There are clear signs that inflation has peaked in many countries and is slowly trending downwards.

Australia’s inflation rate has receded from the 7.8% peak it reached in the fourth quarter of 2022. However, annual inflation [editor's note: at 5.6 per cent over the 12 months to May 2023] is still well above where the Reserve Bank of Australia (RBA) would like it to be.

In fact, while the impact of higher interest rates has started to push Australia’s inflation rate down, there’s still a long way to go before it gets near the RBA’s inflation target band of 2%-3%.

The disinflation process is being helped by a moderation in food and energy prices, and the abatement of supply chain disruptions. On the other hand, higher goods and services prices are continuing to fuel inflation.

In Vanguard’s view, it could take the RBA another 18 months to bring inflation back to the top of its target band. As such, Vanguard doesn’t foresee any cuts to the RBA’s cash rate in 2023.

Vanguard’s forecast is that headline inflation may fall to around 4.5% by the end of 2023 as higher interest rates dampen demand, and that it will then slip inside the RBA’s target band by late 2024 or early 2025.
 

Ongoing inflation risks

Inflation is still high, and there is uncertainty about how long it will take for inflation to return to central bank targets.

The RBA’s board members are continuing to focus on persistently high global services inflation, rising domestic housing prices, the weak Australian dollar, and potentially inflationary wage developments.

The tight labour market, with low unemployment and elevated wage growth, could encourage households to spend more, which will feed into higher prices and sustain inflation above the RBA’s target inflation band.

Other inflation risks include profit seeking from firms, which may opt to keep raising their prices in order to boost profit margins. There may also be renewed global supply chain disruptions and additional commodity price shocks that place upward pressure on inflation.

The RBA is watching Australian labour market data very closely, including wages data, unemployment data, and other measures. 

Wage growth in other countries has already peaked but this hasn’t yet been the case in Australia. This is partly because we tend to have multi-year enterprise employment agreements, so the response to increasing wages in Australia has been slower than in other regions.

Vanguard expects wages (growth) may peak at 4%-4.5% from the current level of 3.7%, and that this will keep stoking inflationary pressures. 

At the same time, Vanguard expects the unemployment rate to likely rise gradually this year to around 4% as financial conditions tighten, and expects it to continue to rise in 2024. 

The RBA has noted that inflation rates overseas have not been coming down quickly and is concerned that if Australia also has sticky inflation, it will need to raise rates even higher. 
 

Economic outlook

Australia’s economy has been relatively resilient, although it is definitely slowing down in response to higher interest rates.

Retail sales have slowed, reflecting poor consumer sentiment, and overall GDP (Gross Domestic Product) growth has been slowing. Vanguard expects GDP growth of 1%–1.5% for all of 2023, although risks are skewed to the downside. 

Vanguard’s proprietary leading indicators model suggests Australia’s growth rate will fall below trend in the coming quarters, amid weak consumer confidence and subdued consumption. 

But despite this outlook, Vanguard’s recession probability model is pointing to only about a 40% chance of a local recession over the next 12 months.

In Australia, there’s a lag between interest rates going up and the economy slowing down. So, the probability for a recession is potentially more of a story for 2024.

Even then, assuming we don’t have any more inflation shocks, Vanguard’s view is that if a recession does occur in Australia, it will be mild.

Economic conditions will be painful, particularly for people who took out a large mortgage to buy a home in the last 12 to 24 months. Even those who locked in their mortgage rate are likely to face much higher interest rate costs once their fixed rate term rolls off.

The flipside is that people relying on cash or fixed income as an income stream are probably happier now that interest rates have moved higher.

The RBA has stated that its desire is to bring inflation down while, at the same time, preserving as many of the gains in employment as possible.

The worse-case scenario is that inflation doesn’t budge. That means interest rates have to go even higher. The economy may even move into recession at the same time that inflation is still above target.
 

Outlook for investors

[Editor’s Note: Do not read the following analysis as a recommendation to invest in fixed income or equities. Do further research of your own or talk to a licensed financial adviser before acting on the information below. Equities can be volatile and deliver negative returns in some years.] 

Equity and fixed income markets have recovered after a challenging year in 2022. Many developed economies, including Australia, have been resilient in the face of higher interest rates, which helps explain why equity markets have been stronger.

Looking ahead, Vanguard expects Australian fixed income portfolios to produce returns of 3%-4% annualised over the next 10 years. This is a vast improvement from the post-Global Financial Crisis period and is potentially positive news for investors seeking a stable income stream.

Equity valuations are slightly elevated in Australia, so Vanguard expects returns of 4%-6%, which is slightly below the long-run average.

Equities remain an important source of potential growth in investors’ portfolios, even though they are prone to market volatility. It’s also important to note that equities can potentially provide a hedge against inflation by providing dividend income and generating capital growth.

Historically, equities have typically provided the best chance of beating inflation over the long run and have ultimately outperformed other asset classes, according to Vanguard analysis.

Bringing inflation down remains the top priority for central banks around the world, but at this point no one knows exactly what path it will take.

So, it’s important for investors to plan for different outcomes. The best approach is often to use your longer-term investment goals and plans to guide your decisions rather than short-term economic and market volatility.

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