February 1, 2022 | Vanguard Perspective
Key highlights
- The surge in cases of the COVID-19 Omicron variant is likely to dent activity early in the first quarter in the United States, but we continue to see full-year 2022 growth around 4%.
- Vanguard believes that the Federal Reserve may need to raise its target for short-term interest rates to 3%. That would require steady rate hikes over the next few years.
- We expect the unemployment rate to fall below its pre-pandemic level toward the end of the 2022.
Asset-class return outlooks
The greatest change in our outlooks from the June 30 running of the Vanguard Capital Markets Model® (VCMM) was in emerging markets equities. Large price declines in the intervening months lowered valuations, which are reflected in a 10-year forecast range that is 60 basis points higher in the September 30 running. In fixed income, yields increased marginally in the third quarter, allowing for a marginal rise in forecasts for many fixed income sub-asset classes.
Our 10-year, annualized, nominal return projections, as of September 30, 2021, are shown below. Please note that the figures are based on a 1.0-point range around the rounded 50th percentile of the distribution of return outcomes for equities and a 0.5-point range around the rounded 50th percentile for fixed income.
| Equities | Return projection | Median volatility |
| U.S. equities | 2.3%–4.3% | 16.7% |
| U.S. value | 3.1%–5.1% | 19.2% |
| U.S. growth | –0.9%–1.1% | 17.5% |
| U.S. large-cap | 2.2%–4.2% | 16.3% |
| U.S. small-cap | 2.2%–4.2% | 22.5% |
| U.S. real estate investment trusts | 1.9%–3.9% | 19.1% |
| Global equities ex-U.S. (unhedged) | 5.2%–7.2% | 18.4% |
| Global ex-U.S. developed markets equities (unhedged) | 5.3%–7.3% | 16.4% |
| Emerging markets equities (unhedged) | 4.2%–6.2% | 26.8% |
| Fixed income | Return projection | Median volatility |
| U.S. aggregate bonds | 1.4%–2.4% | 4.6% |
| U.S. Treasury bonds | 1.2%–2.2% | 4.7% |
| U.S. credit bonds | 1.6%–2.6% | 4.7% |
| U.S. high-yield corporate bonds | 2.2%–3.2% | 10.4% |
| U.S. Treasury Inflation-Protected Securities | 1.0%–2.0% | 4.6% |
| U.S. cash | 1.2%–2.2% | 1.2% |
| Global bonds ex-U.S. (hedged) | 1.3%–2.3% | 3.8% |
| Emerging markets sovereign | 2.3%–3.3% | 10.1% |
| U.S. inflation | 1.5%–2.5% | 2.3% |
These probabilistic return assumptions depend on current market conditions and, as such, may change over time.
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 September 30, 2021. Results from the model may vary with each use and over time. For more information, see the Notes section.
Source: Vanguard Investment Strategy Group.
Omicron takes a toll on the economy
United States
The surge in cases of the COVID-19 Omicron variant is likely to dent activity early in the first quarter in the United States, quarantining in the workforce being more disruptive than any semblance of a “fear factor” to engage in activity.
- Although we expect the effects to be significant, we also expect them to be short-lived. As such, we continue to see full-year 2022 growth around 4%.
- Growth appears to have stabilized in the fourth quarter; we continue to see fourth-quarter growth around 5.5%.
Euro area
COVID-19-related restrictions on activity continue in many countries in the euro area, although the toughest of them, in the Netherlands, are being scaled back.
- The recent surge in daily virus cases to more than 2,000 per million is likely to continue to weigh on growth in the first quarter of 2022.
- This development is part of Vanguard’s base case and, as such, we maintain our full-year 2022 forecast for growth around 4%.
China
Gross Domestic Product (GDP) for all of 2021 increased by 8.1%, according to preliminary National Bureau of Statistics estimates. For all of 2022, we anticipate GDP growth around 5%, a level that would likely be below an official growth target that we expect will be set in a range of 5% to 6%.
- Headwinds include a “zero-COVID” policy that continues to result in broad lockdowns ahead of the forthcoming Lunar New Year and Beijing Winter Olympics.
- Given these headwinds, we expect below-consensus growth around 3.5% in the first quarter of 2022, followed by above-consensus growth around 5% in the second quarter on the strength of anticipated policy stimulus and tweaks to zero-COVID.
Emerging markets
COVID-19 and developed-market central banks may influence how economies in emerging markets perform in 2022.
- Countries with a combination of high vaccine-acquired and infection-acquired immunity to COVID-19, largely in Latin America but also in emerging Europe, will be supported simply by being able to keep their economies open.
- Countries primarily in emerging Asia with less immunity could be hampered by continued virus vulnerability.
- We foresee emerging-market growth around 5.5% in 2022, with diminished global liquidity a potential downside risk.
Inflation will remain elevated through the first half of 2022
The Consumer Price Index in the United States rose by 7% in December compared with December 2020, the largest 12-month increase since June 1982. The gauge rose by 0.5% on a seasonally adjusted basis in December compared with November, less than November’s 0.8% rise.
- Vanguard estimates that the effects from supply constraints will persist into 2022 before inflation normalizes gradually toward the pre-pandemic trend.
- We foresee inflation remaining elevated before slowing in the second half of 2022, bringing the core Personal Consumption Expenditures Price Index (PCE) for year-end 2022 in the range of 2.3%–2.6% year-over-year.
A revised outlook for when the FED will hike rates
Amid heightened inflation, falling unemployment, and increasing wage pressures, we believe the Fed will begin a rate-hike cycle in the first half of 2022, and perhaps as early as its March meeting depending on wage and inflation data in the interim.
- We anticipate at least two quarter-point hikes in 2022 to the Fed’s target range for its federal funds rate, with additional policy-tightening likely warranted, whether through balance sheet reduction or one or two additional policy rate hikes.
- Vanguard believes that the Federal Reserve may need to raise its target for short-term interest rates to 3% from its current range of 0%–0.25%. That would require steady rate hikes over the next few years, to a degree that markets haven’t priced in beyond 2022.
- The delicate position for the Fed is to tighten policy enough to moderate inflation pressures without doing so too aggressively and ending the business cycle prematurely, according to a new Q&A with Vanguard economists Josh Hirt, Asawari Sathe, and Adam Schickling.
- Bond investors should welcome the prospect of higher interest rates. Although rising rates may produce modest negative returns for a time, they’re a long-term positive.
- In a recent commentary, Vanguard Global Chief Economist Joe Davis noted that, “In my view, markets are underestimating the degree to which central banks will need to use their powerful tools to pull inflation back to acceptable levels.”
Labor demand begins to push wages up
A second straight below-consensus headline job-creation figure in the United States once again underestimated the labor market’s strength. The Bureau of Labor Statistics reported that 199,000 jobs were created in December and the unemployment rate fell to 3.9%.
- Vanguard anticipates further labor market tightening with continued upward wage pressure amid strong demand for workers.
- We expect the unemployment rate to fall below its pre-pandemic level toward the end of summer in 2022.
Notes:
- All investing is subject to risk, including possible loss of principal.
- Diversification does not ensure a profit or protect against loss.
- Investments in bonds are subject to interest rate, credit, and inflation risk.
- Investments in stocks or 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.
- Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
- 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.
