Vanguard economic and market outlook for 2023

Vanguard research December 2022 Vanguard economic and market outlook for 2023: Beating back inflation ● Generationally high inflation has led to a marked slowing in global economic activity. Rapid monetary tightening aimed at bringing down inflation will ultimately succeed, but at a cost of a global recession in 2023. ● Current and expected conditions are like those that have signaled past global recessions. Significantly deteriorated financial conditions, increased policy rates, energy concerns, and declining trade volumes indicate the global economy will likely enter a recession in the coming year. Job losses should be most concentrated in the technology and real estate sectors, which were among the strongest beneficiaries of the zero-rate environment. ● Inflation continued to trend higher in 2022 across most economies as supply chains had yet to fully recover from pandemic-related distortions and as demand was buoyed by strong household and business balance sheets. Inflation has likely already peaked in most markets, but reducing price pressures tied to labor markets and wage growth will take longer. As such, central banks may reasonably achieve their 2% inflation targets only in 2024 or 2025. ● Consistent with our investment outlook for 2022, which focused on the need for higher short-term interest rates, central banks will continue their aggressive tightening cycle into early 2023 before pausing as inflation falls and job losses mount. Importantly, we see most central banks reluctant to cut rates in 2023 given the need to cool wage growth. ● Although rising interest rates have created near-term pain for investors, higher starting rates have raised our return expectations for both U.S. and international bonds, which we now expect to return roughly 4%–5% over the next decade. ● Equity markets have yet to drop materially below their fair-value range, which they have historically done during recessions. Longer term, however, our global equity outlook is improving because of lower valuations and higher interest rates. Our return expectations are 2.25 percentage points higher than last year. From a U.S. dollar investor’s perspective, our Vanguard Capital Markets Model projects higher 10-year annualized returns for non-U.S. developed markets (7.2%–9.2%) and emerging markets (7%–9%) than for U.S. markets (4.7%–6.7%).

Lead authors Joseph Davis, Roger A. Jumana Saleheen, Qian Wang, Andrew J. Ph.D. Aliaga-Díaz, Ph.D. Ph.D. Ph.D. Patterson, CFA Kevin DiCiurcio, Alexis Gray, Asawari Sathe, Joshua M. Hirt, Shaan Raithatha, CFA M.Sc. M.Sc. CFA CFA Vanguard Investment Strategy Group Global Economics Team Joseph Davis, Ph.D., Global Chief Economist Americas Asia-Pacific Roger A. Aliaga-Díaz, Ph.D., Americas Chief Economist Qian Wang, Ph.D., Asia-Pacific Chief Economist Joshua M. Hirt, CFA, Senior Economist Alexis Gray, M.Sc., Senior Economist Andrew J. Patterson, CFA, Senior Economist Capital Markets Model Research Team Asawari Sathe, M.Sc., Senior Economist Qian Wang, Ph.D., Global Head of VCMM Adam J. Schickling, CFA Kevin DiCiurcio, CFA, Senior Investment Strategist Maximilian Wieland Daniel Wu, Ph.D., Senior Investment Strategist David Diwik, M.Sc. Ian Kresnak, CFA Ariana Abousaeedi Vytautas Maciulis, CFA Europe Olga Lepigina, MBA Jumana Saleheen, Ph.D., Europe Chief Economist Ben Vavreck, CFA Shaan Raithatha, CFA, Senior Economist Lukas Brandl-Cheng, M.Sc. Roxane Spitznagel, M.Sc. Alex Qu Lulu Al Ghussein, M.Sc. Acknowledgments: We thank Brand Design, Corporate Communications, Strategic Communications, and the Asset Allocation teams for their significant contributions to this piece. Further, we would like to acknowledge the work of Vanguard’s broader Investment Strategy Group, without whose tireless research efforts this piece would not be possible. 2

Contents Global outlook summary ......................................................................................................................................4 I. Global economic perspectives ....................................................................................................................8 Global economic outlook: Beating back inflation.............................................................................................8 United States: A narrow path gets narrower .................................................................................................18 Euro area: The European Central Bank (ECB) will continue to tighten despite recession ...................23 United Kingdom: Recession looms large as cost-of-living crisis intensifies ..............................................27 China: A cyclical bounce meets a structural downturn .................................................................................30 Emerging markets: Headline growth resilience meets underlying economic divergence .....................34 II. Global capital markets outlook ...............................................................................................................37 Global fixed income markets: Sowing the seeds for brighter days ahead ...............................................39 Global equity markets: Normalizing return outlook ......................................................................................45 A balanced portfolio still offers the best chance of success .......................................................................56 III. Appendix ...............................................................................................................................................................59 About the Vanguard Capital Markets Model ..................................................................................................59 Indexes for VCMM simulations .......................................................................................................................... 60 Notes on asset-return distributions The asset-return distributions shown here represent Vanguard’s view on the potential range of risk premiums that may occur over the next 10 years; such long-term projections are not intended to be extrapolated into a short-term view. These potential outcomes for long-term investment returns are generated by the Vanguard Capital Markets Model® (VCMM) and reflect the collective perspective of our Investment Strategy Group. The expected risk premiums—and the uncertainty surrounding those expectations—are among a number of qualitative and quantitative inputs used in Vanguard’s investment methodology and portfolio construction process. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of September 30, 2022. Results from the model may vary with each use and over time. For more information, see the Appendix section “About the Vanguard Capital Markets Model.” 33

Vanguard economic and market outlook for 2023 - Page 3

Global outlook summary The global economy in 2023: A recession by any other name Beating back inflation Global macro and financial market conditions In our 2022 economic and market outlook, we today and those anticipated in the coming outlined how we believed the removal of policy months are similar to those that have signaled accommodation would shape the economic and global recessions in the past. Energy supply-and- financial market landscape. Policy has in fact demand concerns, diminishing capital flows, driven conditions globally in 2022, one of the declining trade volumes, and falling output per most rapidly evolving economic and financial person mean that, in all likelihood, the global market environments in history. But one fact has economy will enter a recession in the coming year. been made abundantly clear: So long as financial Central banks generally seek to avoid a recession. markets function as intended, policymakers are Inflation dynamics mean that supply-side price willing to accept asset price volatility and a pressures on inflation are likely to reverse in 2023. deterioration in macroeconomic fundamentals However, policymakers must tighten financial as a consequence of fighting inflation. The conditions to stop high inflation from becoming normalization of consumer behavior, stabilization entrenched into the decision-making of households of supply pressures, and rapid monetary tightening and businesses. That said, households, businesses, suggest a more challenging macroeconomic and financial institutions are arguably in a better position to handle an eventual downturn, to the environment in 2023 that, in our view, will help extent that they have stronger balance sheets. bring down the rate of inflation. All recessions are painful, and we expect the length and depth of the recession in 2023 to Global inflation: Persistently surprising vary by region. Inflation has continued to trend higher across Our base case is a global recession in 2023 most economies, in many cases setting brought about by the efforts to return inflation multidecade highs. The action taken, and likely to to target. Whether history views the 2023 be taken in the months ahead, by central banks recession as mild or significant matters little for reflects a promising effort to combat elevated those affected by the downturn. But failing to inflation that has proven more persistent and act aggressively to combat inflation risks harming broad-based. Supply-demand imbalances linger households and businesses through entrenched in many sectors as global supply chains have yet inflationary pressures that last longer than the to fully recover from the COVID-19 pandemic and pain associated with any one recession. as demand is supported by strong household and As the table below highlights, growth is likely to business balance sheets buoyed by pandemic-era end 2023 flat or slightly negative in most major stimulus. The war in Ukraine continues, threatening economies outside of China. Unemployment is another surge in energy and food commodities likely to rise over the year but nowhere near as prices. Effective monetary policy requires good high as during the 2008 and 2020 downturns. decision-making, good communication, and good Through job losses and slowing consumer luck. The current backdrop is missing the good- demand, a downtrend in inflation is likely to luck component, posing a challenge for persist through 2023. We don’t believe that policymakers whose fiscal and monetary tools central banks will achieve their targets of 2% are less effective at combating supply shocks. inflation in 2023, but they will maintain those targets and look to achieve them through 2024 and into 2025—or reassess them when the time is right. That time isn’t now; reassessing inflation targets in a high-inflation environment could have deleterious effects on central bank credibility and inflation expectations. 4

Vanguard’s economic forecasts GDP growth* Unemployment rate Headline inflation† Monetary policy 2023 2023 2023 Country/ Year-end Year-end Neutral region Vanguard Consensus Trend Vanguard Consensus NAIRU Vanguard Consensus 2022 2023 rate U.S. 0.25% 0.9% 1.8% 5% 4.4% 3.5%–4% 3% 2.4% 4.25% 5% 2.5% Euro area 0% 0.2% 1.2% 7.4% 7.1% 6.5%–7% 6.0% 5.8% 2% 2.5% 1.5% U.K. –1.1% –0.8% 1.7% 4.7% 4.4% 3.5%–4% 6.3% 6.8% 3.5% 4.5% 2.5% China‡ 4.5% 5% 4.3% 4.7% N/A 5% 2.2% 2.3% 2.65% 2.6% 4.5% * For the U.S., GDP growth is defined as the year-over-year change in fourth-quarter gross domestic product. For all other countries/regions, it is defined as the annual change in total GDP in the forecast year compared with the previous year. † For the U.S., headline inflation is defined as year-over-year changes in this year’s fourth-quarter Personal Consumption Expenditures (PCE) Price Index compared with last year. For all other countries/regions, it is defined as the average annual change in headline Consumer Price Index (CPI) inflation in the forecast year compared with the previous year. Consensus for the U.S. is based on Bloomberg ECFC consensus estimates. ‡ China’s policy rate is the one-year medium-term lending facility (MLF) rate. Notes: Forecasts, which may have been updated from earlier outlooks, are as of November 30, 2022. NAIRU stands for non-accelerating inflation rate of unemployment. The neutral rate is the interest rate that would be neither expansionary or contractionary when the economy is at full employment and stable inflation. This table displays our median neutral rate estimates with an effective range of +/- 1 percentage point. Source: Vanguard. Global fixed income: Brighter days ahead fair, but the growing likelihood of recession and The market, which was initially slow to price declining profit margins skew the risks toward higher interest rates to fight elevated and higher spreads. Although credit exposure can add persistent inflation, now believes that most volatility, its higher expected return than that of central banks will have to go well past their U.S. Treasuries and low correlation with equities neutral policy rates—the rate at which policy validate its inclusion in portfolios. would be considered neither accommodative nor restrictive—to quell inflation. The eventual peak Global equities: Resetting expectations and persistence of policy rates, which will depend heavily on the path of inflation, will determine Rising interest rates, inflation, and geopolitical how high bond yields rise. Rising interest rates risks have forced investors to reassess their rosy and higher interest rate expectations have expectations for the future. The silver lining is lowered bond returns in 2022, creating near-term that this year’s bear market has improved our pain for investors. However the bright side of outlook for global equities, though our Vanguard higher rates is higher interest payments. These Capital Markets Model (VCMM) projections have led our return expectations for U.S. and suggest there are greater opportunities outside international bonds to increase by more than the United States. twofold. We now expect U.S. bonds to return Stretched valuations in the U.S. equity market 4.1%–5.1% per year over the next decade, in 2021 were unsustainable, and our fair-value compared with the 1.4%–2.4% annual returns framework suggests they still don’t reflect we forecast a year ago. For international bonds, current economic realities. We also see a high bar we expect returns of 4%–5% per year over the for continued above-average earnings growth, next decade, compared with our year-ago especially in the U.S. Although U.S. equities have forecast of 1.3%–2.3% per year. This means that continued to outperform their international for investors with an adequately long investment peers, the primary driver of that outperformance horizon, we expect their wealth to be higher by has shifted from earnings to currency over the the end of the decade than our year-ago forecast last year. The 30% decline in emerging markets would have suggested. In credit, valuations are 5

over the past 12 months has made valuations in expectations are 2.25 percentage points higher those regions more attractive. We now expect than they were at this time last year. Within the similar returns to those of non-U.S. developed U.S. market, value stocks are fairly valued relative markets and view emerging markets as an to growth, and small-capitalization stocks are important diversifier in equity portfolios. attractive despite our expectations for weaker near-term growth. Our outlook for the global From a U.S. dollar investor’s perspective, the equity risk premium is still positive at 1 to 3 VCMM projects higher 10-year annualized returns percentage points, but lower than last year for non-U.S. developed markets (7.2%–9.2%) because of a faster increase in expected and emerging markets (7%–9%) than for U.S. bond returns. markets (4.7%–6.7%). Globally, our equity return 6

Indexes used in our historical calculations The long-term returns for our hypothetical portfolios are based on data for the appropriate market indexes through September 30, 2022. We chose these benchmarks to provide the best history possible, and we split the global allocations to align with Vanguard’s guidance in constructing diversified portfolios. U.S. bonds: Standard & Poor’s High Grade Corporate Index from 1926 through 1968; Citigroup High Grade Index from 1969 through 1972; Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; and Bloomberg U.S. Aggregate Bond Index thereafter. Ex-U.S. bonds: Citigroup World Government Bond Ex-U.S. Index from 1985 through January 1989 and Bloomberg Global Aggregate ex-USD Index thereafter. Global bonds: Before January 1990, 100% U.S. bonds, as defined above. From January 1990 onward, 70% U.S. bonds and 30% ex-U.S. bonds, rebalanced monthly. U.S. equities: S&P 90 Index from January 1926 through March 1957; S&P 500 Index from March 1957 through 1974; Dow Jones Wilshire 5000 Index from the beginning of 1975 through April 2005; and MSCI US Broad Market Index thereafter. Ex-U.S. equities: MSCI World ex USA Index from January 1970 through 1987 and MSCI All Country World ex USA Index thereafter. Global equities: Before January 1970, 100% U.S. equities, as defined above. From January 1970 onward, 60% U.S. equities and 40% ex-U.S. equities, rebalanced monthly. Notes on risk All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. Diversification does not ensure a profit or protect against a loss in a declining market. 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. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Stocks and bonds of companies in emerging markets are generally more risky than stocks of companies in developed countries. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent price fluctuations. Investments that concentrate on a relatively narrow market sector face the risk of higher price volatility. Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. 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. High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings. Although the income from U.S. Treasury obligations held in the fund is subject to federal income tax, some or all of that income may be exempt from state and local taxes. 7

I. Global economic perspectives Global economic outlook: proven more persistent and broad-based. Supply- Beating back inflation demand imbalances linger in many sectors as In our 2022 economic and market outlook, we global supply chains have yet to fully recover outlined the reasons why we believed that the from the COVID-19 pandemic, and as demand removal of policy accommodation would shape is supported by strong household and business the economic and financial market landscape in balance sheets buoyed by pandemic-era stimulus. the year ahead. Policy has in fact been a key The war in Ukraine continues, threatening driver of conditions globally, as 2022 has proven another surge in energy and food commodities to be one of the most rapidly evolving economic prices. Effective monetary policy requires good and financial market environments in recent decision-making, good communication, and good history. Figure I-1 shows that the current and luck. The Federal Reserve has been behind the expected pace of change in monetary policy is curve in hiking rates this year, reflecting imprecise unlike anything we’ve seen in the last 30 years, decision-making, but more importantly it is particularly on a globally coordinated scale. missing the good-luck component, posing a challenge for policymakers whose fiscal and The action taken, and likely to be taken in the monetary tools are less effective at combating months ahead, by central banks reflects an effort supply shocks. to combat multidecade high inflation that has FIGURE I-1 Globally coordinated monetary tightening % s e t a Forecast y r c i l o United States k p n United Kingdom a l b Australia a r t n e uroe C Note: Dotted lines represent Vanguard’s forecast for policy rates as of October 31, 2022. Sources: Vanguard calculations, based on data from Thomson Reuters Datastream and Bloomberg. 8

Because central banks’ tools are most effective FIGURE I-2 in bringing down inflation by tamping down Global inflation has been driven by a demand, the decomposition of the drivers of multitude of factors inflation is crucial. By our estimates (Figure I-2), supply and demand factors are evenly contributing Consumer price inﬂation: . to inflationary pressures. If central banks are to rein in inflation, they will probably have to depress Contribution demand to the extent that a recession becomes to change in . very likely. Figure I-3 outlines our projected headline consumer probabilities of recession along with the likely price inﬂation forces that tip the economy into recession. . . . . Central Fiscal Stronger than Shelter Energy and bank target stimulus expected strength ood prices COVID rebound Notes: This decomposition of inflation into each of the subcategories is based on subjective analysis of our latest inflation forecast for year-end 2022 compared with expectations at the start of 2021. Shelter inflation is the component that captures the effect of shelter costs in the overall CPI. Shelter includes prices for both renters and homeowners. For renters, shelter inflation measures rent, temporary lodging away from home, and utility payments. For homeowners, the U.S. Bureau of Labor Statistics calculates what it would cost to rent a similar house. Values in the figure reflect rounding. Sources: Vanguard calculations, based on data from Moody’s, Refinitiv, and Bloomberg, as of October 31, 2022. FIGURE I-3 Near-term recession risk is elevated across major developed markets Probability of recession by end of 2023 Drivers/key risks United States 90% • Federal Reserve tightening path • Inflation eroding consumer purchasing power • Ukraine war impact including energy crisis Euro area 90% • Inflation eroding consumer purchasing power • European Central Bank tightening path United Kingdom 90% • Bank of England tightening path • Inflation eroding consumer purchasing power Source: Vanguard, as of September 30, 2022. 9

Global conditions today and those that are of a global recession, Figure I-4 assigns a expected to materialize in the coming months probability that the world is in a state of 2 are similar to conditions that have signaled recession at any given point in time. Only in global recessions in the past. Energy supply- 2001 was the probability of global recession as and-demand concerns, decreasing capital flows, high as it is today without an actual recession declining trade volumes, and falling output per taking place within the subsequent 12 months.3 person mean that, in all likelihood, the global From this we infer that the chances of a global economy will enter a recession in the coming recession in 2023 are very high. 1 year. Borrowing from the World Bank’s definition FIGURE I-4 Global recession indicator is at dangerous levels % Indicates global recession Recession probability % probability Note: Probabilities derived from vector similarity matrixes for global unemployment, real per capita GDP, industrial production, foreign direct investment, trade, and global energy demand were used to identify similarities between the period under consideration and other recessionary periods. Sources: World Bank, British Petroleum Statistical Review of World Energy, OECD, Federal Reserve Bank of St. Louis FRED database, OeNB, CPB Netherlands Bureau for Economic Policy Analysis, and UNCTAD, as of October 31, 2022. Global unemployment data are from Kose, Sugawara, and Terrones (2020). 1 While there is no universal definition of a global recession, the World Bank defines a global recession as a period in which (1) annual global real GDP per capita declines and (2) there is strong evidence for a broad-based decline in multiple global economic activity indicators (Kose, Sugawara, and Terrones, 2020). 2 See World Bank, 2022, Risk of Global Recession in 2023 Rises Amid Simultaneous Rate Hikes, press release issued September 15, 2022, available at www.worldbank.org/en/news/press-release/2022/09/15/risk-of-global-recession-in-2023-rises-amid-simultaneous-rate-hikes. 3 A recession did occur in the United States from March to November 2001, though a global recession as defined by the World Bank was avoided. 10

Periods of global recession tend to be associated financial system nearly came to a halt as with considerable economic and financial market liquidity constraints led to solvency concerns pain (Figure I-5). This is in part because, rather at systemically important financial institutions than simply a drop in demand or an increase exposed to securities tied to U.S. mortgage debt. in supply constraints, there is typically broader And in 2020, large portions of the global economy dislocation in macroeconomic fundamentals essentially shut down in efforts to stem the or the functioning of financial markets. In 1974 health risks of the COVID-19 pandemic. The and 1981, global economies were locked in a starting point for the global economy in 2022 stagflationary environment brought about by was stronger than in a typical year before a oil supply shocks and an unhinging of inflation global recession (Figure I-5): output and industrial expectations; that led to wages and prices activity were a little stronger and unemployment moving ever higher in a vicious cycle broken significantly lower. Taken at face value, a stronger only by substantial monetary policy tightening footing into the recession could result in a milder and ensuing recessions. In 2007, the global downturn supported by strong balance sheets. FIGURE I-5 Comparison: Global recessions versus now Percentage change – – % Real per capita GDP growth Global energy consumption (year-over-year nustrial activity ine (year-over-year rae (year-over-year Gross omestic savings (year-over-year Global unemployment (year-over-year ypical global recession ear be ore global recession Notes: Global recession years were 1975, 1982, 1991, 2009, and 2020. Year before includes the year before each, excluding 2019. Vanguard calculations are as of October 31, 2022. The typical global recession reflects the median result for each category in the global recession years. Sources: World Bank, British Petroleum Statistical Review of World Energy, OECD, Federal Reserve Bank of St. Louis FRED database, OeNB, CPB Netherlands Bureau for Economic Policy Analysis, UNCTAD, and Our World in Data, as of October 31, 2022. Global unemployment data and years of global recession are from Kose, Sugawara, and Terrones (2020). 11

Today, policymakers face a threat from global banks will increase the urgency of their tightening inflation brought on by a combination of a processes. Second, central banks have built up strong post-COVID recovery, lingering supply- credibility regarding their resolve and ability to chain disruptions, the war in Ukraine, and overly keep inflation at their target rates. This is mainly accommodative fiscal and monetary policy. In due to successful efforts to bring inflation down response, monetary policy has begun to swing in the 1980s and maintain it at around 2% over toward restrictive conditions, much as it did the past 30 years. The credibility gained by during the 1980s (Figure I-6), though on a more central banks is what has helped anchor inflation coordinated scale. There are similarities between expectations today. This is the key reason why the the global recessions of the 1970s and what may likelihood of central banks changing their inflation transpire in coming months, such as relatively targets amid a high-inflation environment tight labor markets (Figure I-7) and the presence remains low for now, as doing so could hurt their of supply-side shocks, but there are also key credibility and thus their ability to address differences. First, rather than double-digit inflation in future episodes. That said, a change inflation rising ever higher and on the back of in the inflation target at some future date cannot rising inflation expectations and wages, inflation be ruled out should it be supported by changes in expectations have largely stayed contained, policy preferences or the structure of the particularly those that look out over longer economy (Gagnon and Collins, 2019). periods (Figure I-8). Should that change, central FIGURE I-6 Global financial conditions continue to tighten x e d n I s Tighter conditions on ti di on C al i nc a n FI al lob Easier conditions G– Note: The global index is a GDP-weighted average of the Vanguard U.S., Bloomberg U.K., Vanguard euro zone, and Goldman Sachs Japan financial conditions indexes. Sources: Vanguard calculations, based on data from Thomson Reuters Datastream, Bloomberg, and Goldman Sachs, as of October 31, 2022. 12

FIGURE I-7 Employers having trouble filling vacant jobs . Job openings . per unemployed . . . S United States (LHS) Developed maret . U eU.S. (HS) . - s x e t e t . e a . k t r d S a e . t . d m i e n p U o . l e . v e . D Note: Data include Australia, Austria, Belgium, the Czech Republic, Finland, Germany, Japan, Norway, Portugal, Spain, Sweden, the United Kingdom, and the United States. Sources: Vanguard calculations, based on data from Thomson Reuters Datastream, as of October 31, 2022. FIGURE I-8 Long-term inflation expectations have remained anchored % Median -year-ahead expected inﬂation rate Median -year-ahead expected inﬂation rate -year expected inﬂation ( June June June June June June June June June June Notes: Global inflation expectations were calculated for G7 countries based on GDP weights. Subcomponent contributions were calculated on a GDP-weighted basis. For CPI subcomponent weights at the country level, 2021 weights were used for the U.S., the U.K., the European Union, and Canada; 2020 weights were used for Japan. West Texas Intermediate (WTI) spot data were used for oil prices, and WTI forward prices were used for forecast estimates. Sources: Survey of Consumer Expectations, Federal Reserve Bank of New York, and Federal Reserve Bank of St. Louis FRED database. 13

Credibility can affect fiscal policy as well. prime minister, the U.K. has seen a return of fiscal The market response to the United Kingdom’s orthodoxy. Tax rises and spending cuts worth “mini-budget” was swift and harsh (Figure I-9), a 2.5% of GDP over the next five years have placated clear signal that the proposed tax and spending markets. The U.K. fiscal watchdog—the Office for changes negatively affected the perceived Budget Responsibility (OBR)—has affirmed that willingness and ability of the U.K. government the latest fiscal plans put public sector net debt to service its debts. This should serve as a stark to GDP on a sustainable path. Gilt yields have reminder that markets will not tolerate unfunded returned to levels seen prior to the mini-budget, expenditures (tax cuts or spending increases) and the sterling has recovered against the dollar beyond a certain level. Following the appointment and euro. of Jeremy Hunt as chancellor and Rishi Sunak as FIGURE I-9 U.K. gilt yields have declined to pre-mini-budget levels Mini- Bank o ngand unt Sunak appointed budget interene -turn a prime miniter .% . d . l e i Y . -ear git . -ear git . -ear git September October October October October Notes: Intraday data from September 22, 2022, to October 27, 2022. “Mini-budget” refers to the growth plan announced by Chancellor of the Exchequer Kwasi Kwarteng on September 23, 2022. The Bank of England intervened on September 28 to restore financial stability, announcing it would buy an unlimited amount of long-term gilts. On October 17, new Chancellor of the Exchequer Jeremy Hunt reversed almost all the measures of the mini-budget. On October 24, Rishi Sunak was announced as the new U.K. prime minister. Source: Bloomberg, as of October 31, 2022. 14

Last year, we introduced the theory of fiscal Congressional Budget Office expects under space as one approach to estimating how much current U.S. tax and spending policies, the debt countries can maintain without risking upward trajectory of debt quickly becomes sustainability and likely interest rate increases unsustainable. Although the debts taken on (Ostry et al., 2010, and Zandi, Cheng, and during the pandemic were necessary to prevent Packard, 2011). Taking the U.S. situation as an suffering on a global scale, something needs to example, Figure I-10 shows that the current be done going forward to start reining in gaps high-inflation, high-interest-rate environment between taxes and spending before financial does little to affect the sustainability of current markets begin to take action themselves. debt levels, as the two forces offset each other, The time is not now, but it is approaching. but if deficits are to average 5% as the FIGURE I-10 U.S. debt ratio is expected to remain flat even in a higher-rate, higher-inflation environment Scenario Higher primary deﬁits Scenario Higher interest rates, higher inﬂation U.S. debt/GDP Scenario Higher interest rates, tame inﬂation Baseline Notes: Debt-to-GDP ratios were forecasted according to a standard debt accumulation equation. We used real GDP growth taken from July 2022 Congressional Budget Office (CBO) extended baseline projections. The other variables are defined as follows (based on 2022–2032 averages): In the base case, nominal interest rates were assumed to be 1.6%, inflation was assumed to be 2%, and the primary deficit was assumed to be 2%. We modifed those assumptions as indicated by the labels in the figure. For Scenario 1, we used 2.5% for the nominal interest rate. For Scenario 2, we used 2.5% for the nominal interest rate and 2.8% for inflation. For Scenario 3, we used 5% for the primary deficit. Sources: CBO July 2022 extended baseline projections and Vanguard, as of November 4, 2022. 15

In addition to previously mentioned goods and spent at home, concern about the viability or energy supply shocks and accommodative policy safety of their current industry, and/or their considerations, labor market dislocations have increased ability to spend time and money played a role in shaping our current environment. acquiring those additional skills. In Figure I-11, Our research has shown that, as with the other the one-third of jobs with the least amount of factors, this is in part due to the pandemic and interpersonal or cognitive capabilities fall into its lingering impacts (Clarke, Tan, and Schickling, Category A, the middle one-third into Category 2022). That said, the factors driving labor B, and the one-third with the highest requirement market frictions over the last few years (slowing of interpersonal and cognitive capabilities into population growth, increasing retirements, and Category C. As individuals move from a Category changing skill supply-and-demand dynamics) are A role to a Category C role, they typically require likely an acceleration of labor market trends that increasing amounts of training to allow them had been in place well before COVID-19 and the to develop the interpersonal and cognitive policy responses to it that threw economic and capabilities required of that type of role. Our financial markets into turmoil. work shows that the movement from A to B to C roles from 2021 to 2022 is substantially greater In 2018, we presented a more optimistic than that which occurred in 2018 to 2019, before perspective on automation’s impact on labor the pandemic. markets, outlining why automation and broader trends in the skills required of jobs meant that In addition to the movement of workers between labor demand, rather than declining, was likely types of jobs, this upskilling also implies future to shift to incorporate different skill sets productivity increases over time that would in (Tufano et al., 2018). Mirroring what has been part offset any inflationary pressures associated the case during most economic downturns with higher wages. But the road to that point will (Kopytov, Roussanov, and Tashereau-Dumouchel, be painful. Staffing shortages (Figure I-12) are 2018), increasing numbers of studies and our likely in the near term, meaning that wage analysis in Figure I-11 highlight how people pressures and the risks they pose to inflation are took the time to upskill during the pandemic likely to persist absent the intervention of central (Ganguli et al., 2022), because of more time banks and the impacts outlined earlier. FIGURE I-11 Job upskilling is a tailwind for potential economic growth Occupation Job category key transitions Heavier amount A B C More interersona by job category of routine tasks an cognitive functions 2018 to 2019 2021 to 2022 A to B B to C A to B B to C 67,746 11,663 725,000 44,000 Number of workers Notes: Occupations categorized as A entail more routine tasks, while B and C occupations entail more cognitive and interpersonal job functions. Average 2021 pay levels for each category in our sample data were $37,200, $51,800, and $60,500. Sources: Vanguard calculations, based on data from the Bureau of Labor Statistics Current Population Survey, as of September 30, 2022. 16

FIGURE I-12 From an economic, financial market, and A global recession will offer only temporary social perspective, the last few years have relief from a tight U.S. labor market left us with no shortage of volatility and pain. That is, unfortunately, likely to persist in the near Labor supply-demand balance 2022 2025 term as we work through the lasting impacts of Supply: the pandemic and subsequent policy reactions. Expected civilian labor force 165 million 165.5 million A recession, probably global in nature, seems Demand: 170 million 174 million likely in the next year and, with it, job and output Employment + job openings losses that hopefully lead to declines in inflation. Current shortfall 5 million 8.5 million That said, households, businesses, and financial institutions are in a much better position to Labor shortfalls likely offset handle the eventual downturn, such that drawing parallels with the 1970s, 1980s, 2008, or 2020 Labor shortfalls 2025 seems misplaced. 1 Non-uniquely human to uniquely + 1.5 million human job transitions 2 Legal migration returns to + 3 million pre-COVID rate a. Work-from-anywhere dividend + 600 thousand 3 b. Demographic dividend + 1.8 million Implied 2025 shortfall 1.6 million A milder, but still tight, labor market Implied 2022 2025 Vacancy/Unemployment (V/U) 2.0 1.2 Wage growth 6% 4% Inflation (CPI) 5%–6% 2%–3% Notes: Non-uniquely human to uniquely human job transitions reduce the labor shortfall since the workers’ output per hour increases after the transition. The work-from-anywhere dividend is an estimate of the increase in labor force participation brought on by increased remote work opportunities. The demographic dividend refers to the sizable percentage of nonworking individuals ages 60 to 75 who report a desire to return to the labor force if conditions are right. Sources: Vanguard calculations, based on data from the Bureau of Labor Statistics, as of September 30, 2022. 17

United States: A narrow path Compared with recent history, the current gets narrower monetary tightening cycle is historic and leaves Economic outcomes in the U.S. for 2023—much the narrowest of paths for the economy to like in the rest of the developed world—will be escape without a period of recession. Figure I-13 dominated by monetary policy efforts to illustrates the rapid rise in the policy rate over the accelerate the path of inflation back to target. last four quarters and relative to previous cycles. Growth slowed materially in 2022, but inflation has remained stubbornly elevated and the labor market strong. Further slowdowns in growth and a weakening of the labor market are necessary conditions for disinflation. FIGURE I-13 The pace of rate hikes in 2022 has been historic +.% (Four -bps to -bps an one -bps rate hikes) +.% (Seven -bps rate hikes) +.% (One -bps rate hike) Change in eﬀective federal = basis funds rate points cycle cycle Current cycle Notes: The figure shows changes in the effective federal funds rate during the first four quarters of each hiking cycle. The current cycle assumes an additional 50 bps of tightening will occur at the December 2022 Federal Open Market Committee meeting. A basis point equals one-hundredth of a percentage point. Sources: Vanguard and the Federal Reserve Bank of St. Louis, as of October 31, 2022. 18

Overall, we expect GDP growth of around 0.25% relative to before the pandemic. Figure I-14 over the course of 2023. Key interest-rate- shows the current severity of real income sensitive sectors of the economy such as housing shortfall compared with the pre-COVID income have already abruptly slowed, and consumers are trend. Households in aggregate have thus far facing wage gains that, while nominally strong, absorbed rising prices by relying on a strong labor have turned sharply negative in real terms. We market and a remaining savings buffer built up estimate that given the pace of inflation relative during the pandemic, but inflation has depressed to wages, the average household experienced a sentiment, and overall growth activity has slowed $400 shortfall per month in its standard of living below trend as we head into 2023. FIGURE I-14 Real purchasing power is a key headwind to growth $ Pandemic stimulus measures d e z i l a Real disposable u n n income a on li il tr $ d en tr January July January July January July Sources: Vanguard and Refinitiv, as of October 31, 2022. 19

Although the U.S. labor market has been may peak around 5%, a historically low rate surprisingly resilient to these mounting economic for a recession. Furthermore, as a result of the challenges, aided by structural labor-supply moderation in labor demand and declining constraints, we expect that demand for labor consumer confidence, job turnover rates are likely will moderate as consumers and companies brace to return to more normal levels, which will help for a recession. But considering how tight the reduce wage inflation to a more sustainable 4% labor market is entering this recession—as shown nominal growth rate. We expect a weaker labor in Figure I-15 in job openings per unemployed, and market on a number of fronts as outlined above, the slower pace of new labor force entrants as a which will hopefully put downward pressure result of slower population growth—unemployment on inflation. FIGURE I-15 Tepid working-age population growth limits the downside for the U.S. labor market . % e t a Job openings opulion €ore‚s r h per unemployed gro re t . w (LH (H o r) g s n o iold employed t- a . l uear py o- p d r- . ao wt r- o f ( r a . e Job openings per un y - ee Thr Sources: Vanguard calculations, based on data from Datastream, DataBuffet, and the Bureau of Labor Statistics, as of October 31, 2022. 20

Among the drivers of U.S. inflation, in addition to of a stronger pickup in services—especially the a tight labor market, 2022 saw the lagged impact stickier component of shelter inflation—will keep of supply constraints resulting from pandemic- inflation from falling back quickly. We see era dynamics pushing inflation higher (Figure I-16). inflation by the end of 2023 settling at 3%, which As we step into 2023, early signs of a recovery in is higher than the Federal Reserve’s inflation goods supply and softening demand could help target of 2%. In other words, we do not see balance supply and demand for consumption inflation returning to target next year. goods and bring prices lower. But expectations FIGURE I-16 Inflation has proved more persistent because of COVID-related shocks and the shelter component % Forecast Other oo s Other serces COVID (suppl shocs Shelter Core CI – Notes: The COVID supply shocks component includes subcomponents that faced extreme supply bottlenecks and demand shocks during peak COVID, namely transportation services and vehicles. Other goods includes apparel, household furnishings, and recreational goods. Other services includes health care, education and communication, recreational services, and other services. Energy price shocks are not directly included in transportation services but are indirectly included through higher airfares. Shelter inflation is the component that captures the effect of shelter costs in the overall CPI. Shelter includes prices for both renters and homeowners. For renters, shelter inflation measures both rent and utility payments. For homeowners, the BLS calculates what it would cost to rent a similar house. Sources: Vanguard calculations, based on data from the Bureau of Labor Statistics, as of October 31, 2022. 21

As we discussed earlier, monetary policy and inflation and a slowdown in wages as a tighter the communications from policymakers have policy rate environment begins showing its full squarely focused on inflation, and policy rates are effect on the economy in 2023. currently at levels broadly considered restrictive for economic activity, with more likely in coming Given such price and labor dynamics of late, quarters. That said, we’re starting to see signs our monetary policy outlook has become more of progress in the fight against inflation. Prime hawkish, and we expect a “higher for longer” among these is housing activity, where signs of policy rate environment ahead. Our baseline slowing momentum are already evident. Given outlook envisions the policy rate tightening to the lag with which housing activity filters into reach a peak of 5% by early 2023 and remaining inflation, this will eventually result in a slower at similar levels throughout the year. Given the pace of shelter inflation sometime in the second uncertainty that the inflation path has posed half of 2023. In early 2023, shelter inflation will thus far, we expect the Fed to favor a pace of remain strong, reflecting the still-robust housing tightening based strongly on data dependence, market momentum of early 2022 (Figure I-17). with wage and inflation expectations being key The stronger gains in shelter inflation, in our view, watch variables that will influence the Fed’s will be offset by a faster deceleration in goods ultimate path. FIGURE I-17 Both traditional and alternative data suggest a slowdown in shelter inflation only after mid- to late 2023, keeping core inflation elevated at year-end 2023 OER hange‚ hange (LHS, -mont c c average, ge ge MoM%) a a t t en en Traditional c € c indicators per per (LHS, estimate h h t t of OER MoM%) mon mon - - Alternative er– – er data leading v v o o - - indicators h–€ – h t t (RHS, MoM%) n n o– – o M ƒ M Notes: Owners’ equivalent rent (OER) represents the CPI subcomponent of owner-imputed rent, which holds the highest weight in core CPI. Traditional indicator estimates of OER MoM% are based on a Vanguard proprietary model used to forecast OER MoM gains. Alternative data indicators contain publicly provided data from private rental and housing firms. Weighted average of MoM changes in alternative data has been a relatively good signal of turning points in the monthly pace of shelter inflation. Sources: Vanguard calculations, based on data from Zillow, Apartment List, the Bureau of Labor Statistics, the U.S. Bureau of Economic Analysis, Refinitiv, and Moody’s, as of October 31, 2022. 22

Euro area: The European Central Bank FIGURE I-18 (ECB) will continue to tighten despite A European energy crisis recession a. European natural gas prices remain elevated Inflation and the policies enacted to address it have played a large role in shaping the economic % change ) Europe + % conditions in the euro area. The war in Ukraine h ) W u added another layer of uncertainty, volatility, M United States +% t / MMB and price pressures in 2022. Activity held up well e ( / c $ i in the first half of the year, supported by a strong r e ( c n p i a r post-pandemic recovery. Growth momentum, e . p p S o . r U though, slowed sharply in the second half as u higher energy prices (Figure I-18a), tighter E financial conditions, depressed sentiment, and January July January July weakening global growth all weighed on the economy. We expect euro-area GDP growth to Notes: Increase since December 31, 2020. ICE Dutch TTF natural gas price slow from around 3% in 2022 to 0% in 2023. for Europe, and Henry Hub natural gas price for the the U.S. Daily data from January 1, 2021, to November 23, 2022. Looking ahead, we are encouraged by Europe’s Source: Bloomberg, as of November 23, 2022. flexibility in adapting to the sharp reduction in Russian gas imports. Over 90% of its gas storage capacity has been filled, helped by additional b. European gas imports: How the gap will be plugged imports from other pipeline and liquefied natural gas suppliers, and efforts have been made to use Required reduction in alternative energy sources in some industries. gas consumption = % s Russia Storage r This should help soften the blow. That said, we e t e Substitution with still expect gas demand to contract by about 15% m other fuels c this winter relative to last year (Figure I-18b) given ubi Substitution toward c Supply Supply renewables the war-related supply constraints. on li (ex- (ex- Additional supply il B Russia) Russia) from other countries Sources: International Energy Agency, European Commission, and Vanguard estimates, as of October 31, 2022. 23

Forward-looking data, including Vanguard’s risks to this view are skewed to the downside; leading economic indicator, point to continued We do not rule out the prospect of a double-dip weakness ahead (Figure I-19). In our base case, recession in the second half of 2023 given that we expect that the euro-area economy will have European gas supply will be starting from a much entered recession from the fourth quarter of lower base than in 2022 and financial conditions 2022, with growth turning positive only in the will be tighter. Upside risks include milder-than- second half of 2023. We anticipate that Germany expected weather or an earlier-than-expected and Italy will underperform, given their relatively resolution to the war. As with the U.S., many large energy-intensive industrial sectors. The of the risks come down to luck. FIGURE I-19 Vanguard leading economic indicator points to further deterioration in economic growth s % % e Below trend, negative momentum r g o n Below trend, positive momentum t a a h h c c t Above trend, negative momentum i e d w n o ag Above trend, positive momentum g i r t n n i P ge GD earoverear ange d c a D r e e p a G f l e r r a e o a e g - y o - a r r t – u e n E v e o c - r r e a P e – y Notes: Monthly data from January 2000 to October 2022. The Vanguard leading economic indicator (VLEI) dashboard considers a range of leading indicators, sorted based on current levels relative to trend and underlying momentum. Indicators include consumer confidence, industrial production, retail sales, trade- weighted euro, factory orders, and stock market indexes. Source: Vanguard, as of October 31, 2022. 24

Also similar to the U.S. situation is that the The breadth of inflation has also increased central challenge for European policymakers throughout 2022. Eighty percent of the CPI is remains rising inflation. To be successful in now tracking at an annual rate above 3%, and guiding inflation back down to target, the core inflation accelerated from 2.6% at the start European Central Bank will need a combination of the year to 5% as of November. We expect of good decision-making, good communication, both headline and core inflation to peak in and good luck. The headline Consumer Price Index December 2022 and then fall gradually in 2023 as (CPI) rate doubled, from 5% at the start of 2022 energy and food price base effects unwind and to 10% in November, predominantly because of demand softens. We still, though, expect inflation accelerating energy and food prices. A weakening to average 5.5%–6% in 2023, well above the of the euro, partly driven by the war-induced ECB’s target of around 2%, as services inflation negative terms-of-trade shock (Figure I-20), has persists and core goods pressures dissipate amplified this inflationary pressure, as it raised only gradually (Figure I-21a). the cost of imports priced in foreign currencies, 4 putting downward pressure on growth. FIGURE I-20 The current account has switched from surplus to deficit % ) P D f G % o t ( n u o c c t a n e– r r u C– – Note: Monthly data from January 2000 to August 2022. Sources: Vanguard calculations, based on data from Bloomberg, as of October 24, 2022. 4 A country’s terms of trade refers to the relative price of exports compared with imports. 25

The ECB will be concerned about the stickiness functioning of monetary policy. The introduction of inflation, particularly in the services of the Transmission Protection Instrument will component, amid a still-tight labor market. help allay concerns here. In our central scenario, Indeed, the unemployment rate is at a record the presence of this tool, coupled with a delay of low 6.5% (as of October 2022), wage growth quantitative tightening until the second half of has increased to 4% year-over-year compared 2023, will limit any material blowout in peripheral 5 with a pre-pandemic average of 2%, and there spreads. is tentative evidence that high inflation is now flowing through to longer-term inflation Finally, given our central scenario of recession, expectations (Figure I-21b). we expect euro-area governments to keep energy-related fiscal measures for at least the We therefore expect the ECB to build on the first half of 2023 in order to cushion demand, 200 basis points’ worth of rate increases it has which we estimate will average between 2% already delivered, with the deposit rate having and 3% of GDP. This will delay any plans for risen from –0.5% at the start of 2022 to 1.5% fiscal consolidation until the latter part of at the October 2022 meeting. (A basis point is 2023 at the earliest. Given weak growth, one-hundredth of a percentage point.) Our base continued energy support, and rising interest case is for the deposit rate to reach at least 2% costs, euro-area debt-to-GDP ratios are unlikely by year-end and to peak at 2.5% in early 2023. to fall meaningfully in the near term. Italy will be We expect this restrictive policy stance to be under the most scrutiny because of its relatively maintained through 2023, with risks to our high debt burden and the election of a new terminal rate view skewed to the upside given government. Debts will remain sustainable in the the underlying strength of the labor market.. near term, but solutions to growing debt burdens must be discussed going forward. As policymakers continue to raise rates, they will need to be mindful of the risk of euro-area fragmentation, which would impair the proper FIGURE I-21 Inflation is a challenge for policymakers a. Peak in inflation is yet to come b. Long-term inflation expectations have become stickier e Forecast s Above % target t Q ng n a de h c n e spo ag e t Headline r n e y c inﬂation e r v e r p u s r a f e o y - ge r Core a e t v inﬂation o - en r c a er Q e P Y – <. . . . . . . . . . . ≥. to to to to to to to to to to . . . . . . . . . . Predicted inﬂation (%) Note: Monthly data from January 2020 to November 2022 and Vanguard forecasts thereafter. Note: Longer-term expectations refer to 2027 in Q4 2022 and to 2024 in Sources: Vanguard calculations, based on data from Bloomberg, as of Q4 2019. November 22, 2022. Sources: ECB and Survey of Professional Forecasters, as of October 28, 2022. 5 As measured by the euro-area employment cost index. 26

United Kingdom: Recession looms large primarily driven by higher energy and food prices, as cost-of-living crisis intensifies though the core goods and services components The war in Ukraine, the unique structure of the also rose significantly. The government’s Energy U.K. energy market, and domestic political Price Guarantee (EPG) policy, which caps unit instability posed challenges to the U.K. economy energy prices, should keep a lid on inflation in the in 2022. Activity slowed consistently throughout near term. the year as higher commodity prices, tighter In our base case, we expect inflation to fall financial conditions, very low confidence, and a gradually from a peak of above 11% in the weak global growth backdrop all dragged on last quarter of 2022 and to average 6% to demand. This was before the mini-budget was 6.5% in 2023, well above the Bank of England’s announced and then renounced weeks later in 2% target. an effort to appease financial markets. We expect 2022 U.K. GDP growth of about 4%, Aside from energy prices, the Bank of England coming from a low 2021 base, but—as with will be closely monitoring developments in the other major developed markets—slowing to labor market to calibrate its appropriate policy –1% to –1.5% in 2023. response. As in the U.S., job vacancies in the U.K. remain close to record highs, and wage pressures We expect the economy to have entered recession have intensified, with wages rising roughly 6% in the third quarter of 2022. Business surveys year-over-year. The latter issue is of particular are now consistent with a sharp contraction in concern as strong wage growth will lead to more output, and consumer confidence metrics are persistent inflationary pressure, predominantly at historical lows. Forward-looking indicators, through the stickier services component. In our including Vanguard’s leading economic indicator, central scenario, we expect the Bank of England suggest further weakness ahead. We expect the to raise interest rates to around 3.5% by the end recession to last at least six quarters and to be of 2022 and to a peak rate of 4.5% in early 2023. deeper than in the euro area. We expect this restrictive policy stance to persist The U.K.’s annual rate of CPI inflation doubled through 2023. in 2022, from 5.4% at the start of the year to 11.1% as of October 2022. The acceleration was 27

With the implementation of the EPG and higher large proportion of U.K. mortgagers are on fixed interest rates, we expect the narrative of the rates, it will take time for this effect to feed U.K.’s “cost-of-living” crisis to shift away from through to the economy. That said, we estimate higher energy prices and toward higher mortgage that 35% to 45% of the total stock of U.K. interest payments. If the Bank Rate does reach mortgages will be repriced to newer rates over 4.5%, this would imply new mortgage rates of the course of 2023. This will further weaken the at least 5.5% for the average borrower—a near- outlook for the consumer and exert downward quadrupling of interest costs (Figure I-22). As a pressure on housing valuations. FIGURE I-22 New mortgage rates have moved in line with higher U.K. bond yields % -year ﬁxed mortgage rate -year gilt yield – Note: Monthly data from January 31, 2000, to September 30, 2022. Source: Bloomberg, as of October 21, 2022. 28

The year 2022 was also one of political instability The U.K. is arguably in a more fragile situation for the U.K. Disagreements within the Conservative than other developed economies. Growth is Party led to three different prime ministers already weak and global inflation shocks are (and four different Chancellors of the Exchequer). amplified given that it is a small, open economy. Despite the aggregate fiscal consolidation of the To bring inflation back down to target, the Autumn Statement, policy is actually set to ease economic sacrifice—ultimately through higher in the next two financial years to protect the unemployment—could be larger. economy during recession, with the expected tightening occurring thereafter (Figure I-23). Raising interest rates sharply to address this heightened inflation challenge may also unveil Concerns remain over the sustainability of the hidden risks, particularly given the U.K.’s relatively U.K.’s debt profile. Although the debt-to-GDP large financial sector. The stress experienced by ratio, at below 100%, is lower than in many some domestic pension funds amid volatility in other developed economies, substantial fiscal the gilt market earlier this year is one example consolidation was penciled in the Autumn of this risk to financial stability. Statement to prevent it from rising significantly in the next five years (Figure I-23). FIGURE I-23 A modest loosening in fiscal policy until 2024 % ) Spending gP n iD Tightening Tax n el G sa Total on oi l /m go n i n n e t h g if t et% o N( Loosening – / / / / / / Sources: Vanguard and the OBR, as of November 21, 2022. 29

China: A cyclical bounce meets that the cyclical bounce will be modest compared a structural downturn with those that followed the global financial crisis As in major developed economies, policy has in 2009 and the 2020 Wuhan lockdown, given the played and will play a large role in economic expected global recession, uncertainty around the outcomes in China, but for different reasons. exit path from COVID-19, the lack of willingness China’s economic fortunes are governed by and capacity to overstimulate the economy, and what we have termed an “impossible trilemma,” a structural slowdown of growth potential in the in which policymakers must balance three long run. competing priorities: maintaining a zero-COVID Policymakers have announced that they plan to policy (ZCP), ensuring financial stability, and prepare for reopening the economy by relaxing sustaining strong levels of economic growth. In COVID controls, promoting vaccine and drug 2022, policymakers focused on upholding ZCP development, and improving hospital facilities. and ensuring financial stability at the cost of This could engineer a long-awaited recovery in growth. As a result, we forecast GDP growth to consumption and service activities. Crucially, end 2022 at around 3%, well below the historical however, we think the exit from COVID-19 is average and official targets of 5.5%. In 2023, unlikely to be smooth, as China’s health care we expect that policymakers’ focus is likely to system remains vulnerable to large outbreaks. gradually shift away from maintaining a strict A gradual reopening is more likely in our view ZCP toward achieving slightly stronger economic as booster vaccination rates for the older growth levels. population improve and an mRNA vaccine This will most likely result in a cyclical bounce and/or effective treatment becomes widely in 2023 of 4.5% GDP growth with risks skewed to available, which should lead to a more evident the upside on that view, driven by gradual rebound in the economy following the National loosening of COVID controls and a stabilizing real People’s Congress (NPC) next March. estate sector (Figure I-24). Nonetheless, we believe FIGURE I-24 Cyclical bounce expected in 2023 as the zero-COVID policy is unwound and the real estate sector stabilizes a. 2023 cyclical GDP bounce decomposed b. Chinese GDP unlikely to fully recover to pre-COVID into drivers levels .% % n i in . nge Upside e r Pre-COVID- g s hae n u . c b tren a s h r m Downside c e gee c f . a o v t e en D on c m ti . o i h r s t COVID boost per o p w e s f o v l r . Property boost i e om t v c P g ulae aseline e D . Global growth P l D G drag m D u G – –. C Dec. Dec. Dec. Dec. Dec. Downsde ase ase psde Sources: Vanguard calculations, based on data from Bloomberg, as of October 31, 2022. Notes: The baseline assumes a gradual decline in COVID restrictions with the pace accelerating after the March NPC meetings, but no complete abolishment. It also assumes that real estate investment stabilizes but does not rebound. The downside scenario assumes COVID restrictions remain at pandemic highs by the March leadership meetings and decline gradually through year-end, plateauing at a high level. It also assumes real estate investment continues to fall but at a slower pace than in 2022. The upside scenario assumes COVID restrictions are largely abolished after the March NPC meetings while real estate investment has a modest recovery. 30

Along with ZCP, China’s real estate sector reopening of the economy, which will help boost was a major drag on headline growth in 2022, demand at a low level following a nearly 10% subtracting around 2%. In 2023, we expect a contraction in 2022. We believe the rebound cyclical rebound in the sector, which may boost will be restrained by the significant structural growth by slightly more than 1 percentage point challenges facing China’s real estate sector, relative to 2022. This rebound is driven by including oversupply, poor affordability, and supportive fiscal and monetary policy, stabilizing worsening demographic trends (Figure I-25). sentiment and real estate investment, and FIGURE I-25 Despite easing regulation, the housing market is unlikely to rebound because of a structural downturn a. Housing remains oversupplied in China, with increased demand providing only a slight offset to supply growth s t i n g u n Supply Excess supply i s u o f h s o n o i l l i Demand M b. Cyclical factors will provide near-term support to housing, but structural factors will lower demand over the next five years r % . % r a a e . ye y - - r r Real estate e e . onv d v tio n o demand a - a - l r r . a m a e e orecast opu y p e ye e de t g e g a n – . agn t a - a s h g h c l e –. ine c a e k g e ag ora R t– –. t n W n e e c Demographics c r– – . r e e p– – . p Sources: Vanguard calculations, based on data from Bloomberg, as of October 31, 2022. 31

A modest cyclical bounce, following the deep the second quarter, we expect policy to switch downturn in 2022, suggests that a negative to a more neutral stance. In addition, the output gap is likely to persist toward the end depreciation in the renminbi in the second half of next year even in our upside scenario, with of 2022 is a reminder that Chinese policymakers the normalization in consumption and services have limited space to stimulate, as further and continuing to lag behind that of production. more aggressive easing may lead to capital Such an incomplete and uneven recovery of the outflows and higher inflation. The currency is economy would keep consumer inflation subdued. likely to remain under pressure in 2023 as We expect headline CPI to average 2.2% in 2023, developed-market central banks continue raising with core inflation below 1%. As such, the People’s interest rates in efforts to curb inflation, though Bank of China is likely to continue with modest the improved growth outlook in China and the liquidity easing and interest rate cuts in the near interventions by the People’s Bank of China to term, bucking the global trend. Nonetheless, we prevent panic about financial stability could help also believe that policymakers will refrain from stabilize the renminbi down the road. Our fair- overstimulating the housing market and the value model (Figure I-26) suggests that the broader economy in 2023, given concerns about renminbi is now close to fair value based on ever-rising leverage and financial stability risks. fundamentals. In fact, once the economy starts to rebound in FIGURE I-26 Our fair-value model is showing the renminbi fairly valued at current levels e t a t r Fair-value range o p Spot rate D s S Fair value U / Y N C Sources: Vanguard calculations, based on data from DataStream, as of October 31, 2022. 32

In addition to policymakers’ reluctance to slowed notably over the same time frame overstimulate, a worsening structural growth (Figure I-27). These developments will weigh outlook is expected to restrain the recovery in on productivity growth, a key determinant of 2023 and the growth outlook in the years ahead. potential growth rates. Also concerning is that Foreign direct investment flows into China over progress has reversed during the pandemic on 2017–2021 were significantly lower than they the shift from an investment-led economy to had been in the prior five years, amid a slowing a consumption-led one, exacerbating concerns globalization trend and rising geopolitical tension, about growth sustainability in the medium term. while the pace of private sector investment FIGURE I-27 Japanification warning signs, with rising concerns about long-term growth sustainability Foreign direct investment Ratio of private versus state investment net inﬂows percentage of GDP Consumption share of GDP – . % .% average – . % .% average Sources: Vanguard calculations, based on data from Bloomberg and the CEIC, as of October 31, 2022. 33

Emerging markets: Headline growth We expect EM growth of 3.4% in 2023 to resilience meets underlying economic significantly outperform developed-market divergence growth of 0.3%, but we are likely to see notable divergence once again across regions. While Asia The story of emerging markets (EM) in 2022 has will benefit from a cyclical bounce in China and been one of remarkable resilience (Figure I-28a) falling inflation, EM Europe will continue to face despite myriad macroeconomic shocks. Although inflation pressures from uncertain energy supply food and energy prices rose, financial conditions and a weak European growth backdrop. In Latin tightened significantly, and Chinese growth America, growth is likely to disappoint consensus disappointed, EM growth, foreign exchange, and as U.S. growth slows materially in 2023, prompting inflation have not underperformed developed central banks to adjust policy rates down from markets. However, the relative headline resilience very high levels. masks the regional divergence (Figure I-28b). FIGURE I-28 Diverging fortunes for emerging-market economies a. Emerging markets GDP growth will remain b. But we expect significant divergence among resilient relative to developed markets growth regions to continue in 2023 in 2023 . % .% . % .% . % . % .% .% .% .% .% . % .% .% .% .% .% % Developed markets Emerging markets Developed Emerging Emerging Emerging markets Asia Europe Latin America Note: Vanguard forecasts for 2022 and 2023. Sources: Vanguard calculations, based on data from Thomson Reuters Datastream, as of October 31, 2022. 34

Our below-consensus outlook for the Latin In EM Asia, we are expecting 2023 GDP American region is driven by a few factors. growth of 4.6%, broadly in line with consensus. First is our below-consensus U.S. growth outlook. Our view is driven by two countervailing forces. Seventy percent of Mexican exports go to the Our forecast for a cyclical growth rebound in U.S., and Mexican exports are highly correlated China supports a positive EM Asian growth with the U.S. inventory cycle (excluding autos). outlook. Additionally, as inflation in EM Asia After a strong build over the last year, we expect falls, we expect central banks to end their hiking inventory growth to slow along with the slowing cycle, which will support growth. EM Asian export U.S. economy. This will put downside pressure on growth has been a major growth support during both Mexican growth and the Mexican current the recovery from the pandemic. We believe that account. Second, Latin America is the only EM consensus expectations for a mix of modest rate region with central bank interest rates above hikes and cuts and broadly flat inflation are fair. inflation. However, inflation is falling quickly across many Latin American economies (Figure I-29). This means interest rates will be even more restrictive at current levels, further slowing economic growth. FIGURE I-29 Inflation in emerging Europe is mainly energy-driven at this point, while inflation in both emerging Latin America and emerging Asia looks more persistent ) % the ng oan mh Emerging Eurpe -c e ee thrag (t n one c tir ae Emerging Latin America p ﬂ nd i e Emerging Asia ez dlinuali an en Ha – Feb. Dec. Oct. August June April Sources: Vanguard calculations, based on data from Refinitiv, as of October 31, 2022. 35

In EM Europe, we expect 2023 GDP growth to FIGURE I-30 be flat at 0%, below consensus of 0.6%. Our European real spot rates remain deeply below-consensus view is driven by our below- negative, while Latin American rates look consensus developed-market European outlook as though they have room to come down as well as an inflation outlook that we expect to remain precarious throughout 2023. EM European 0.44% inflation continues to accelerate, though a recent reprieve has come in the form of energy price –1.55% subsidies. These expensive subsidies can lead to widening fiscal deficits, which lead to tighter financial conditions and lower growth. Should governments try to limit deficit expansion, the energy price subsidy would likely crowd out other –8.36% government spending priorities, possibly limiting Emerging Latin Emerging potential growth. The big risk for Europe is that, Asia America Europe should inflation remain stubbornly high because Sources: Vanguard calculations, based on data from Refinitiv, as of of a structural energy shortage, central banks October 31, 2022. would likely need to continue hiking interest rates to get them to restrictive territory. Figure I-30 shows that EM European interest rates are a long way from being positive on a real basis, in contrast to their EM peers. 36

II. Global capital markets outlook In our economic and market outlook for 2022, Looking ahead, our return outlook—which has we highlighted the risks global capital markets been on a steady downward trajectory since faced from the dual pressures of high equity 2009—is ticking up. This is especially true in fixed valuations and interest rates that did not reflect income, where our U.S. and international bond the seriousness of inflation pressures. As the year forecasts are more than two times higher than started, markets began to price this shift, and they were a year ago. In equities, U.S. valuations discount rates rose. Rising discount rates, coupled are more attractive than they were last year with geopolitical shocks and slowing growth, led but are still above our estimate of fair value. to a sell-off that was notable not only for its International equities, however, are at the low depth but also for its breadth and persistence. end of our fair-value estimates (Figure II-1). Although it is impossible to say with confidence when equity and bond markets will bottom, valuations and yields are clearly more attractive than they were a year ago. FIGURE II-1 Equity and bond valuations are attractive Undervalued Fairly valued Stretched 0 25 50 75 100% Valuation percentile relative to fair value 34% (57%) 44% (51%) 44% (64%) 70% (5%) Number in parenthesis lobal lobal S areate S euities is valuation as of e€S e€S bons September 30, 2021 euit‚ areate Notes: The U.S. valuation measure is the current cyclically adjusted price/earnings ratio (CAPE) percentile relative to fair-value CAPE for the Standard & Poor’s Composite Index from 1940 to 1957 and the S&P 500 Index from 1957 through September 30, 2022. Global ex-U.S. equity is a 70% developed markets/30% emerging markets blend. Developed-market equity valuation measures are the current CAPE percentile relative to the fair-value CAPE for the local MSCI index. The ex-U.S. developed markets valuation measure is the market-weighted average of each region’s (Australia, U.K., euro area, Japan, and Canada) valuation percentile. Emerging markets is based on the percentile rank based on our fair-value model relative to the market. U.S. aggregate bonds are the weighted average between intermediate-term credit and Treasury valuation percentiles. The global ex-U.S. aggregate valuation measure is the market-weighted average of each region’s (Australia, U.K., euro area, Japan, and Canada) valuation percentile. The valuation percentiles in parenthesis are as of one year prior. Sources: Vanguard calculations, based on Robert Shiller’s website, at aida.wss.yale.edu/~shiller/data.htm, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, and Refinitiv, as of September 30, 2022, and September 30, 2021. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022, and September 30, 2021. Results from the model may vary with each use and over time. Vanguard’s distinct approach to forecasting To treat the future with the deference it deserves, Vanguard has long believed that market forecasts are best viewed in a probabilistic framework. This annual publication’s primary objectives are to describe the projected long-term return distributions that contribute to strategic asset allocation decisions and to present the rationale for the ranges and probabilities of potential outcomes. This analysis discusses our global outlook from the perspective of a U.S. investor with a dollar- denominated portfolio. 37

A notable characteristic of the sell-off in global The figure also shows that our outlook for global stocks and bonds in 2022 was the degree to stocks and bonds has reversed its downward 6 which both fell together. Figure II-2 shows our trend in the last decade. This higher return 10-year outlook and realized returns for a globally outlook is in large part because of higher interest diversified, 60% stock/40% bond portfolio since rates to fight inflation, which caused asset price 2001. Rising equity valuations in 2021 pushed declines through the equity valuation and realized returns above our forecasted range bond yield channels. These forces also raised from 10 years prior, but large losses in both expectations for the next decade, because yields equity and fixed income over the last 12 months on developed-market sovereign debt are the have brought those returns within the range. foundation on which other risky returns are built. FIGURE II-2 Returns on a 60/40 balanced portfolio are now more in line with our view from 10 years ago 10-year annualized returns % 5.5% Interquartile range Actual return Median expectation Notes: The chart shows the actual 10-year annualized return of a 60/40 stock/bond portfolio compared with the VCMM forecast for the same portfolio made 10 years earlier. For example, the 2011 data point at the beginning of the chart shows the actual return for the 10-year period 2001–2011 (solid line) compared with the 10-year return forecast made in 2001 (dotted line). After 2022, the dotted line is extended to show how our forecasts made between 2013 and 2022 (ending between 2023 and 2032) are evolving. The interquartile range represents the area between the 25th and 75th percentile of the return distribution. The portfolio is 36% U.S. stocks, 24% international stocks, 28% U.S. bonds, and 12% international bonds. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 6 This breakdown in correlation was disconcerting for many investors and led some to question whether the 60% stock/40% bond portfolio still had merit as an investment tool. Our research finds that correlations can move aggressively over shorter investment horizons but that it would take long periods of consistently high inflation for long-term correlation measures—those that more meaningfully affect portfolio outcomes—to turn positive (Wu et al., 2021). 38

7 Global fixed income markets: Sowing respectively. As shown in Figure II-3a, the steep the seeds for brighter days ahead decline in U.S. bonds—along with the 12-month The pain of rising interest rates has been felt return that rolled off—reduced 10-year annualized most acutely in global fixed income markets. returns by 2 percentage points. Figure II-3b shows Both the Bloomberg U.S. Aggregate Bond Index a similar story for international bonds. However, and the Bloomberg Global Aggregate ex-USD losses there offset previous higher-than-expected Index (Hedged) have declined more than in any returns from lower relative interest rates and 12-month period in their histories, down 14.6% brought actual results more in line with our and 9.9%, for the year ended September 30, 2022, expectations from a decade ago. FIGURE II-3 Rising interest rates created near-term pain, but have raised our long-term forecast a. Fastest policy tightening in 40 years led to b. Currency hedging offset similarly large losses on unprecedented losses for U.S. bonds international bonds for U.S. investors 10-year annualized returns 10-year annualized returns % % 2.0% 1.0% Interquartile range Actual return Median expectation Notes: Figure II-3a shows the actual 10-year annualized return of U.S. bonds compared with the VCMM forecast of 10 years earlier. Figure II-3b shows the actual 10-year annualized return of U.S. dollar-hedged international bonds compared with the VCMM forecast of 10 years earlier. For example, the 2011 data point at the beginning of each chart shows the actual return for the 10-year period 2001–2011 (solid line) compared with the 10-year return forecast made in 2001 (dotted line). After 2022, the dotted line is extended to show how our forecasts made between 2013 and 2022 (ending between 2023 and 2032) are evolving. The interquartile range represents the area between the 25th and 75th percentile of the return distribution. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 7 Return data begin in 1975 for the Bloomberg U.S. Aggregate Bond Index and 2000 for the Bloomberg Global Aggregate ex-USD Index Hedged. 39

Although rising interest rates have created analysis should give long-term investors reasons near-term pain for fixed income investors, to be optimistic about the prospects of their we expect that those with sufficiently long fixed income portfolios. investment horizons will be better off in end-of- period wealth terms by the end of the decade Against a backdrop of rapidly rising rates, our than if they had just realized our return forecast fixed income return outlook for the next decade from the end of last year (Figure II-4). This is (Figure II-5a) is significantly better than last because of the effect of duration. When interest year’s projections, at 4.1%–5.1%, based on more rates rise, bonds reprice lower immediately. attractive valuations (Figure II-5b). Expected However, cash flows can then be reinvested at returns for non-U.S. bonds in local currency are higher rates. Given enough time, the increased lower than those of U.S. bonds in light of the income from higher coupon payments will offset relatively lower yields in non-U.S. developed the price decline, and an investor’s total return markets, but the differences are negligible once should increase. we account for currency impacts. Further, the diversification through exposure to hedged Of course, higher returns are not guaranteed. non-U.S. bonds should help offset some risk The median of this analysis is informed by the specific to the U.S. fixed income markets (Philips trajectory of yields implied by the forward yield et al., 2014). Broad U.S. investment-grade bonds curve. Figure II-4 shows that there is a possibility should outperform U.S. Treasury bonds by that investors may not have higher wealth at the 1.1 percentage points on an annualized basis. end of the decade because interest rates continue Importantly, while recent returns have called to rise throughout the next decade. But this into question fixed income’s role in portfolios, we continue to believe its inclusion is warranted as a 8 portfolio stabilizer and a long-term diversifier. FIGURE II-4 We expect investors to be better off because, not in spite, of the sell-off $ , y a f M Return forecast as of s o December , d a e t s e v n i f $ Return forecast as of e o u l September , a V Notes: The chart shows actual returns for the Bloomberg U.S. Aggregate Bond Index along with Vanguard’s forecast for cumulative returns over the subsequent 10 years as of December 31, 2021, and September 30, 2022. The dotted lines represent the 10th and 90th percentiles of the forecasted distribution. Data are as of September 30, 2022. Sources: Vanguard calculations and Bloomberg, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of December 31, 2021, and September 30, 2022. Results from the model may vary with each use and over time. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 8 Despite the historic sell-off of fixed income in 2022, its inclusion in the portfolio still improved results, because bonds are a lower-volatility asset. Our research (Wu et al., 2021) finds that asset allocation matters more than correlation regime when estimating outcomes over a long-term horizon. 40

FIGURE II-5 The green shoots of higher bond returns a. Higher rates have pushed expected bond returns higher 5th 25th 50th 75th 95th Median percentile percentile percentile percentile percentile volatility U.S. high-yield corporate bonds 4.5% 6.1% 7.1% 8.2% 9.8% 10.4% Emerging sovereign bonds 4.2 6.0 6.9 7.9 9.2 11.0 U.S. Treasury bonds 2.4 3.4 4.2 4.9 6.1 5.8 U.S. intermediate TIPS 1.4 2.6 3.7 4.8 6.6 5.0 U.S. bonds 2.9 3.9 4.6 5.3 6.5 5.6 U.S. mortgage-backed securities 2.7 4.0 4.8 5.5 6.4 4.7 Global ex-U.S. bonds (hedged) 2.4 3.6 4.5 5.4 6.9 4.4 U.S. inflation 0.3 1.6 2.5 3.3 4.6 2.3 U.S. cash 1.7% 2.9 3.9 4.9 6.4 1.4 Notes: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualized nominal returns in USD for asset classes highlighted here. Median volatility is the 50th percentile of an asset class’s distribution of annualized standard deviation of returns. Asset class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains. Indexes are unmanaged; therefore, direct investment is not possible. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. U.S. inflation is the 10-year average of year-over-year U.S. headline CPI. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. b. Fixed income is fairly valued Undervalued Fairly valued Stretched 0 25 50 75 100% Valuation percentile Number in parenthesis is valuation 34% (50%) 34% (52%) 35% (71%) 39% (73%) 40% 44% (73%) 45% (70%) 56% („1%) as of September Short-term ntermeiate- ntermeiate ( 2%) ƒon-term €ih-‚iel …S 30, 2021 Treasuries term soverein reit TS Treasuries reit Treasuries ebt Notes: Credit (emerging sovereign, high-yield and intermediate) and mortgage-backed securities (MBS) valuations are based on current spreads relative to year 30. Treasury valuation is the key rate duration-weighted average of our proprietary fundamental fair-value model. TIPS are calculated using 10-year-ahead annualized inflation expectation relative to years 21–30. The valuation percentiles in parenthesis are as of one year prior. Source: Vanguard calculations, as of September 30, 2022, and September 30, 2021. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022, and September 30, 2021. Results from the model may vary with each use and over time. 41

U.S. interest rates: Valuations are attractive The evolution of fair value will depend heavily After rising by as much as 260 basis points in on the direction of inflation, the Fed’s response, 2022, the 10-year U.S. Treasury yield has traded and the market’s expectations for future policy in a range of 3.7%–4.3% as the market tries to rates. Figure II-6 shows the expected impact of ascertain the direction of Fed policy. But we our economics team’s inflation and federal funds believe that the terminal rate and the amount rate forecast on the 10-year Treasury yield over of time policy is held at that level will be what the next three years. ultimately matters for U.S. Treasury returns. Based on current economic conditions and Fed policy guidance, our Treasury fair-value model suggests that the yield curve is within our 9 fair-value range. FIGURE II-6 Higher long-term yields are possible, but any trip above historical averages is likely to be brief % erage -year yied – Projected range of 10-year Treasury yied 10-year Treasury yied 10-year Treasury yied rojected ase case€ Notes: The chart shows the actual 10-year Treasury yield quoted on a constant maturity basis since 1995 and Vanguard’s forecast based on a range of economic scenarios. The forecasts are derived from a statistical model specification that is a five-variable vector error correction model, including the 10-year Treasury yield, first three principal components of covariance matrix for 10-year trailing inflation, 10-year trailing food inflation, the 10-year trailing hourly earnings growth, effective federal funds rate, and 5-year trailing real GDP estimated over the period January 1979–September 30, 2022. Sources: Vanguard calculations, based on data from FactSet, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv, and Global Financial Data. 9 For more details on our Treasury attribution model, see Davis et al., 2021. 42

In our baseline scenario—in which inflation falls Corporate bonds: Cheaper valuations, throughout 2023 but remains above the Fed’s but downside risks remain 2% target and the federal funds rate rises to Despite a record pace of Fed tightening and 4.5% and stays there for the next 12 months a historic rise in Treasury yields in 2022, credit before gradually falling to 2.5%—we expect the spreads have remained remarkably resilient. 10-year yield to peak around its recent highs Our fair-value framework, shown in Figures II-7a (4%–4.3%). In a more pessimistic scenario— and II-7b, uses the same four variables to model shown by the top of the gray band in Figure investment-grade and high-yield spreads but II-6—the Fed’s fight against inflation forces it finds that these variables differ in their to raise rates as high as 5.7%. In this scenario, importance. For instance, both investment-grade the 10-year yield could peak as high as 5.5%. and high-yield spreads are most sensitive to If the fight against inflation requires less action economic conditions, but the slope of the yield from the Fed, the 10-year yield has likely already curve matters more for investment-grade than peaked, and we would expect lower 10-year yields for high-yield. Conversely, high-yield is more as policy rates normalize more quickly. No matter sensitive to corporate debt fundamentals given the scenario, our view that the Fed will ultimately its riskier credit profile. be successful in bringing down inflation means that it will be difficult for long-term yields to Over the last 12 months, worsening economic remain above their historical average from the conditions from inflation and the Fed’s fight to past 35 years. contain it have been the main factors pushing credit spreads higher. Tighter policy is also raising Expected long-term inflation rates implied by the risk of a recession, which leads the yield curve Treasury Inflation-Protected Securities (TIPS) to invert and could put downward pressure on also support this view. Breakeven inflation rates profits and debt sustainability metrics. Strong peaked in the first half of 2022, as energy prices balance sheets, however, have prevented spreads reached record highs, at 2.98% annually over the (especially high-yield ones) from widening further. next decade. These expectations have since Although both investment-grade and high-yield moderated to 2.15% as of September 30, 2022. bond spreads are within our fair-value range, it is This is below our median VCMM 10-year annualized reasonable to expect that they could widen more inflation forecast of 2.5% (see Figure II-5a), which given our outlook for weaker economic conditions, leads us to view longer-term inflation protection high short-term interest rates to fight inflation, as cheaper than last year but within our fair-value and slower corporate profit growth. range (see Figure II-5b). Higher TIPS returns are a result of inflation exceeding market expectations. To that end, only upside inflation surprises will create excess return opportunities. Regardless of their attractiveness from a valuation perspective at any point in time, TIPS offer some benefit to long-term investors who are sensitive to inflation risk. 43

Over the next decade, we expect investment- shorter investment horizons, our research grade bonds to return 4.8%–5.8% and high-yield finds that for investors with a sufficiently long bonds to return 6.6%–7.6% per year. These investment horizon who are looking to maximize returns are not dissimilar from our forecasted their end-of-period wealth, credit can improve equity returns for the next decade, but they also portfolio outcomes. This improvement comes come with equity-like volatility. Although this from credit’s premium over Treasuries and its 10 volatility may be concerning for investors with low correlation with equity. FIGURE II-7 Credit spreads are near fair value, but risks are elevated because of the macro environment a. Investment-grade % d ea spr air-vale ed t range s u dj Investment- a - grade OAS n o i t Investment- p O grade OAS fair vale – Notes: Investment-grade credit spreads are yields on bonds characterized by their low default risk (credit rating above BBB–) above the yield on a Treasury security of the same duration. Data are from July 1976 to June 2022. Fair value is specified by an Ordinary Least Squares (OLS) regression model where the dependent variable is the investment-grade option-adjusted spread (OAS) of the Bloomberg U.S Corporate Investment Grade Index and the explanatory variables (all one month lagged) are our proprietary Vanguard leading economic indicator (VLEI), the 10-year Treasury yield minus the 2-year Treasury yield (yield curve slope), the debt-to-profit ratio (ratio of U.S. debt outstanding of nonfinancial corporations to U.S. nonfinancial corporate business profits before tax), and year- on-year change in quarterly corporate profits. Sources: Vanguard calculations, based on data from Bloomberg, Refinitiv Datastream, and Barclays Live, as of September 30, 2022. b. High-yield % d ea spr ed t s u dj a Fair-value - n range o i t p High-yield OAS O High-yield OAS fair value Notes: High-yield credit spreads are yields on bonds characterized by their elevated default risk (credit rating BB+ or lower) above the yield on a Treasury security of the same duration. Data are from January 1987 to June 2022. Fair value is specified by an Ordinary Least Squares (OLS) regression model where the dependent variable is the high-yield option-adjusted spread (OAS) of the Bloomberg U.S. Corporate High Yield Index and the explanatory variables (all one month lagged) are our proprietary Vanguard leading economic indicator (VLEI), the 10-year Treasury yield minus the 2-year Treasury yield (yield curve slope), the debt- to-profit ratio (ratio of U.S. debt outstanding of nonfinancial corporations to U.S. nonfinancial corporate business profits before tax), and year-on-year change in quarterly corporate profits. Sources: Vanguard calculations, based on data from Bloomberg, Refinitiv Datastream, and Barclays Live, as of September 30, 2022. 10 Our VCMM forecast suggests that median correlations between U.S. equities and investment-grade and high-yield bonds will be 0.22 and 0.31, respectively. 44

Global equity markets: Normalizing Figures II-8a and II-8b show that the global sell-off return outlook is bringing U.S. returns closer to our forecasts The sell-off in equity markets this year has been from 10 years ago but that international equities indiscriminate. U.S., developed ex-U.S., and have continued to underperform our expectations. emerging-market equity indexes have all posted Although discrepancies exist at the regional level, losses greater than 20% in the last nine months. our forecast 10 years ago for global equities has 11 Valuation declines were more pronounced in proved accurate. This underscores the challenges U.S. markets, but a strengthening dollar meant investors face when tilting their portfolio heavily U.S.-based investors realized larger losses on in one direction, and it highlights the benefits of their unhedged international equity exposures global diversification. than on their local ones. Even though this is negative from a short-term, realized-return perspective, it means that the global opportunity set is now more attractive than it was a year ago. FIGURE II-8 Investors are reassessing their rosy view of equities, which is pushing our return outlook higher a. U.S. equities are falling back toward our forecast b. International equities have continued to lag from a decade ago expectations from a decade prior 10-year annualized returns 10-year annualized returns % % % % Interquartile range Actual return Median expectation Notes: Figure II-8a shows the actual 10-year annualized return for U.S. equities compared with the VCMM forecast made 10 years earlier. Figure II-8b shows the actual 10-year annualized return for international equities compared with the VCMM forecast made 10 years earlier. For example, the 2011 data point at the beginning of each chart shows the actual return for the 10-year period 2001–2011 (solid line) compared with the 10-year return forecast made in 2001 (dotted line). After 2022, the dotted line is extended to show how our forecasts made between 2013 and 2022 (ending between 2023 and 2032) are evolving. The interquartile range represents the area between the 25th and 75th percentile of the return distribution. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. 11 Our median forecast for a market-cap-weighted portfolio of U.S. and international equities for the 10-year period from September 30, 2012, to September 30, 2022, was 7.6% per year, and the same portfolio returned 8% over that period. 45

Figures II-9a and II-9b show our expectations for (or undervaluation) should not, in itself, suggest U.S.-based investor equity returns and our view a short-term action by investors. Time-varying of valuations across developed and emerging portfolio construction should balance risk and markets and factors. Our valuations and return in a utility-based framework and requires forecasting frameworks are intended to set acceptance of model and active risk (Aliaga-Díaz long-term expectations. Therefore, overvaluation et al., 2022). FIGURE II-9 Expected returns are higher, but we still see more opportunities internationally a. Equity market 10-year outlook: Setting reasonable expectations 5th 25th 50th 75th 95th Median percentile percentile percentile percentile percentile volatility U.S. small-cap –2.6% 2.5% 6.1% 9.7% 15.1% 22.9% U.S. value –2.7 2.2 5.7 9.1 14.2 19.8 U.S. REITs –2.6 2.4 5.9 9.4 14.4 20.1 Global ex-U.S. equities 2.2 5.8 8.4 11.0 14.9 18.8 U.S. growth –3.4 1.0 4.1 7.1 11.6 18.6 U.S. equity –1.3 2.8 5.7 8.6 12.9 17.4 U.S. large-cap –1.5 2.7 5.6 8.5 12.8 17.1 Commodities –13.0 –2.9 4.3 11.8 23.4 16.6 Notes: The forecast corresponds to the distribution of 10,000 VCMM simulations for 10-year annualized nominal returns in USD for asset classes highlighted here. Median volatility is the 50th percentile of an asset class’s distribution of annualized standard deviation of returns. Asset class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains. Indexes are unmanaged; therefore, direct investment is not possible. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. b. Valuations are more attractive than a year ago Undervalued Fairly valued Stretched 0 25 50 75 100% Valuation percentile ƒ m„er in parent‚esis is al atin as … 19% (50%) 32% (78%) 35% (46%) 55% (58%) 57% (7%) 69% (7%) Septem„er †0‡ 2021 Small-cap Emerging Ex-U.S. al e arge-cap r€t‚ markets eelpe markets Notes: With the exception of emerging markets and ex-U.S. developed markets, valuations are relative to U.S. equities as the base at the 50th percentile. Growth, value, and small-cap are all based on the percentile rank based on our fair-value model relative to the market. Large-cap valuations are composite valuation measures of the style factor to U.S. relative valuations and the current U.S. cyclically adjusted price/earnings ratio (CAPE) percentile relative to its fair-value CAPE. The ex-U.S. developed markets valuation measure is the market-weighted average of each region’s (Australia, U.K., euro area, Japan, and Canada) valuation percentile. Emerging markets are based on the percentile rank based on our fair-value model relative to the market. Valuation percentiles in parenthesis are as of one year prior. Sources: Vanguard calculations, based on Robert Shiller’s website, at aida.wss.yale.edu/~shiller/data.htm, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, and Refinitiv, as of September 30, 2022, and September 30, 2021. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022 , and September 30, 2021. Results from the model may vary with each use and over time. 46

Valuations are more favorable, but the Our median fair-value estimate sits at 23.7 times opportunity set is still limited the trailing 10-year average of real earnings. High inflation and rising real interest rates have Higher (lower) inflation and a more (less) caused Robert Shiller’s cyclically adjusted price/ aggressive Fed could cause our fair value to settle earnings (CAPE) ratio for the Standard & Poor’s lower (higher). Our analysis indicates that much 500 Index and our estimate of fair value to larger, more persistent shifts in the inflation and decline. Figure II-10 shows our model estimate interest rate environments are needed to move and suggests that although equity valuations valuations meaningfully beyond the standard have improved, they are still overvalued. error of our fair-value estimate. FIGURE II-10 U.S. equity valuations are more attractive than they were a year ago Dot-com bubble o d i e t at s r u j s Fair-value d g a n i range lyrn ala CAP c e li/ c e c y i C r p Notes: The U.S. fair-value cyclically adjusted price/earnings ratio (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 model including equity-earnings yields, 10-year trailing inflation, and 10-year U.S. Treasury yields estimated from January 1940 to September 30, 2022. Details were published in Davis (2017). A declining fair-value CAPE suggests that higher equity-risk premium (ERP) compensation is required, whereas 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, FTSE Russell, FactSet, Barclays Live, and Global Financial Data, as of September 30, 2022. 47

Profit margins are unlikely to continue in margins as a slower pace in the trend of powering U.S. earnings globalization is partially offset by higher 12 In addition to stretched valuations, the risks productivity because of idea sharing. posed to earnings by high inflation and the growing likelihood of recession underscore our We expect U.S. earnings growth to average cautious stance on U.S. equities. Our framework 5% per year over the next decade, which is below for assessing U.S. earnings growth breaks it the 6.4% that investors experienced over the last down into revenue growth and profit margins. decade. Although this information is useful in We find that revenue growth is a function of informing our forecast, long-term investors must global GDP growth and that profit margins are remember that what matters most for equity determined by global trade intensity and labor returns is the price paid for earnings, not the costs. Figure II-11 shows our model for U.S. profit earnings themselves. Our research finds that margins compared with actuals. Profit margins GDP growth explains some of revenue growth, are currently at a cyclical high, and we expect which in addition to profit margins explains them to decline toward our estimates in the earnings growth. But earnings growth explains coming years, mostly because of higher labor only about 15% of the variation in equity returns; costs. Longer term, we expect a modest decline valuations matter more. FIGURE II-11 U.S. profit margins may face cyclical pressure in the near term, but should remain above long-term averages % Cyclical pressures s n gi r a Longer-term m trend ﬁt o r otal proﬁt p . margins S . U Fair alue Fair-alue range Notes: Profit margins are broken into their cyclical and trend components and forecasted using an Ordinary Least Squares (OLS) regression model with trade intensity (sum of imports and exports) and labor costs as the independent variables. We expect higher productivity to drive higher profit margins given the linear relationship between productivity and profit margins and our view for higher productivity based on our proprietary Idea Multiplier. For more information on the Idea Multiplier, see The Idea Multiplier: An Acceleration in Innovation Is Coming (Davis et al., 2019). Sources: Vanguard calculations, based on data from Refinitiv, as of June 30, 2022. 12 For more information on Vanguard’s view on these two “megatrends,” see Lemco et al., 2021, and Davis et al., 2019. 48

After value’s resurrection, the risks The one part of the U.S. market where our are more balanced fair-value frameworks see some opportunity In the U.S. market, the return of value investing is in small-caps, albeit to a much smaller degree has been a notable narrative that has continued than we saw in value last year. We find that in 2022. Unlike in the first quarter of 2021, value’s similar drivers—interest rates, inflation, volatility, outperformance over the last 12 months has had and corporate profits—explain 72% of the more to do with growth’s relative weakness than variations in small-cap versus large-cap price/ value’s relative strength. Our “fair value of value” book ratios (Figure II-12b). Currently small-caps sit framework (Figure II-12a) shows how interest below our estimate of fair value, even when we rates and inflation have driven value’s secular account for the mounting inflation pressures and decline over the last 40 years. As we highlighted rising interest rates experienced in the last year. in our economic and market outlook for 2021, Our excess return projections for small-caps, however, by the end of 2020, the value trade had however, are de minimis (20 basis points per year been oversold (Davis et al., 2020). This led us to over the next decade)—especially when compared believe that even if the macroeconomic conditions with the 160 basis points of annualized excess that supported growth persisted, value was likely return for value over growth. to outperform in the coming years. Although more favorable valuations have Value’s outperformance now means that the improved our outlook for U.S. equities compared 13 with last year, we still caution investors against risks are more symmetrical. On one hand, recession dynamics historically have helped expecting returns similar to the 11.3% per year growth. On the other hand, there’s reason to they experienced in the last decade. In addition to believe that this recession might not look exactly our expected 5% annualized earnings growth, we like the past and that higher interest rates and expect dividend yields to average 1.9% per year inflation could continue supporting value. (in line with the last decade) but valuations to contract 1.2% annually. All told, these factors underpin our forecast for U.S. equities to return 4.7%–6.7% annually. 13 We still expect value to outperform over the next decade, but this outperformance has less to do with relative valuations and more to do with the “value premium” that our research, along with that of academic and other practitioners, finds. 49

FIGURE II-12 Some parts of the U.S. market are still attractively valued a. With value/growth valuations at fair value, the risks are more symmetrical k . o o b / . e c i r p h t . w o r g Historical average o . t k o o b / . e c i r p Fair-value range e u l . a Historical ratio v f o Median fair-value o i . t estimate a R erloer 0 conﬁdence intervals Notes: The valuation ratio is projected based on a vector error correction model and using a five-lag vector autoregression model to project the systematic drivers. Sources: Vanguard calculations, based on data from FactSet, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, Refinitiv, and Global Financial Data, as of September 30, 2022. b. There may still be opportunity in small-caps k . o o b / e . c i r t p e k . r a o m. k t o o b / e c . i r p p a c . - Fair-value l l a range m Historical ratio f s. o o Median fair-value i t a estiate R Note: The statistical model specification is a five-variable vector error correction model, including a respective ratio of price to book, 10-year trailing inflation, 10-year real Treasury yield, equity volatility, and growth of corporate profits, estimated over the period January 1979–September 2022. Sources: Vanguard calculations, based on data from FactSet, the U.S. Bureau of Labor Statistics, the Federal Reserve Board, Thomson Reuters, and Global Financial Data, as of September 30, 2022. 50

International equities: ahead. Our outlook is positive for international More value with less growth equities despite our view that the U.S. will have U.S. equities have outperformed their global higher earnings growth, though we may need peers by a very wide margin over the last decade. to see a weaker dollar for international On a cumulative return basis, a portfolio of U.S. outperformance to be sustained. stocks bought in 2012 is worth twice as much as a portfolio of international stocks bought in the Figure II-13 shows our outlook for U.S. and same period. Although many reasons have been international equities and a breakdown of the cited for this outperformance—stronger U.S. expected total return difference for the decade growth, a less uncertain economic environment, ahead. Although the valuations gap has narrowed and the sector composition of the U.S. market— since last year, we expect more favorable our framework focuses on the durable sources of international valuations, higher dividend payout outperformance. To that end, we believe that ratios, and a weaker dollar to drive international the valuation-based expansion in U.S. equities is outperformance. sowing the seeds for lower returns in the decade FIGURE II-13 Since relative valuations have improved, a weaker dollar is becoming a more important driver of expected international outperformance Annualized return .% .% .% –.„% .% .% MSCI USA Valuation arning iien oreign€ MSCI ACƒI return change groth iel e‚change e‚ USA return (– ) return (– ) Foreign- Foreign- Valuation Earnings Dividend exchange change growth yield return Total return MSCI USA Index –1.18% 5.0% 1.9% — 5.7% MSCI ACWI ex USA Index –0.27% 4.3% 3.3% 1.2% 8.5% Notes: Forward-looking return estimates are from the VCMM, as of September 30, 2022, for the period October 1, 2022, through September 30, 2032. The U.S. equity return is represented by the MSCI USA Index return; the international equity return is represented by the MSCI ACWI ex USA Index return. Returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains. The two end bars representing U.S. and international expected returns are median expectations. As a result, this comparison does not account for the correlation between U.S. and international equities. The sum of the individual bars in the middle may not equal the difference between the two end bars because of rounding. Sources: Vanguard calculations, based on data from Refinitiv and Global Financial Data, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. 51

More favorable valuations internationally, FIGURE II-14 however, are not a new story. Nevertheless, Dollar strength has held back international international has been unable to generate performance for U.S. investors this year any significant outperformance relative to the U.S. This is in large part because of the dollar’s MSCI MSCI MSCI MSCI MSCI UK Europe Japan EM USA strength, which has reduced an unhedged U.S.- Index Index Index Index Index based investor’s return on international equities % Local return this year. As of September 30, 2022, our capital Currency return markets model suggests that the U.S. dollar is n– r 13% above what the fundamental, long-term u t e drivers of currency value suggest. This leads us l r a t o to project a 1.2% annualized decline in the dollar T– relative to a basket of international currencies over the next decade. – Figure II-14 shows how a strong dollar has Notes: The chart breaks down the unhedged USD return from December amplified losses in international equities for 31, 2021, to September 30, 2022, into the local and exchange rate return unhedged U.S.-based investors. This effect has components. The indexes used are the MSCI UK Net Total Return Index, the MSCI Europe Net Total Return Index, the MSCI Japan Net Total Return Index, been particularly acute in developed markets the MSCI Emerging Market Net Total Return Index, and the MSCI USA Net where returns have held up much better in Total Return Index. The currency exchange rates are the EUR/USD, GBP/ USD, and JPY/USD cross-rates. The MSCI Emerging Markets currency return local currency terms because of less-stretched is derived using the local currency index, which accounts for exchange rate valuations. Currency returns are notoriously differences based on each country’s weight in the index. difficult to forecast over short investment Sources: Vanguard calculations, based on data from Bloomberg and Global Financial Data, as of September 30, 2022. horizons, and many factors can cause them to 14 deviate from their fundamentals. However, over a sufficiently long investment horizon, we expect global inflation and policy convergence to lead to exchange-rate normalization. 14 Because all currencies are relative pairs, it is possible that the headwinds the U.S. dollar faces will be even stronger for international currencies, which would cause the U.S. dollar to strengthen, all else equal. 52

An improved return outlook and slowed, and U.S. rates are rising faster. Higher consistent diversification benefits interest rates in the U.S. relative to emerging from emerging markets markets raise fair value because they lead Within international markets, our fair-value the dollar to trade at a forward discount to framework shown in Figure II-15 suggests that emerging-market currencies, which (according emerging markets are attractively valued for the to uncovered interest rate parity) should raise 15 expected returns for a U.S.-based investor. first time since the pandemic. Steep sell-offs in 2021 and 2022 stemming from elevated inflation, Our outlook suggests that emerging markets aggressive policy tightening, slowing growth, should return between 7% and 9% (2.3 percentage and political risks have increased the emerging- points higher than U.S. equities) over the next market risk premium. Although near-term risks decade. Further, emerging-market equities still in the form of a strong dollar, global recession, have a lower correlation with U.S. equities than and geopolitical tensions remain, the narrative developed ex-U.S. markets and a higher inflation appears oversold. Faster policy normalization in 16 emerging markets than in the U.S. and slowing beta to U.S. inflation. For these reasons, we economic conditions were the main drivers believe that a balanced allocation to emerging- behind the decline in our fair-value estimate market equities plays an important role in from September 2021 to June 2022. Rate hikes investors’ portfolios. in emerging markets, however, have broadly FIGURE II-15 Emerging-market valuations are attractive o i t a r E / s P t e k r a Fair-value range g m n i MSCI Emerging Markets g r P/E rati atual e m E MSCI Emerging Markets P/E rati re ite Notes: The statistical model specification is a five-variable Ordinary Least Squares regression that uses the following variables: inflation for six major emerging markets countries (Brazil, China, India, South Korea, Mexico, and Taiwan) weighted by MSCI monthly index weights; monthly average of daily real 2-year U.S. Treasury yield; emerging markets central bank policy rates weighted by GDP in U.S. dollars, minus the federal funds rate; Vanguard’s leading economic indicators (VLEI) for China, Brazil, and Mexico (weighted average based on country GDP in U.S. dollars); and monthly average of daily U.S. equity market volatility, as measured by the CBOE Volatility Index (VIX). P/E3 is the price divided by trailing 3-year average earnings. Sources: Vanguard calculations, based on data from the Federal Reserve Bank of St. Louis FRED database and Bloomberg, as of September 30, 2022. 15 See Davis et al. (2021) for more details on our fair-value model. 16 The predicted median correlations for emerging-market equities are 0.70 with U.S. equities and 0.74 with developed ex-U.S. equities. The inflation beta—the linear regression coefficient between the 30-year U.S. inflation forecast and the 30-year asset return forecast—is 0.71 for emerging markets versus –0.44 for developed-market ex-U.S. equities. 53

17 Inflation hedging is a provide the best probability of beating inflation. multidimensional problem Investors with a shorter investment horizon may There is no one-size-fits-all solution to inflation prefer to maintain their purchasing power by hedging—it depends on an investor’s objectives, matching inflation. To this end, traditional investment horizon, and risk tolerance. inflation hedges such as TIPS and commodities Figure II-16a breaks down the inflation-hedging are useful. These securities, however, can introduce properties of major asset classes across these a real-return drag on the portfolio if they are held three dimensions. For investors looking to for extended periods. Commodities can also generate a positive real return over a very long introduce high volatility, which could be incongruent horizon, equities—especially nonlocal ones— with a shorter investment horizon. FIGURE II-16 Commodities are not an investor’s only tool to fight inflation a. There is no one-size-fits-all solution to inflation hedging Global ex-U.S. equities ) s r a ye REITs t x U.S. equity e n n ( r u t e U.S. bond Commodities l r Global ex-U.S. bonds a e R Short-term TIPS TIPS Inﬂation beta Notes: The chart compares real (inflation-adjusted) annualized return projections over the next 10 years to the inflation beta for various asset classes. Inflation beta is the slope coefficient of a linear regression of the year 30 return forecast on a constant and the year 30 inflation forecast. The size of each bubble represents the forecasted median annualized volatility over the next 10 years. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. 17 As long as local and nonlocal inflation correlation is less than 1, nonlocal equities will serve as an effective inflation hedge. This is because higher local inflation should cause the local currency to depreciate, which would raise nonlocal equity returns, all else equal (Rodel, 2014). 54

Given the similar energy supply dynamics driving shows that a shock to inflation and growth is current inflation, it is easy to draw parallels to reflected in commodity prices only for as long the 1970s, when oil embargos in the Middle East as the inflation/growth pressures remain. contributed to inflation pressures in the U.S. and This means that to realize the full benefit of commodity returns provided a useful hedge. commodities as an inflation hedge, investors Our research indicates that commodity returns must be able to time their entry into and exit are a function of realized inflation and the from the position or accept a persistent return economic growth environment. We also find that drag because of a lower Sharpe ratio for shocks to these drivers are both quickly reflected commodities than for U.S. and international 18 in commodity prices and short-lived. Figure II-16b equities. FIGURE II-16 (CONTINUED) Commodities are not an investor’s only tool to fight inflation b. Commodity returns are sensitive to growth and inflation but can decay quickly after a shock % % s Persistent shock s n over years – n One-oﬀ ur ur shock in year t t e e r r ual ual n n n n A A – – – – – – Forecast horizon (years) Forecast horizon (years) Shock range Baseine Notes: The figure shows the impact of a shock to inflation and the Vanguard leading economic indicator (VLEI) on nominal commodity returns over time, based on the distribution of return outcomes from the VCMM derived from 10,000 simulations. The solid lines correspond to the median forecast and the shaded area highlights the range from the 25th to the 75th percentile after a shock of the given persistence. The turquoise line and area show the impact of a persistent shock increasing annualized inflation over years 1–3 by one standard deviation and increasing VLEI in years 1–3 by 0.5 standard deviation. The yellow line and area show the impact of a temporary shock increasing inflation in year 1 by one standard deviation and increasing VLEI in year 1 by 0.5 standard deviation. The red dotted line shows the baseline forecast without any additional shocks. See the Appendix section titled “Indexes for VCMM simulations” for further details on asset classes. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. 18 The Sharpe ratio is a measure of return above the risk-free rate that adjusts for volatility. A higher Sharpe ratio indicates a higher expected risk-adjusted return. Based on the VCMM median return and volatility forecasts for U.S. and global ex-U.S. equities, cash, and commodities in Figure II-5a and Figure II-9a, global ex-U.S. equities have the highest expected Sharpe ratio (0.24), followed by U.S. equities (0.10) and commodities (0.02). 55

A balanced portfolio still offers the best equity returns have reduced the equity risk chance of success premium. This is reflected in the TVAA portfolio The policy response to higher and more persistent with a 10-percentage-point decrease in the inflation and the subsequent repricing of risk in equity allocation, which is a meaningful global capital markets has led to a dramatic derisking move. shift in our time-varying asset allocation (TVAA) This TVAA strategy breaks down the major asset outlook. The TVAA looks to harvest the risk class into smaller sub-assets to provide additional premia for which we think there is modest return portfolio tilt benefits. On the domestic equity predictability based on the VCMM. It leverages front, we see a tilt toward the value factor given the Vanguard Asset Allocation Model (VAAM) favorable risk and return characteristics. Within to optimize a portfolio that maximizes end-of- international equities, there is an equal allocation period wealth with a penalty for dispersion of to emerging markets and developed (ex-U.S.) outcomes based on our 10-year return forecasts markets given emerging markets’ lower (Aliaga-Díaz et al., 2022). Figure II-17 shows the correlation with U.S. equities. On the domestic optimal TVAA portfolio, based on our current fixed income side, the portfolio is tilted toward outlook, versus its policy benchmark, which credit given the time diversification benefits we is a 60% stock/40% bond portfolio. outlined earlier in this section and the higher TVAA methodology is appropriate for investors expected returns in Figures II-5a and II-9a. who are willing to take on active risk in the form In short, the TVAA portfolio is inclined toward of “model forecast risk.” For investors whose reducing equity risk because of the compressed objectives and risk tolerances make it prudent equity risk premium and reallocating it toward to consider adjusting their asset allocations when fixed income with a credit tilt. This results in market conditions materially change, the VAAM, a lower volatility for the TVAA portfolio while combined with time-varying VCMM asset returns, producing expected returns similar to those provides a consistent and holistic way to analyze of the 60/40 benchmark (Figure II-18). Although the trade-offs in time-varying portfolio solutions. the expected Sharpe ratio and maximum The TVAA portfolio targets the same risk profile drawdown of the time-varying portfolio are as the traditional benchmark portfolio, with the better than that of the benchmark 60/40 flexibility to deviate from the benchmark based portfolio, this comes at the expense of active on the Vanguard projected outlook. The global risk (that is, tracking error to the benchmark) interest rate tightening cycle in 2022 has raised of 2.3%, which translates to a 51% probability our expected bond return forecasts by more than of underperforming the benchmark in any the equity market sell-off has raised expected given year. equity returns. Higher bond returns and lower 56

FIGURE II-17 A more attractive risk/return trade-off means our time-varying asset allocation framework favors bonds and emerging markets Benchmark U.S. equities nternational equities U.S. bonds nternational bonds % equities % fied income % equities % fied income U.S. U.S. U.S. Emerging Developed U.S. intermediate nternational bonds Time-varying value groth small market market credit bonds (hedged) asset allocation factor factor factor equity equity U.S. long-term reasury (unhedged) U.S. short-term reasury U.S. aggregate bonds Notes: Time-varying portfolio allocations were determined by the VAAM. The assets under consideration were U.S. and non-U.S. equities and fixed income, in addition to real estate investment trusts (REITs), U.S. high-yield corporate bonds, and emerging-market equity, which were used to illustrate time-varying allocation not only within equities versus fixed income but also within sub-asset classes. See “Indexes for VCMM simulations” in the Appendix for additional details on asset class indexes. Maximum home-bias constraint of 60% was applied for U.S. equities, and 70% was applied for U.S. fixed income. Allocation to non-U.S. equities would have been higher had there been no home-bias constraint, given its higher expected return. VCMM 10-year projections as of September 2022 were used. The sum of individual sub-asset class allocations may not total 100% because of rounding. Source: Vanguard calculations, as of September 30, 2022. FIGURE II-18 We expect a similar return with lower volatility from our time-varying portfolio September 2022 TVAA Benchmark Equity allocation 50% 60% 10-year expected annualized total return 6.4% 6.4% 10-year expected annualized volatility 9.4% 10.3% 10-year expected Sharpe ratio 0.25 0.24 10-year expected maximum drawdown –7.7% –9.2% Excess return to the benchmark 0% — Tracking error to the benchmark 2.3% — Probability of underperformance relative to benchmark in any given year 51.0% — Notes: Vanguard calculations are based on portfolios optimized by the VAAM, using return projections from the VCMM. The Sharpe ratio is a measure of return above the risk-free rate that adjusts for volatility. A higher Sharpe ratio indicates a higher expected risk-adjusted return. Source: Vanguard calculations, as of September 30, 2022. IMPORTANT: The projections and other information generated by the 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. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2022. Results from the model may vary with each use and over time. 57

References Guenette, Justin Damien, M. Ayhan Kose, and Aliaga-Díaz, Roger, Harshdeep Ahluwalia, Giulio Naotaka Sugawara, 2022. Is a Global Recession Renzi-Ricci, Todd Schlanger, Victor Zhu, Carole Imminent? September 2022, EFI Policy Note 4, Okigbo, 2022. Vanguard’s Portfolio Construction World Bank Group. Framework: From Investing Principles to Custom Kopytov, Alexandr, Nikolai Roussanov, and Portfolio Solutions. Valley Forge, Pa.: The Vanguard Mathieu Tashereau-Dumouchel, 2018. Short-Run Group. Pain, Long-Run Gain? Recessions and Technological Clarke, Andrew S., Fu Tan, and Adam J. Schickling, Transformation. Working Paper No. 24373. 2022. The Great Retirement? Or the Great Cambridge, Mass.: National Bureau of Economic Sabbatical? Valley Forge, Pa.: The Vanguard Group. Research. Davis, Joseph, 2017. Global Macro Matters: As U.S. Kose, M. Ayhan, Naotaka Sugawara, and Marco E. Stock Prices Rise, the Risk-Return Trade-off Gets Terrones, 2020. Global Recessions. Policy Research Tricky. Valley Forge, Pa.: The Vanguard Group. Working Paper No. 9172. Washington, D.C.: World Bank. Davis, Joseph, Qian Wang, Andrew Patterson, Lemco, Jonathan, Asawari Sathe, Adam J. Adam J. Schickling, and Asawari Sathe, 2019. Schickling, Maximilian Wieland, and Beatrice Yeo, Megatrends: The Idea Multiplier: An Acceleration 2021. Megatrends: The Deglobalization Myth(s). in Innovation is Coming. Valley Forge, Pa.: The Valley Forge, Pa.: The Vanguard Group. Vanguard Group. Davis, Joseph, Roger A. Aliaga-Díaz, Peter Westaway, Ostry, Jonathan D., Atish R. Ghosh, Jun I. Kim, Qian Wang, Andrew J. Patterson, Kevin DiCiurcio, and Mahvash S. Qureshi, 2010. Fiscal Space. IMF Alexis Gray, Jonathan Lemco, and Joshua M. Hirt, Staff Position Note, September 1, 2010, Issue 011, 2020. Vanguard Economic and Market Outlook for International Monetary Fund. 2021: Approaching the Dawn. Valley Forge, Pa.: Philips, Christopher B., Joseph H. Davis, Andrew The Vanguard Group. J. Patterson, and Charles J. Thomas, 2014. Global Davis, Joseph, Roger A. Aliaga-Díaz, Peter Fixed Income: Considerations for Fixed Income Westaway, Qian Wang, Andrew J. Patterson, Investors. Valley Forge, Pa.: The Vanguard Group. Kevin DiCiurcio, Alexis Gray, Asawari Sathe, and Rodel, Maximilian, 2014. Inflation Hedging with Joshua M. Hirt, 2021. Vanguard Economic and International Equities. The Journal of Portfolio Market Outlook for 2022: Striking a Better Balance. Management 40(2): 41–53. Valley Forge, Pa.: The Vanguard Group. Tufano, Matthew, Asawari Sathe, Beatrice Gagnon, Joseph E., and Christoper G. Collins (2019). Yeo, Andrew S. Clarke, and Joseph Davis, 2018. The Case for Raising the Inflation Target is Stronger Megatrends: The Future of Work. Valley Forge, Than You Think. Peterson Institute for International Pa.: The Vanguard Group. Economics, Washington, D.C. Available at World Bank, 2022, Risk of Global Recession in https://www.piie.com/blogs/realtime-economic- 2023 Rises Amid Simultaneous Rate Hikes. Press issues-watch/case-raising-inflation-target- release issued September 15, 2022. Available stronger-you-think#:~:text=Raising%20the%20 at https://www.worldbank.org/en/news/press- inflation%20target%20raises,is%20lower%20 release/2022/09/15/risk-of-global-recession-in- unemployment%20on%20average. 2023-rises-amid-simultaneous-rate-hikes. Ganguli, Ina, Jamal Haidar, Asim Ijaz Khwaja, Wu, Daniel, Beatrice Yeo, Kevin DiCiurcio, and Samuel W. Stemper, and Basit Zafar, 2022. Qian Wang, 2021. Global Macro Matters: The Stock/ Economic Shocks and Skill Acquisition: Evidence Bond Correlation: Increasing Amid Inflation, but Not From a National Online Learning Platform at the a Regime Change. Valley Forge, Pa.: The Vanguard Onset of COVID-19. Working Paper No. 29921. Group. Cambridge, Mass.: National Bureau of Economic Research. Zandi, Mark, Xu Cheng, and Tu Packard, 2011. Fiscal Space. Ratio, 60(80): 100. 58

III. Appendix About the Vanguard Capital Markets Model IMPORTANT: The projections and other classes as well as uncertainty and randomness information generated by the Vanguard Capital over time. The model generates a large set of Markets Model regarding the likelihood of various simulated outcomes for each asset class over investment outcomes are hypothetical in nature, several time horizons. Forecasts are obtained do not reflect actual investment results, and are by computing measures of central tendency not guarantees of future results. VCMM results in these simulations. Results produced by the will vary with each use and over time. tool will vary with each use and over time. The VCMM projections are based on a statistical The primary value of the VCMM is in its analysis of historical data. Future returns may application to analyzing potential client behave differently from the historical patterns portfolios. VCMM asset-class forecasts— captured in the VCMM. More important, the comprising distributions of expected returns, VCMM may be underestimating extreme volatilities, and correlations—are key to the negative scenarios unobserved in the historical evaluation of potential downside risks, various period on which the model estimation is based. risk–return trade-offs, and the diversification benefits of various asset classes. Although The VCMM is a proprietary financial simulation central tendencies are generated in any return tool developed and maintained by Vanguard’s distribution, Vanguard stresses that focusing Investment Strategy Group. The model forecasts on the full range of potential outcomes for the distributions of future returns for a wide array of assets considered, such as the data presented broad asset classes. Those asset classes include in this paper, is the most effective way to use U.S. and international equity markets, several VCMM output. We encourage readers interested maturities of the U.S. Treasury and corporate in more details of the VCMM to read Vanguard’s fixed income markets, international fixed income white paper (Davis et al., 2014). markets, U.S. money markets, commodities, and certain alternative investment strategies. The The VCMM seeks to represent the uncertainty theoretical and empirical foundation for the in the forecast by generating a wide range of Vanguard Capital Markets Model is that the potential outcomes. It is important to recognize returns of various asset classes reflect the that the VCMM does not impose “normality” on compensation investors require for bearing the return distributions, but rather is influenced different types of systematic risk (beta). At the by the so-called fat tails and skewness in the core of the model are estimates of the dynamic empirical distribution of modeled asset-class statistical relationship between risk factors and returns. Within the range of outcomes, individual asset returns, obtained from statistical analysis experiences can be quite different, underscoring based on available monthly financial and the varied nature of potential future paths. economic data. Using a system of estimated Indeed, this is a key reason why we approach equations, the model then applies a Monte Carlo asset-return outlooks in a distributional simulation method to project the estimated framework. interrelationships among risk factors and asset 59

Indexes for VCMM simulations The long-term returns of our hypothetical portfolios are based on data for the appropriate market indexes through September 30, 2022. We chose these benchmarks to provide the most complete history possible, and we apportioned the global allocations to align with Vanguard’s guidance in constructing diversified portfolios. Asset classes and their representative forecast indexes are as follows: • U.S. equities: MSCI US Broad Market Index. • Global ex-U.S. equities: MSCI All Country World ex USA Index. • U.S. REITs: FTSE/NAREIT US Real Estate Index. • U.S. cash: U.S. 3-Month Treasury—constant maturity. • U.S. Treasury bonds: Bloomberg U.S. Treasury Index. • U.S. short-term Treasury bonds: Bloomberg U.S. 1–5 Year Treasury Bond Index. • U.S. long-term Treasury bonds: Bloomberg U.S. Long Treasury Bond Index. • U.S. credit bonds: Bloomberg U.S. Credit Bond Index. • U.S. short-term credit bonds: Bloomberg U.S. 1–3 Year Credit Bond Index. • U.S. high-yield corporate bonds: Bloomberg U.S. High Yield Corporate Bond Index. • U.S. bonds: Bloomberg U.S. Aggregate Bond Index. • Global ex-U.S. bonds: Bloomberg Global Aggregate ex-USD Index. • U.S. TIPS: Bloomberg U.S. Treasury Inflation Protected Securities Index. • U.S. short-term TIPS: Bloomberg U.S. 1–5 Year Treasury Inflation Protected Securities Index. • Emerging-market sovereign bonds: Bloomberg Emerging Markets USD Aggregate Bond Index. • Commodities: Bloomberg Commodity Index. • Mortgage-backed securities (MBS): Bloomberg U.S. Mortgage Backed Securities Index. All equity indexes below are weighted by market capitalization: • Small-cap equities: Stocks with a market cap in the lowest two-thirds of the Russell 3000 Index. • Large-cap equities: Stocks with a market cap in the highest one-third of the Russell 1000 Index. • Growth equities: Stocks with a price/book ratio in the highest one-third of the Russell 1000 Index. • Value equities: Stocks with a price/book ratio in the lowest one-third of the Russell 1000 Index. 60