From Vanguard’s Senior Economist, Alexis Gray
The Reserve Bank of Australia (RBA) raised the cash rate by 0.25% today, lower than the 50bps markets had anticipated, taking the cash rate to 2.60% for the first time since mid- 2013. It follows the release of August monthly inflation figures last week, which revealed headline inflation running at 6.8%, well above the RBA’s 2-3% target.
The RBA chose to slow the pace of rate hikes, acknowledging the banks’ desire to return inflation to target while keeping the economy on an ‘even keel’. This hints at the inherent trade-off the RBA now faces to tame inflation without knocking the economy into recession. Indeed, the RBA discussed the pressure on household budgets and the banks’ desire to assess the outlook following six consecutive rate hikes. This is a prudent step in Vanguard’s view and will reduce the risk of a policy overshoot.
The economic outlook
We expect the RBA to lift the cash rate to 3.5-4.0% by mid-2023. This is a necessary step to bring inflation back to the RBA’s 2-3% target, which we expect to occur in early 2024.
Also read: Australian Economic View – October 2022
Following a strong start to the year, there are now clear signs that economic activity is cooling in response to higher interest rates. Consumer confidence remains depressed and while retail spending is positive, it is gradually trending lower, and house prices have contracted at a national level for five consecutive months. In addition, global growth momentum continues to diminish, and inflation remains stubbornly high. As a consequence, we forecast Australian GDP growth to slow from 3.25% in 2022 to around 1.25% in 2023, and currently place the risk of recession at 45% over the next 24 months.
Implications for investors
Equity and fixed income markets have suffered losses in recent weeks as markets adjust to the reality of higher interest rates and weaker economic growth. The unusually positive return correlation we’ve seen this year between equities and fixed income may soon fall, and the lockstep downward spiral of the two asset classes could end.
When all this comes to pass, fixed income will resume its role as a buffer for equities. The other factor in favour of bonds and balanced portfolios: Interest rates are likely to stay elevated even as inflation moderates, likely ending many years of negative real (inflation-adjusted) rates in fixed income. We’re on the verge of entering a period of positive real rates, which further strengthens the case for fixed income.
If history is any indication, the patience of balanced investors will pay off: Over the past half-century, the traditional 60/40 portfolio has never had a three-year period with negative returns for both equities and fixed income. While we don’t yet know where the bottom is, data from previous years show that investors who get out now will inevitably miss the rebound.
The market’s current lower valuations have the upside of increased expected returns. Our 10-year annualised return forecasts for global equity markets are largely 2 percentage points higher than at the end of 2021. And in good news for bond investors, our fixed income return forecasts in many regions are 2 percentage points higher.
Overall, with improved outlooks for fixed income and equity markets, return expectations for a balanced portfolio are gradually normalising back to historical averages. For most investors, staying balanced and diversified across asset classes and borders remains a prudent course.
