July 13, 2022 | Vanguard Perspective
Market perspectives: Recession risks ahead
At the start of the year, we expected global economies to continue to recover from the effects of the COVID-19 pandemic but at a more modest pace than in 2021. While that holds true, the pace of change in macroeconomic fundamentals such as inflation, growth, and monetary policy has failed to live up to expectations.
Labor and supply-chain constraints were already fueling inflation before the year began, but Russia's invasion of Ukraine and China's zero-COVID policy exacerbated the situation. Central banks have been forced to play catchup in the fight against inflation, ratcheting up interest rates more rapidly and possibly higher than previously expected. But those actions risk cooling economies to the point that they enter recession.
"Global economic growth will likely stay positive this year, but some economies are flirting with recession, if not this year, then in 2023," said Andrew Patterson, Vanguard senior international economist.
Compared with the start of the year, Vanguard has downgraded its 2022 GDP growth forecasts for all the major regions, increased its inflation forecasts, and become more hawkish about monetary policy.
Expected 10-year asset-class returns have risen
Stock and bond markets have been hit hard so far in 2022. But there is an upside to down markets: Because of lower current equity valuations and higher interest rates, our model suggests higher expected long-term returns than our forecasts as of year-end.
Our 10-year annualized return forecasts for equity markets are largely 1 percentage point higher than at the end of 2021. Rising yields may detract from bonds' current prices, but that means higher returns in the future as interest payments are reinvested in higher-interest bonds.
Global equity and fixed income outlook
Inflation, policy elevate the risk of recession
In the United States, inflation has reached 40-year highs, eroding consumers' purchasing power and driving the Federal Reserve to aggressively raise interest rates. We expect the equivalent of 12 to 14 rate hikes of 25 basis points for the full year, with the target federal funds rates landing in the 3.25%–3.75% range by year-end. We expect a terminal rate of at least 4% in 2023—higher than what we consider to be the neutral rate (2.5%) and above what's currently being priced into the market. (The neutral rate is the theoretical rate at which monetary policy neither stimulates nor restricts an economy.)
We have downgraded expected U.S. GDP growth from about 3.5% at the start of the year to about 1.5%. The factors that led to our downgrade will likely continue through 2022—namely, tightening financial conditions, wages not keeping up with inflation, and lack of demand for U.S. exports. Labor market trends are likely to keep downward pressure on the unemployment rate through year-end, though increases in 2023 are likely as the impacts of Fed policy and slowing demand take hold. We assess the probability of recession at about 25% over the next 12 months and 65% over 24 months. We believe that a period of high inflation and stagnating growth is more likely than an economic "soft landing" of growth and unemployment rates around or above longer-term equilibrium levels (about 2% for growth and 4% for unemployment).
In the euro area, headline inflation driven by high energy prices may spike to above 10% in the third quarter. Inflation has become widespread, spurring the European Central Bank into what it expects will be a "sustained path" of interest rate increases. In September, rates will likely be out of negative territory for the first time in a decade. We forecast economic growth to be about 2% to 3% for the full year. However, Europe's dependence on Russian natural gas and the challenges of managing monetary policy for 19 countries put the euro area at a higher risk of recession than the United States in the next 12 months. A complete cutoff from Russian gas would likely lead to rationing and recession. We assess the probability of recession around 50% over 12 months and 60% over 24 months.
China will fall far short of policymakers' growth target of about 5.5%, given that it's a challenge to achieve all three of their goals: the growth target, financial stability, and a zero-COVID policy. (The latter affects not just China's economy, but the global economy as well.) We believe the actual 2022 GDP growth rate will be just above 3%, far below China's pace for many years. Given China's zero-COVID policy, additional outbreaks resulting in renewed lockdowns could further detract from growth. That said, recession is unlikely, with probability at 30% over 12 months and 35% over 24 months.
We recently downgraded our forecast for full-year 2022 growth in emerging markets, from about 5.5% at the start of the year to about 3%. Emerging markets continue to face headwinds from slowing growth in the United States, the euro area, and China, as well as from developed markets' central bank tightening and from domestic and global inflation. Although higher commodities prices do benefit some emerging economies, they're a negative in the aggregate.
Probability of recession for select regions
Vanguard forecasts as of June 30, 2022
|Economic growth||Headline inflation||Monetary policy||Unemployment rate|
Notes: Forecasts evolve with new data, and our views will inevitably change. Growth is the change in annualized GDP year over year. Inflation is the headline consumer price index, which includes the volatile food and energy sectors. Monetary policy is our year-end projection for the central bank’s short-term interest rate target.
Source: Vanguard forecasts as of June 30, 2022.
Is inflation inevitable?
Persistent inflation has several economies, including the U.S., edging closer to recession. In this short video, Vanguard’s chief economist says four conditions need to be met to avoid that path.
Joe Davis: Inflation is at generational highs, and many are concerned about the threat of recession. So, what's Vanguard's view?
Our own economic projections now indicate a greater than 50% probability of a recession occurring over the next 12 to 18 months, both in the United States and other developed markets, in particular Europe.
Why the increased odds of recession? Well, now we have two forces pushing on inflation. The well-documented supply constraints of food and energy and other products leading to higher costs of living for many consumers and businesses. And the second force, which we have long documented—the tight labor market pushing up wage pressures, which also contribute to higher inflation for a number of products and services.
Now, greater than 50% odds are not 100%, and recession is not a foregone conclusion. So, what would it take for the U.S. economy and other markets to avoid a recession, a scenario that is not fully priced by the financial markets? Well, in my mind, there are four.
For the Federal Reserve, respectfully, I would strongly urge moving short-term interest rates to 3% before the end of the summer. That would help tamp down inflation expectations, which have started to creep up given the recent experience of high inflation.
We would need to see commodity prices fall further from here. Say, perhaps, oil below $100 a barrel— which, if that would occur, would fully offset the rise in food prices, which have also been material over the past 12 months for most consumers.
If we would see inventories rebuild as they have been doing over the past several months, that would potentially provide some modest price relief, and that is critical to bring down headline inflation, which is north of 8.5%.
And then, finally, we need to see a little bit of luck on labor supply. And, indeed, we would need to see at least one million Americans more join the labor force over the summer. That would help better balance the strong demand for labor with the lack of supply. And that would provide still-heady wage growth, but perhaps at a slightly lower rate and yet still ahead of the rate of cost of living, should we see these three other conditions met.
So, four conditions to avoid recession. And, unfortunately, I don't view this as a multiple-choice exam, and in fact we would need to see all four met for the U.S. economy and other markets to avoid recession.
So, bottom line: Soft landings, which is the goal of many central banks; soft landings are rare, and they're rarer than recessions. And should the U.S. economy and other markets fall into recession, that will be unfortunate, although it will not spell the end of economic growth in the future.
The path of the recovery, it has certainly narrowed. But the road isn't blocked just yet, and in the months ahead we will have a better sense of where the economy unfolds.
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