Key points

• Concerns about a softening US economy intensified after July’s downward revisions to the US labour market report, driving Treasury yields lower and raising expectations for a Federal Reserve rate cut in September.

• US inflation, which may remain sticky as tariffs take hold, adds a layer of complexity to the Fed’s policy decisions.

• In the UK, the labour market also continues to show signs of softening, while in the euro area, the outlook holds steady in spite of a higher tariff rate. 

The US labour market report for July 2025 surprised investors much like the July 2024 report did. Both reflected less job creation than expected. Both revealed downward revisions to prior-month job-creation figures and a moderate increase in the unemployment rate. And both triggered dovish shifts in monetary policy expectations, with US Treasury yields falling across the curve. 

US Treasury yield curve before and after July labour market reports¹

Note: Daily Treasury yields shown are US Treasury par yield curve annualised interest rates.

Source: Vanguard and Bloomberg.

Yet despite the similarities, there are clear differences. The muted job gains in July 2024 were perceived then as a bump in an otherwise strong labour market. The economy was deemed to be in sufficiently good health. A 50-basis-point Federal Reserve (Fed) interest rate cut in September was made possible by inflation that was trending steadily downward with no reflation risk in sight. 

Now, markets again expect a September rate cut, placing the probability around 80%, up from 40% the day before the labour report’s release. It would be the first cut since December 2024. But this time, a cut is more likely to reflect a weakening trend in a US labour market characterised by downward revisions eroding confidence and job growth faltering. Also, the US economy is facing stickier inflation and potentially higher price-stability risk, given the anticipated effects of tariffs. The Fed faces mounting challenges and expectations to recalibrate its policy stance.

Whether recent labour market developments mark the beginning of a broader slowdown or a temporary blip remains to be seen. For now, caution remains the prevailing sentiment.

Ultimately, corporate earnings play a major role in shaping risk sentiment. In 2024, the third-quarter earnings season reassured investors. Driven by big tech companies, it’s doing the same in 2025. Although we see a measured softening in the labour market and the broader economy, as well as the potential for a small struggle with inflation, we don’t foresee recession around the corner. 

Our economic outlooks

United States

On track, but treading carefully

Recent trade developments have helped reduce some uncertainty for the US economy, leading us to raise our baseline assumption for the effective tariff rate modestly higher to a range near 17% by year-end. However, the economic impact of offsetting factors such as foreign investment agreements and the delayed pass-through of elevated tariff rates to consumers will need to be evaluated as more information emerges. For now, we see the economy tracking in line with our expectations of a softening labour market, GDP growth of around 1.5% and core inflation of around 3% by year-end. 

We see the Fed as being on track for two rate cuts this year, given recent softness in the labour market.  

United States economic forecasts

Notes: GDP growth is defined as the year-on-year change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is at December 2025. Core inflation is the year-on-year percentage change in the Personal Consumption Expenditures Price Index, excluding volatile food and energy prices, as at December 2025. Monetary policy is the upper end of the Federal Reserve’s target range for the federal funds rate at year-end.

Source: Vanguard.

United Kingdom

The labour market continues to show signs of softening

The UK labour market continues to weaken. Employment fell for a sixth straight month in July and for the eighth time in nine months. Around 165,000 jobs have been lost over the whole period, with job vacancies also falling. The latest unemployment rate has risen to 4.7%, its highest level in four years. 

With the labour market and wage inflation cooling, we expect an easing in services inflation, which has been around 5% in recent months. We anticipate that both headline and core inflation will end 2026 just above 2%.

Further fiscal policy tightening appears inevitable, and this is a key reason for our below-consensus 2026 economic growth forecast of around 0.8%. Meanwhile, we expect the Bank of England to continue its current pace of cutting interest rate every quarter, with the bank rate falling from 4% currently to 3.75% at year-end 2025 and to 3.25% by mid-2026. 

United Kingdom economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December 2025. Core inflation is the year-on-year change in the Consumer Prices Index, excluding volatile food, energy, alcohol and tobacco prices, as at December 2025. Monetary policy is the Bank of England’s bank rate at year-end.

Source: Vanguard.

Euro area

US trade deal raises tariffs, but the outlook holds steady 

Following the European Union’s recent trade agreement with the United States, we have revised up our year-end forecast for the effective tariff rate on EU goods exports from 15% to 17%, which is higher than the current level of around 10%. Given the modest scale of the revision, we do not expect a material impact on the region’s economic outlook. 

We anticipate softening global activity and elevated policy uncertainty to weigh on demand in the second half of the year. 

Inflation is expected to end 2026 below 2%, with just one more rate cut this cycle, putting the policy rate at 1.75% at year-end.  

Euro economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December 2025. Core inflation is the year-on-year change in the Harmonized Indexes of Consumer Prices, excluding volatile energy, food, alcohol and tobacco prices, as at December 2025. Monetary policy is the European Central Bank’s deposit facility rate at year-end.

Source: Vanguard.

Japan

Door opens for next interest rate hikes

A structural labour shortage in Japan continues to reinforce a virtuous wage-price spiral for a nation that had long struggled with deflation. Inflation remains firmly above target and the labour market is tight. Improvements in employment and income have supported domestic demand. 

Corporate sentiment is showing signs of recovery after July’s tariff agreement with the United States. Although recent spikes in import prices and food costs are expected to fade, underlying inflationary pressures remain intact.

We expect the Bank of Japan to continue its gradual monetary policy normalisation, shifting from the current 0.5% rate target towards a neutral policy stance closer to 1%, as economic conditions evolve in line with its forecasts.

Japan economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as at December 2025. Core inflation is the year-on-year change in the Consumer Price Index, excluding volatile fresh food prices, as at December 2025. Monetary policy is the Bank of Japan’s year-end target for the overnight rate. 

Source: Vanguard.

China

Growth momentum to weaken amid deflationary pressures

We recently increased our 2025 GDP economic growth forecast to 4.8% from 4.6% because of better-than-expected real GDP growth in the second quarter. This lifted first-half growth to 5.3%, well above the government’s official target of “around 5%.” However, a relatively muted shock from tariff increases and strong growth so far this year may lessen the urgency for additional policy stimulus. We expect growth to slow in the second half, driven by payback effects from frontloaded exports and consumption frontloading, continued weakness in the property sector and elevated global uncertainty.

Given these developments, we foresee prevailing deflationary pressures continuing through the rest of 2025. The path toward reflation is likely to be gradual and bumpy.

China economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. The unemployment rate is as of December 2025. Core inflation is the year-on-year change in the Consumer Price Index, excluding volatile food and energy prices, as of December 2025. Monetary policy is the People’s Bank of China’s seven-day reverse repo rate at year-end.

Source: Vanguard.

Asset-class return outlook

Vanguard has updated its 10-year annualised outlooks for broad asset class returns through the most recent running of the Vanguard Capital Markets Model® (VCMM), based on data as at 30 June 2025.

Our 10-year annualised nominal return projections, expressed for local investors in local currencies, are as follows.

¹ The figures are based on a 2-point range around the 50th percentile of the distribution of return outcomes for equities and a 1-point range around the 50th percentile for fixed income.