As the world gears up for 2025, Vanguard’s Chief Global Economist, Joseph Davis, and team have released a bold and nuanced forecast that challenges conventional narratives about economic resilience, inflation, and market dynamics.
The Resilience Mirage: Supply-Side Fortunes
The United States has defied expectations in recent years, navigating restrictive monetary policy while boasting strong GDP growth and disinflation. Vanguard attributes this to fortuitous supply-side dynamics, including robust productivity growth and an expanding labor pool. From mid-2022 to mid-2024, U.S. productivity surged by 4%, and labor supply expanded by nearly 2%. This tailwind, driven by pandemic-era business formation and fiscal stimulus, propelled the U.S. economy past global peers like Germany and Australia, where productivity stagnated.
But this stroke of good luck carries risks. Vanguard warns that restrictive immigration policies and protectionist trade measures could erode these gains. If productivity growth slows, the Fed might find itself battling inflationary flare-ups rather than celebrating its disinflationary triumph.
Global Easing: An Uneven Symphony
While inflation has retreated globally, the mechanisms behind it are anything but uniform. Central banks are entering a phase of monetary easing, but their paths diverge sharply:
- Euro Area: Growth stagnation and weak productivity have forced the European Central Bank (ECB) into a dovish stance, with rates expected to drop below neutral by year-end.
- China: Struggling with structural headwinds and faltering confidence, Beijing’s fiscal and monetary measures remain insufficient to break its economic malaise. Growth is expected to slow to 4.5% in 2025.
- Japan: A bright spot in Vanguard’s analysis, Japan’s domestic demand is accelerating, and inflation momentum justifies a gradual tightening cycle.
Sound Money: The Era Persists
Central to Vanguard’s outlook is the continuation of the “era of sound money,” defined by real interest rates remaining positive. Despite easing, policy rates are projected to settle above inflation, creating a supportive environment for fixed income but introducing vulnerabilities to equity markets.
The Tension in Equity Markets
Equity investors face a paradox. On the one hand, U.S. markets appear buoyed by valuation-supporting productivity gains, particularly in technology sectors. On the other, stretched valuations expose vulnerabilities to any negative shocks. Vanguard highlights three scenarios:
- Productivity Boom: Sustained gains akin to the 1990s tech revolution could validate current valuations.
- Broadening Growth: Lower rates might spur rotations into undervalued factors like small-cap and value stocks.
- Market Correction: A repeat of 1999, where economic disruption exposes fragility, leading to significant drawdowns.
International equities present a more compelling valuation story, albeit with heightened risks from geopolitical and trade uncertainties. Within emerging markets, China’s outsized influence remains a drag, while countries like India and Indonesia offer modestly brighter prospects.
Bonds: The “Coupon Wall” Effect
Vanguard’s analysis of fixed income reveals a favorable outlook driven by elevated starting yields. Dubbed the “coupon wall,” this phenomenon provides a buffer against potential rate hikes. Over the next decade, U.S. and global bonds are expected to deliver annualized returns of 4.3% to 5.3%. However, inflationary pressures from fiscal spending or waning supply-side support could complicate this narrative.
Lessons from History
Drawing parallels to the 1960s and 1990s, Vanguard underscores the importance of recognizing supply-side surprises. The “soft landing” era of the 1990s succeeded because policymakers embraced productivity gains. Today’s economic resilience will hinge on whether the Fed and its global counterparts can adapt to evolving supply-side realities.
The Vanguard Verdict
2025 will be a year of recalibration—for economies, markets, and policymakers. U.S. resilience faces significant risks from restrictive policies and a potential productivity slowdown. International markets offer opportunities but are not without geopolitical hazards. In this environment, bonds provide a stable anchor, while equities demand strategic caution.
As Joseph Davis and his team conclude, the challenge for investors is navigating a landscape where sound money reigns but market tensions rise. Will supply-side luck endure, or will its retreat expose the fragilities beneath? Only time will tell—but the risks are as real as the opportunities.
Copyright © AdvisorAnalyst, Vanguard
