2025 economic and market outlook

The global monetary easing cycle will be in full swing in 2025, with inflation in most developed economies now within touching distance of central banks’ targets. The good fortune of high productivity growth and a surge in available labor has propelled the U.S. economy, while other economies have been less lucky. The potential for these positive supply-side factors to wane is a key risk to our U.S. outlook, though expansionary fiscal policy may cushion any negative impact on growth.

We reemphasize the view we put forth a year ago, that an era of sound money—with interest rates above the rate of inflation—lives on. That said, markets face a growing point of tension: Assets with the strongest fundamentals have the most stretched valuations, and vice versa. Short-term economic and policy risks will help determine whether momentum or valuations dominate investment returns in 2025.

Figure 1: Vanguard’s 2025 economic forecasts

Notes: Forecasts are as of December 2, 2024. For the U.S., GDP growth is defined as the year-over-year change in fourth-quarter GDP. For all other countries/regions, GDP growth is defined as the annual change in GDP in the forecast year compared with the previous year. Unemployment rate forecasts are the average for the fourth quarter of 2025. NAIRU is the nonaccelerating inflation rate of unemployment, a measure of labor market equilibrium. Core inflation excludes volatile food and energy prices. For the U.S., euro area, U.K., and Japan, core inflation is defined as the year-over-year change in the fourth quarter compared with the previous year. For China, core inflation is defined as the average annual change compared with the previous year. For the U.S., core inflation is based on the core Personal Consumption Expenditures Index. For all other countries/regions, core inflation is based on the core Consumer Price Index. For U.S. monetary policy, Vanguard’s forecast refers to the top end of the Federal Open Market Committee’s target range. China’s policy rate is the seven-day reverse repo rate. The neutral rate is the equilibrium policy rate at which no easing or tightening pressures are being placed on an economy or its financial markets.

Source: Vanguard.

Balance of risks favors bonds

Higher starting yields have greatly improved the risk-return tradeoff in fixed income. Bonds are still back. Over the next decade, we expect 4.3%–5.3% annualized returns for both U.S. and global ex-U.S. currency-hedged bonds. This view reflects a gradual normalization in policy rates and yield curves, though important near-term risks remain.

Figure 2: Vanguard’s outlook for financial markets

Our 10-year annualized nominal return projections are as follows. They are based on a November 8, 2024, running of the Vanguard Capital Markets Model® (VCMM). The figures are based on a 2-point range around the 50th percentile of the distribution of return outcomes for equities and a 1-point range around the 50th percentile for fixed income. More extreme returns are possible.

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of November 8, 2024. Results from the model may vary with each use and over time. For more information, please see the Notes section.

We believe that yields across the curve are likely to remain above 4% in the U.S. A scenario where supply-side tailwinds persist will be supportive for trend growth and thus real rates. Alternatively, the emerging risks related to global trade and immigration policies would also keep rates high due to increased inflation expectations. These risks must be balanced with the possibility that a growth shock, and any associated monetary easing or “flight to safety,” would cause yields to fall meaningfully from current levels.

Higher starting yields, which imply a “coupon wall,” mean that future bond returns are less exposed to modest increases in yields. In fact, for investors with the time horizon to see coupon payments catch up, interest rates that rise further would improve their total returns despite some near-term pain. We continue to believe fixed income plays an important role as a ballast in long-term portfolios. The greatest downside risk to bonds also pertains to stocks—namely, a rise in long-term rates due to continued fiscal-deficit spending or removal of supply-side support. These are the dynamics we are most closely monitoring.

Rational or irrational exuberance: Only time will tell

U.S. equities have generally delivered strong returns in recent years. 2024 was no exception, with both earnings growth and price/earnings ratios exceeding expectations. The key question for investors is, “What happens next?”

In our view, U.S. valuations are elevated but not as stretched as traditional metrics imply. Despite higher interest rates, many large corporations insulated themselves from tighter monetary policy by locking in low financing costs ahead of time. And more importantly, the market has been increasingly concentrated toward growth-oriented sectors, such as technology, that support higher valuations.

Nevertheless, the likelihood that we are in the midst of a valuation-supporting productivity boom, akin to the mid-1990s, must be balanced with the possibility that the current environment may be more analogous to 1999. In the latter scenario, a negative economic development could expose the vulnerability of current stock market valuations.

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.
• 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.