Vanguard Economic and Market Outlook 2022

The gradual removal of policy support and stimulus implemented to combat the economic downturn triggered by the COVID-19 pandemic poses a new challenge for policymakers and a source of risk for financial markets, according to Vanguard Economic and Market Outlook for 2022: Striking a Better Balance.

The global economic recovery is likely to continue, albeit at a slower rate. Health outcomes will remain important given the emergence of the Omicron variant, but the outlook for macroeconomic policy will be more crucial. Labor markets will continue to tighten, with several major economies, led by the U.S., quickly approaching full employment.

Our outlook focuses on these key themes:

Inflation will be lower but stickier. We anticipate that supply/demand frictions will persist well into 2022 and keep inflation elevated. But it is highly likely that increases in the prices of goods and services will slow during the year, even amid persistent wage gains.

How long will inflation last?

A line graph shows year-over-year changes since 2019 in inflation rates in the U.S., the U.K., the euro area, and China, as well as Vanguard forecasts through 2022. In all four countries or regions, rates were roughly stable in 2019, ranging from about 1% in the euro area to just above 2% in the U.S. Inflation rates then declined in unison in the first half of 2020, and they drifted lower still in the euro area and China in the second half of 2020. In the first three quarters of 2021, inflation rates rose in all four countries or regions, ending a fleeting instance of falling prices in China and spiking to a high above 4% in the U.S. We forecast inflation-rate increases in all four countries or regions relative to the latest reported figures, with peaks of about 5% in the U.S. (at the start of 2022), 4% in the U.K. (at the end of 2021), near 3% in the euro area (also in late 2021), and in the low- to mid-1% range in China throughout 2022.

Core CPI, year-on-year change

6%543210-1

2019

2020

2021

2022

Notes: Data and Vanguard forecasts are for year-on-year percentage changes in the core Consumer Price Index, which excludes volatile food and energy prices. Actual inflation is through September 2021 for the U.S., U.K., and China and through October 2021 for the euro area. Vanguard forecasts are presented thereafter.
Sources: Vanguard calculations, using data from Bloomberg and Refinitiv.

The risk of a policy misstep has increased. Central bankers will have to strike a delicate balance between controlling inflation expectations and supporting full employment as they withdraw exceptionally accommodative policies. In the United States, the Federal Reserve may have to raise rates higher than some expect, perhaps to at least 2.5%.

Rising rates won’t upend bond markets. Rising inflation and policy normalization mean that the short-term interest rates targeted by the Fed, the European Central Bank, and other developed-market policymakers are likely to rise. But rising rates are unlikely to produce negative long-term total returns in bond markets. We expect annualized U.S. bond returns of 1.4%–2.4% over the next decade.

Equities face a challenging environment. Low bond yields, reduced policy support, and stretched valuations in some markets form a challenging backdrop for equities. We are projecting the lowest 10-year annualized returns for global equities since the dot-com bubble of the early 2000s. For example, we expect U.S. equity returns of 2.3%–4.3% per year.

U.S equities have not been this overvalued since the dot-com bubble

A line graph shows the wide fluctuations in the cyclically adjusted price/earnings ratio, or CAPE, for the Standard and Poor’s 500 Index from 1950 to late 2021. It also shows the historical average CAPE of about 20. Finally, it shows a fluctuating range of Vanguard estimates of a separate, fair-value CAPE measurement. The graph shows that the index’s CAPE valuation has typically hovered in or near our estimates of the fair-value CAPE. It also highlights the early-2000 valuation peak amid the dot-com bubble and the deviation at that time between valuations and fair valuations. The valuation of the stock index and its deviation from fair value in late 2021 were at their highest levels since the dot-com peak.

Cyclically adjusted price/earnings ratio

50403020100

Fair-value CAPE +/-0.5 standard error

CAPE for the S&P 500 Index

Historical average

Dot-com bubble

1950

1960

1970

1980

1990

2000

2010

2020

Notes: The U.S. fair-value CAPE is based on a statistical model that corrects CAPE measures for the level of inflation and interest rates. The statistical model specification is a three-variable vector error correction, including equity-earnings yields, 10-year trailing inflation, and 10-year U.S. Treasury yields estimated over the period January 1940 to September 2021. Details were published in the 2017 Vanguard research paper Global Macro Matters: As U.S. Stock Prices Rise, the Risk-Return Trade-Off Gets Tricky (Davis, 2017). A declining fair-value CAPE suggests that higher equity risk premium (ERP) compensation is required, while a rising fair-value CAPE suggests that the ERP is compressing.
Sources: Vanguard calculations, based on data from Robert Shiller’s website, at aida.wss.yale.edu/~shiller/data.htm, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv, and Global Financial Data, as of September 30, 2021.

Source: Vanguard Capital