Vanguard's midyear market outlook

Despite the twist presented by an unexpectedly strong U.S. economy, developments in the first half of 2024 have only strengthened our view that a higher-interest-rate environment is here to stay.

Bond interest rates are outpacing inflation for the first time in many years, which is good news for long-term investors. This is happening, we believe, because R-star has become higher. R-star is the equilibrium level of interest rates toward which central banks try to converge. This level is not determined by monetary policy, but instead is driven by demand of capital, or borrowing, and supply of capital, or savings. Due to demographic factors and government debt levels that may remain for years to come, we may have entered a period of persistently higher interest rates. 

Global equity and fixed income outlook

Our ex-U.S. developed markets domestic equities forecasts are flat to marginally higher, though higher U.S. equities valuations have largely dragged down global equities forecasts.

Developed markets sovereign bond yields have mostly risen since the start of the year, pushing our 10-year annualized return forecasts higher as well.

Vanguard’s forecasts for year-end 2024

Here’s how we see things shaking out for the economy in the United States:

• Economic growth. Stronger-than-expected labor supply and productivity gains should continue to support growth before gradually subsiding. After a strong second-quarter start, growth appears to be moderating. Consumer spending held up in the first quarter, particularly on services. We’re monitoring softer gains in real disposable incomes.
• Core inflation. We foresee core inflation gradually falling to an annualized 2.9% at year-end. We expect shelter and other services prices to remain sticky. We don’t foresee core inflation falling to 2% until the end of 2025. Elevated wage growth since the start of 2024 appears persistent and likely to keep services inflation heightened.
• Monetary policy. Continued economic growth, labor momentum, and stubborn inflation are likely to leave the Federal Reserve without the confidence it needs to cut interest rates this year. We anticipate that the Fed will need to see inflation readings near 2.5% year over year to begin easing policy.
• Unemployment rate. Job growth has broadened across private industries, a bullish sign for the labor market. Strong productivity growth and low-income labor supply through immigration have reduced immediate reflationary risks from wage dynamics. However, if wages don’t moderate in the second half, those risks will grow.

The figure below shows how fundamentals in the United States compare with other major economies.

Global fundamentals round-up

*Inflation forecasts are for core inflation, which excludes volatile energy and food prices.

**Our forecast for the United States year-end monetary policy rate reflects our expected Federal Reserve federal funds target range. Notes: Figures related to economic growth, inflation, monetary policy, and unemployment rate are Vanguard forecasts for the end of 2024. Growth and inflation are comparisons with the end of the preceding year; monetary policy and unemployment rate are absolute levels.

Source: Vanguard, as of June 25, 2024.

Three ways this business cycle could land

Remember the soft landing versus hard landing debate last year? “As we’ve avoided recession but seen insufficient progress in the inflation fight, neither camp appears to have been correct,” said Roger Aliaga-Díaz, Vanguard Chief Economist for the Americas.  

Now, at midyear, it’s increasingly evident that the economy’s “landing” won’t occur until 2025. What type still isn’t clear, but Aliaga-Díaz says there are three distinct possibilities:

• Hard landing. This is not necessarily a recession, but at a minimum, a monetary policy-induced slowdown that cools off the labor market and tempers consumer spending and the exuberance of financial markets. As demand slows, wages and prices ease to levels consistent with the Federal Reserve’s 2% target.
• Soft landing. The “painless disinflation” promise really does materialize in this scenario. Monetary policy doesn’t overly restrict the economy, which remains resilient at trend growth pace, yet inflation declines sustainably to 2%. This is the Fed’s projected path for 2025.
• Productivity boom. This is a second—and more realistic—way for inflation to fall without monetary policy producing an economic slowdown, something we saw in the 1990s and to some extent last year. In 2025, breakthroughs in generative artificial intelligence (AI) technology and the significant capital investments associated with it could give an early jolt to labor productivity, which would, in turn, boost supply-driven economic growth.

Economic logic dictates that a hard landing is the most likely way for monetary policy to bring down inflation. A supply-side productivity jolt could also do so, but there is an element of luck in the timing of an AI boom. Whether generative AI is ready to deliver tangible productivity gains next year is far from assured. But then, no one predicted in real time the acceleration in productivity growth in the mid-1990s.

A soft landing remains the most difficult scenario to explain with straightforward economic logic, and, for this business cycle, it’s probably the least likely of the three. 

Webinar: Vanguard’s Midyear Market Outlook

Want the latest updates on the market and Vanguard’s outlook for the remainder of 2024? Watch the replay of a special webinar featuring two of Vanguard’s leading authorities on the economy and the markets: Vanguard Global Chief Economist Joe Davis and Vanguard Global Head of Fixed Income Sara Devereux. In this dynamic session, you’ll get Vanguard’s views on:

• Fed policy moves.
• Where the bond market is going.
• What’s next for inflation.
• Key market developments.
• AI and our economic future.

Notes:

• All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss in a declining market. 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.
• 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.
• 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.
• About the Vanguard Capital Markets Model®:
• IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (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. 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 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 VCMM 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.
• 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.