Bonds to Help Investors Weather 2023 Recession, Vanguard Says

The outlook for investing returns over the next decade has improved thanks to higher bond yields, but investors must first endure a likely recession and possible bear-market lows in 2023, according to Vanguard, the world's second-largest investment manager.

U.S. equity valuations "still don't reflect current economic realities," while stock markets tend to get discounted below fair value in a recession, analysts at Vanguard, which oversees more than $8 trillion, said in its annual outlook.

Central banks are likely to wait until 2024 to lower interest rates, since inflation is likely to end 2023 near 3%, well above the monetary authorities' 2% annual target, Vanguard said.

At the same time, a tight labor market is likely to cap unemployment at about 5%, limiting the recessionary fallout, according to the outlook.

With U.S. equity returns increasingly reliant on gains by the U.S. dollar while earnings growth is likely to slow, U.S. investors in domestic stocks can expect annual returns averaging 5.7% over the next 10 years, Vanguard estimates. The outlook is brighter for U.S. small-cap stocks, expected to average 6.1% over the next decade, and brighter still for international equity markets, at 8.4% annually over the same span.

Meanwhile, Vanguard expects domestic and international bonds to return about 4% to 5% over the next decade, thanks to the big rise in yields this year. A 60/40 portfolio allocating 60% to equities and 40% to bonds should return about 6.5% annually over the next decade, Vanguard projects. That's in line with the 6.3% average annual return of the Vanguard Balanced Index Fund's Admiral Shares (VBIAX) over the last 22 years, despite the 15% loss year-to-date.

While U.S. GDP is likely to increase just 0.25% next year, China's economy will grow 4.5% in 2023 as Beijing relaxes pandemic restrictions, Vanguard predicts. But a rapid reopening amid relatively low vaccination rates risks a "super-wave of infections" that either prompts renewed lockdowns or else overwhelms China's healthcare system, Qian Wang, Vanguard's Asia-Pacific chief economist, said at a news conference on Monday. "Things may have to get worse before they get better," Wang said.

Though China will be a bright spot for the global economy next year, its increased exclusion from global supply chains and reliance on state-owned enterprises presents a growing risk of long-term stagnation, she said.

The euro area's GDP is expected to remain flat next year as high energy costs induce a recession, while the U.K. economy will shrink 1.1%, Vanguard projects. With 35% to 45% of UK mortgages due to reprice to prevailing interest rates in 2023, house payments will take over from energy costs as the next driver of U.K.'s "cost-of-living crisis," according to Vanguard.