard. I imagine that 2023 will be a year of opportunity for active managers particularly. So can you talk a little bit more about why that might be and what opportunities you see for active managers specifically?

Sara Devereux: Sure. So I do think there's going to be a lot of opportunity for active in the new year, and I think it's going to play right into Vanguard's strengths.

First of all, this past year has created an incredible amount of dispersion in valuations, right? More dispersion means more opportunity to monetize relative value. This is a terrific environment for our active fixed income teams to really dig in company by company and do excellent security selection. Security selection always matters. It matters in all environments, but it's particularly important in times of economic stress and in sectors such as high yield and emerging markets.

So we are fortunate to have a best, absolutely best-in-class credit research team and muni credit research team. We have built significant sale there. It is a core part of our active edge, so I think we'll be generating a lot of alpha out of the selection this year.

Another core part of our active edge is our ability to be opportunistic. Okay, we can remain patient while our high fee competitors cannot afford to do so, right? We don't have the pressure to take excess risk just to meet our fee threshold. So, we have breathing room, and with that we have dry powder. So we are entering 2023 with plenty of dry powder that we can deploy when the opportunity is right.

Jill DeBerardinis: Yes, fantastic.

Joe Davis:  That's a great point. We talk about that a lot with the senior investment committee, because it's tough to be patient at times. But if the risk premiums aren't there, you don't have to reach.

Sara Devereux: You don't have to reach.

Joe Davis: But it's tougher to do than to say, right?

Sara Devereux: Yes. By the way, it doesn't mean that we're low risk.

Joe Davis: Eh, more disciplined, relative to breakeven.

Sara Devereux: When the opportunity set is there, we put the risk on. When it's not, we just have that breathing room.

Joe Davis:  We also have to have the courage to deploy the dry powder, because the risk aversion, it's usually happening for a reason, because the markets are selling off.

Sara Devereux: Right, exactly. So, I think 2023 is going to be great.

Jill DeBerardinis: Yes, fantastic. I love to hear that, and I'm sure our audience does as well.

So we're just about at the halfway point, and to me that's an indicator that as much as I'd love to spend a whole hour just talking about fixed income, we might have to pivot to stocks for a moment.

Sara Devereux: Oh, no.

Joe Davis: No.

Jill DeBerardinis: Don't worry. You're not off the hook yet, Sara. That was a really great discussion on fixed income. I appreciate your commentary there so much. But I do want to switch gears and talk about stocks a little bit.

So, Joe, I'm going to just take you high level first. Can you talk about projected returns in the equity markets? Let's look long term first, so let's start with the next ten years, which I know your team is kind of expert in doing through our Capital Markets Model.

Joe Davis: Well I think that's where, Jill, I was referring to it a little bit, a while ago, that the tone of our outlook has changed. And in this case, it has changed for the better. You know, again for context for two or three years, we were using phrases such as guarded, muted return, code word for significantly below historical averages on a ten-year basis.

Now that was all that context I mentioned before. Now again, we had—I'm not saying that because, “oh look, stay the course and see what happens.” I'm doing that because it gives context for the primacy for what I'm saying now is that our expected return outlook is improving; and it's not necessarily because the markets had a tough year, because markets can always go down more. So it's not just mean reversion because the markets were bad, so we are now good. It's because of the fundamentals. So when we put them together, the equity risk premium projected for U.S. equities and for non-U.S. equities has improved.

It's almost all—not so much [that] valuations have gotten a little bit better, Jill, most of it's coming from Sara's world in the real, short rate and the cash rate on fixed income, which is being embedded in the term structure in the forward curve.

So it isn't like stocks are massively undervalued. They're actually not. And as you see in our outlook, we're actually slightly above the fair value range. But the total return for nominal portfolios is improving roughly 200 basis points because of the shift in the term structure, real and nominal, in the Treasury markets which are the base rate for any risk premium we're going to port over for equities.

So it's generally more positive, you know, what the next year brings. I mean history shows that if you're talking recession, you tend to drop a little fair value. But that's more of a temporary, maybe it's a dry powder sort of environment that Sara's alluding to. I actually don't know. I know the power of our framework is pretty strong five or ten years out, and so we're not saying phrases such as “guarded” or “muted.” They're actually a more formative outlook. The first time we've probably used those adjectives in seven or eight years, so it's definitely better.

Jill DeBerardinis: Yes, when I was sitting in this chair last year, the year before, it was “guarded,” “muted,” a lot of commentary around that. It is feeling a lot more positive now.

So I know you've provided this great visual, and thank you for that, which shows valuations across a different range of equity parts of the market. But our audience here, our investment professional audience has picked up on something right away and I want to ask you a question around it because they're smart enough to see here that we've kind of looked at international and said, “You know, we think it's going to outperform the U.S.” And we've been saying that for many years now, and people who follow our outlook regularly have seen that for a long time.

So I just wanted to take a moment here to talk about your conviction level in international outperforming the U.S. What are some of the material drivers you see there? What are some of the things that you think are going to happen?

Joe Davis:  Yes, Jill, and I think it's fair to call that out. It's one of the areas where our projections, you know, if you look across all the indicators, [have] generally done really well. That's the one with the U.S./non-U.S. on the equity side. The reason for our outlook, why it's more positive, is also the reason why it actually has underperformed, same reason. That is that valuation multiple to nearly all of the outperformance of U.S. markets over the past decade, two decades, 25 years has been multiple expansions versus the non-U.S. It's not growth. It is not currency.

So we do not have an embedded currency, although we have currency projections and growth projections, earnings growth projections. That's not why we're saying that. It's because, so why would that be true going forward? That would be that valuations ultimately matter. It would be that some of these phenomena are global in nature.

Now where it could go wrong is if Europe and Japan never got off the zero-bound. I mean I'm trying to look at what's not in the data sample. They would say, “Okay, well that's a great story, Joe, but what if you don't get that sort of conditional improvement?” There's always an assumption embedded, even in history. That would be that if somehow Europe and Japan both—because the dividend yields are materially higher, and the earnings yield is higher. So that would be the risk to that in the projections.

Jill DeBerardinis: How about if we just kind of pull apart emerging markets versus developed markets? You know, what are you thinking there in terms of emerging markets versus developed markets?

Joe Davis:  Yes, well, you could see that on the screen too. It's more positive for similar reasons, although there there's also some effects of the base rate, the base rate for EM interest rates are materially higher. But Sara and her team have some deep knowledge on the fixed income side as well.

So again, I think what the screen is—we do provide that as a service for investors to get a sense of where those relative risk premia are in the marketplace.

You know, the only thing I'd caution is, and I don't think anyone who's watching would do it otherwise, but the narrower we slice any market, equities, fixed income into narrow, narrow slices, you could think of sectors, it's not really risk premia, or those dots you see on the screen, our predictability levels go down.

So on a global equity, I'll just give as context, ten years ago our forecast for the 60/40 portfolio globally came within two basis points of what it actually, two decimal points from where it actually came in at.

Sara Devereux: Good predicting.

Joe Davis:  Yes, but there's offsetting noise. We overestimated the non-U.S. We underestimated the U.S., and so point being is we narrow slice it. We're asking too much of the data, I think, and so that's where you see, in the diversification, in terms of we provide it as a service. But if I was an active manager, an asset allocator, I may be tilting modestly to some of those dots, maybe five percentage points. I would not be moving more significantly, even if they were like so-called two sigma sort of things because

it would be asking too much of the information content because we certainly don't have that much information content.

Jill DeBerardinis: Yes, yes.

All right, Sara, I promised you were not off the hook, and so we're going to bring you back in in terms of international fixed income. So I know it's been quite a while of us not really looking at international fixed income. A lot of investors [were] really turned off by the negative yielding bonds across a lot of the international categories. Are there brighter days ahead there?

Sara Devereux: Oh, yes, good timing on your question. Well, first of all, we almost always recommend having international exposure, just from the diversification benefits, right, because there are certain risks that are really concentrated in the U.S., and you can hedge against those just by having a diversified portfolio.

But you're right, it is a really exciting time because just last week it was the end of the era of negative yields globally. It started in 2014, right? Peaked in 2020 around $18 trillion of the global market with negative yielding, and it ended last week. So better days I think are ahead just in general for global fixed income.

Now, I will also say I think it's going back to active opportunities, thinking about the dispersion and the different paces of the recovery and different stages of the economy in various countries. You know, there's a good deal of dispersion there as well, so the opportunity to add alpha from relative value and monetizing via selection among countries is relatively high right now as well.

Jill DeBerardinis: Yes, fantastic. Great. I'll have to brush up on my international fixed income knowledge since clients are going to probably be asking about it again.

So, you know, I want us to take a step away from the international topic momentarily and get to one other thing that our audience has been asking about. And I think it was inspired by Joe's chart on equity valuations as well. People really want to know how to look at growth versus value. What's the dynamic there, Joe?

Joe Davis: We did a report at the end of 2021. In fact, I think, Sara, you and I even had discussions with that, like the Vanguard Board of Directors—

Sara Devereux: Yes, we did. Yes.

Joe Davis: —because there was a time where growth was just outperforming to such a strong level. In fact, we hadn't seen it since the official industry data sets. There [are] equity market data sets back to the mid-1920s, the so-called CRSP data set.

So our projections—because we were using the factors that drive growth/value outperformance, effectively, at the end of the day, it's discount rates, so real borrowing costs that have different multiple effects—it was, from a statistical point, Jill, it was saying strong odds that growth stocks were going to underperform value stocks on a secular basis significantly, like 400 or 500 basis points annualized compound. It was significant because that's how much the valuation—

Now there were reasons to say, “Okay, maybe the gap won't fully close.” Technology stocks, they have network effects, there are intangibles, they have brand equity, all the things that justify higher multiples. But we tried as best we could. When we accounted even for that, they were still overvalued.

And so where we are now is that gap has closed a lot. There's still a residual, which is a code word for saying growth is still overvalued relative to values. But that gap, the gap has closed by half, perhaps even a little bit more. So I don't think we're seeing these sort of outsized, sort of, differentials, and so I think that most of that speed has resolved. Now would be more of incremental access returns if one was looking to tilt value/growth.

I tell you two things that are clear. Value was not way undervalued before, and also growth stocks are not way undervalued. So if someone's expecting a strong rebound in technology stocks, I think they will be waiting a while because the fundamental deviations from that are just not as compelling as they were two years ago.

Jill DeBerardinis: Yes. I think that does a great job of kind of covering the typical parts of the equity market that we hear about. But the reality is most people's portfolios are made up of a combination of equities and bonds, and I think one of the concerns as of this last year was this idea that maybe the correlations between stocks and bonds were rising.

So I do want to spend a moment there, knowing that's how most people's portfolios are actually constructed and think about should we, as investment professionals, have a concern about bond correlations rising and coming closer to stocks as well in the last year?

Joe Davis: Well, and Sara, we talked about that. If you want to go first, or I want to go first.

Sara Devereux: Well, I think last year was an anomaly. What did I quote? It's the first time since the 1800s that both stocks and bonds were down.

Joe Davis:  Yes, Alexander Hamilton or something.

Sara Devereux: It was extreme, but I think of it, your chance of super deep analysis, but I think of it very broadly. Like last year was all about inflation. This year is going to be more about growth. Right? Don't take your eye off the inflation ball, but it's going to be more about growth. So we're going to go back to a more normal market. I mean we can get really nerdy and talk about the normal distribution and the tail risk. We spent a lot of time residing in those tails over the last year.

Joe Davis: I know, the last three years when you think about the economy, yes.

Sara Devereux: Exactly, I think we're really getting back into the normal zone. We're going to see it now. Your team has done tons and tons of work proving it out on a historical basis and a forward-looking basis.

Joe Davis: It's almost by definition, to Sara's point, Jill. So, the stock/bond correlation went positive, which is not great for diversification because that's the cornerstone of asset allocations, why you pair two risk premiums, right?

I mean this is almost a mathematical truism. They are only highly positive under temporary conditions. Inflation has to be high and rising faster than expected. Once it's either falling or it's not rising as quickly, it becomes price. Okay, so inflation was at this level. Now it's at a higher level. But if it's at the same level, correlations fall. And so that's the important point. Now we, unfortunately, to Sara's point, went through that rapid adjustment, so there's no doubt the correlations flipped.

But, I mean, unless everyone says, “no,” next year we're going to have inflation at 14% and then we're going to have inflation at 20%, then, yes, we'll have correlations keep going because you're going to have the discount rate, interest rates, the ten-year really repricing again and again and again and stocks and bonds both falling.

Once you get stabilization, it's almost like, in theory, for asset allocation. The trend of inflation, I may lose my academic credentials. I mean my economic degree here, but this is true. The trend level of inflation's immaterial for asset allocation because it just changes your nominal total return. It doesn't change the real, you know. But that's when you have to know you're at your case. If we turn out five years from now and trend inflation—there's some that are saying, “Oh, we're a higher-trend inflation world. Five percent's the norm, not two.” Well then, that's a difference because that means we may still have more adjustment in the correlation between stocks and bonds.

Although we generate those projections, that's far from our baseline. I think there are other changes that are in store, but it's not the trend inflation rate.

Jill DeBerardinis: Yes, yes. So that scenario is pretty far off.

Joe Davis:  Yes, and we generate distributions of correlations the same way as others. But again, you can get those. It was very unfortunate. Again, my portfolio of 60/40 took a beating last year. I'm not going to sugarcoat it, but I don't have those expectations going forward. To do that, you would have to have the expectation that inflation is rising and rising faster than expected, again, to repeat the same events we had this past year.

Jill DeBerardinis: All right, so Joe, I am going to give you a chance to talk about something that is a little outside of our realm of what we wrote in our market and economic outlook. And this is a pretty open-ended question, so you can go anywhere with this one. But what is kind of an economic scenario that you are thinking about that you think others are not thinking about right now? So something that maybe you're talking about and you're saying, “Why isn't everyone talking about this?”

Joe Davis: Well I'd say to do that we have to push farther out the horizon. Jill, I appreciate the question. I want to hear Sara's response as well because we always trade notes.

But I think, and we're starting to hear this a little in discussions, so it's not like we would not have read it. But I think, and we're gravitating toward this with our Capital Markets Model, and that is the world where I think real rates are much more durable and higher than we have in the past. I didn't say nominal interest rates, but I heard real rates.

I think there's secular. There's a lot of arguments out there saying the secular forces of disinflation are over. I'm not saying that that's not necessarily true. What I'm saying is would you think central banks are just going to sit there and markets are going to sit there? Because we've had those drivers change over the past 200 years, positive and negatively. You have the real rate neutralize the supply and demand.

And so I think we're starting to see in the TIPS market real rates, which is a fancy way for saying, “We were skeptical of those saying that we're going to have secular stagnation, and we're stuck near the zero-bound permanently.” I was very skeptical of that. We didn't know the timing, so I think history will show that we're starting to change to a more, I would say maybe it's more normal when I got into the business in the ‘90s. Not the ‘70s, but the ‘90s is probably the more.

And I think there's a number of secular, cyclical arguments for that. If I'm right, then that means we don't have a deep recession as the Feds tighten. If anything, the economies are a little bit more resilient than we thought because that's a fancy way for saying the neutral rate, which no one knows what it is, myself included, is a little bit higher than what we thought just two years ago. But that's what we're thinking about, but you have to look at various megatrends and put them together before you come to that conclusion.

Jill DeBerardinis: Yes, interesting. Sara, anything else to add on that?

Sara Devereux: Yes, actually the proverbial, “our star” debate. We talk about this all the time. This is not our central scenario, but we do talk about this and it is like the concept. I've heard a few other people sort of talk about it too.

What if the last decade of zero lower bound, what if that's the anomaly and that we're going to go back?

Joe Davis: I totally believe that, totally.

Sara Devereux: Right, we could go back to a pre-GFC playbook. Me, I get really excited about that because we're fixed income. That means yields are higher. That means the whole era of reach for yield and do all this crazy stuff, put leverage in your portfolio, going to these esoteric asset classes. We don't even do that anymore. It means we can stay in public, high-grade, fixed income and get incredible returns. So it's kind of exciting to think about that. It is not our base case, but it's something we do like to talk about.

Joe Davis: It's called the neutral rate, which is like, it's like you don't know what it is, right? It's—you're trying to feel your way in a dark room, Jill. But it does have importance for policy and where the Fed's going. The Fed doesn't know what it is. They assume a certain number of closer to zero. And what I'm arguing and what I think Sara is pointing to is maybe it's higher, it's 1.0%, 1.5%. That's where the TIPS yield is now and so that means that the amount of normalization that we're talking about is not drastic. But it means that if we're going to have inflationary pressures, they're not necessarily going to manifest in actual inflation. You're going to get higher, really—

So as an investor, put it this way, I think it's a “return to sound money” if I had to put a slogan or headline on it. I think this notion of easy and tight money, I think we also—some investors and savers have really borne the brunt of negative real rates because it really subsidizes leverage and more speculation.

So I think that's a clear positive. It shows up in our projections for probabilities of success for various asset allocation strategies because the real yield is positive. It's just compound. I mean it's really simple, but that's an active area of debate, of academic research. You're going to hear the Federal Reserve continue their talk about central banks, but the long sweep of history shows that you do come, intermittently, on these periods, like Sara's mentioned, that we also had during the Great Depression. And then there's a whole flurry because of recency bias. You tend to think of it. But those forces that pushed you in there, that doesn't mean that they're permanent. They can also change, and so that's where I think we're going.

Jill DeBerardinis: Yes, always fascinating to hear a viewpoint that is not in any of our published research, of course, so thank you for sharing.

Sara, I'm going to go back to a topic we started on earlier and I want to round it out a little bit more.

Sara Devereux: Sure.

Jill DeBerardinis: We talked a bit earlier about munis and munis being kind of interesting to watch right now in a particularly attractive part of the market. Since we have enough time to cover it today, and I know we have so many people in our audience who are holders of muni funds, I'd love to go there and just think about [the] fundamentals within munis, and what is it that's making munis look so attractive right now?

Sara Devereux: Sure, so absolutely. I couldn't agree more. Munis have some of the best fundamentals that they have had in decades. Right, strong economic growth [and] fiscal support over the past few years have really helped some of the state and local governments kind of put together a rainy day fund. They had increased tax receipts, they had fiscal support, and so they've shored up their balance sheets and they're in a really good position for the future. So fundamentals are very strong.

Now, munis underperformed last year. Despite these fundamentals, they underperformed. I mean, all of fixed income underperformed. Every asset class, except for cash and commodities, underperformed last year. Munis were down about 9% on the year, along with other asset classes.

Now, we think munis have overshot because they moved down not just with fundamentals but with outflows. There are a lot of tax-sensitive investors who took money out to monetize those losses for various reasons. We believe that money will come back in, and we think valuations have overshot.

So, for example, in munis you get tax adjusted, right? Tax-equivalent yield is about 6%. That's higher than investment-grade corporates. Right, and munis are higher credit quality. Seventy percent of the municipal universe is AA or better. So you're really, you know, versus investment-grade, for example, you're getting more value and less risk. So we actually think it is an incredible time to get back in munis with a long-term horizon, both because the fundamentals are strong and the valuations are terrific.

Joe Davis: It's almost like the muni bond risk premium's higher than the taxable bond risk premium.

Sara Devereux: Yes, absolutely, because of a technical.

Joe Davis: I mean for basis points, that's closer to the equity risk premium. Even for the U.S. over bonds, we're projecting like 300 basis points median. So that's pretty significant.

Sara Devereux: It's material.

Jill DeBerardinis: I'll take that tradeoff any day.

Sara Devereux: Good one.

Jill DeBerardinis: So, anyone that's watched a webcast with me before knows that I will always end on a positive note, and I'm going to ask you guys both the same question and we're going to end on a really positive note, which is: final thoughts, what are you most excited to watch in the markets in 2023? I want each of you to weigh in on that and, Sara, I'm going to start with you.

Sara Devereux: Oh, sure. Oh, gosh, so what am I excited about for next year? Next year, I'm really excited. I mean if you didn't pick up on it already, I'm really excited about fixed income. No, but I'm really excited about—

Jill DeBerardinis: We're glad.

Sara Devereux: —Vanguard's ability to deliver for our clients. This is the kind of environment where our edge really, really shines, our economic teams, our investing teams. So I'm just really thrilled because I think we're going to deliver great results for our clients. I'm really looking forward to it.

Joe Davis: I said before, Jill, the return, there's a time value in money now and I was increasingly skeptical of the zero-bound. I know part of it was due, but having real, positive interest rates adjusted for inflation, and we're not actually there yet, even though the Fed's moved 400 and some basis points. They're actually below the rate of inflation. But when we finally get there, there's going to be a lot of desire for the Fed to cut rates. I think we should, as investors, we should be applauding that because you're talking about, now, much more significant compounding for our clients' portfolios. Our probability of success for our clients' goals is going to increase. And after four or five years of being guarded, as you said, Jill, I'm happy to finally not be as guarded as we have been.

Jill DeBerardinis: Yes, great. I really appreciate the conversation today. I really appreciate both of you sharing your thoughts and just being wonderful experts that we have here at Vanguard, so thank you.

Sara Devereux: Thanks, Jill.

Joe Davis: Yes.

Jill DeBerardinis: And to our audience, thank you very much for spending an hour with us. I would encourage you to also join us for Part 2 of this webinar series, which will be on Thursday, January 26. We're going to feature portfolio construction experts discussing investing strategies and potential tradeoffs you may encounter in 2023. It's going to be a really good one.

As a reminder, we have some resources available for you to download. And if we could have just a few more minutes of your time, we would appreciate you filling out the Provide Feedback box. We welcome your feedback, suggestions, and ideas for future topics.

With that, the conversation doesn't end here. Vanguard aims to be your partner in tackling the challenges that 2023 will bring in investment portfolios, so please reach out to your Vanguard sales executive with additional questions as they arise. From all of us here at Vanguard, thank you for watching.

© 2023 The Vanguard Group, Inc. All rights reserved.


All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against loss in a declining market. Beware that fluctuations on the financial market and other factors may cause declines in the value of your account. There is not guarantee that any particular asset allocation or mix of the funds you will meet your investment objectives or provide you with a given level of income.

Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets. Prices of mid- and small-cap stocks often fluctuate more than those of large- company stocks. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. High-yield bonds generally have medium- and lower- range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.

Although the income from U.S. Treasury obligations held in the fund is subject to federal income tax, some or all of that income may be exempt from state and local taxes

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

U.S. Treasury investments and some U.S. government agency bonds are backed by the government, so it's highly likely that payments will be made on time. But their prices can still fall when interest rates go up.

IMPORTANT: The projections and 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. VCMM results will vary with each use and over time.


The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard's Investment Strategy Group. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.</p

The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk– return trade-offs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered, such as the data presented in this paper, is the most effective way to use VCMM output.

The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognize that the VCMM does not impose “normality” on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths. Indeed, this is a key reason why we approach asset-return outlooks in a distributional framework.

Vanguard Economic and Market Outlook for 2023: Beating Back Inflation

This white paper offers expert insights into economic growth, inflation, monetary policy, and the forces shaping the markets.


  • All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
  • IMPORTANT: The projections and 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. VCMM results will vary with each use and over time.
  • The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
  • The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

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