But unlike last year, when central banks were raising rates at a rapid pace, 2024 is very much a story about when, how quickly, and how sharply they will start cutting rates.

Rising expectations around looming cuts to interest rates – a signal that central banks believe surging inflation levels are being brought back under control – provided a strong tailwind for sharemarkets in 2023.

Four months into 2024 (to end-April), that market’s tailwind is still there and has propelled markets to new highs. But it has eased off slightly as investors continue to ponder how central banks will manage interest-rate settings in an environment where high inflation levels remain sticky.
 

A resilient economy

It is Vanguard’s opinion that the Australian economy has shown modest signs of progress since the start of the year and is proving to be broadly resilient.

Vanguard continues to expect that Australia will just avoid a recession in 2024, with a forecast economic growth rate below trend at around 1%. 

Recently, the key drivers of inflation have been domestic in nature. Productivity growth has been low, leaving unit labour costs growing at a rate above what would be consistent with the Reserve Bank of Australia’s (RBA) 2%-3% inflation target. 

Vanguard’s view is that the pace of both headline and core inflation is expected to fall year-on-year to around 3% by the end of 2024. 

Business confidence has significantly improved this year, and the Federal Government is running a modest fiscal deficit to fund investments in key sectors.

Vanguard’s view is that the lifting of certain trade restrictions by China on Australian exports, particularly on a range of agricultural commodities and goods, could provide a boost to the Australian economy over time.

That said, the Chinese economy is still being buffeted by persistent headwinds, including a prolonged property downturn and subdued business confidence.

However, as a major commodities producer and trading partner with China, Australia potentially stands to gain the most of any country from a recovery in China’s domestic demand in 2024. Vanguard hold the view that, stronger infrastructure and manufacturing investment could help cushion the impact from China’s persistent housing downturn.
 

Inflation challenges remain

Australia has seen economic growth moderating this year, which has been the intended outcome from policy tightening.

Still, inflation is poised to remain elevated, in Vanguard’s view, buoyed by incremental increases in real household income, the resurgence in the housing market, and sustained investments in key sectors such as education, healthcare, and transportation, facilitated by a modest fiscal deficit.

Although the unemployment rate has ticked up of late, strong wages growth and slow productivity gains have led to a slower disinflation process than expected.

As productivity growth has lagged, unit labour costs have outpaced levels consistent with the RBA's inflation target band, reflecting some of the “sticky” components of inflation, as the chart below shows.

Moreover, inward migration has added to housing demand, feeding into sticky price pressures via higher rents. 

Vanguard’s forecast is that Australia’s inflation rate may gradually ease back to 3% by the end of 2024, which is at the top end of the RBA’s target, and could then inch down further in 2025.
 

Core inflation is stubbornly sticky

Notes: Monthly data are from Dec. 2004 through Mar. 2024. Forecasts thereafter run through year-end 2025. Source: Vanguard calculations, based on data from Bloomberg, as of 31 March 2024

The lower rates road remains long

Central banks, such as the US Federal Reserve Bank and the RBA, are continuing to hold their rate cards close to their chests, indicating they are in no hurry to play their hand anytime soon [with rate cuts].

In Australia the labour market is still at a historically tight level, with the employment-to-population ratio close to a multi-decade high, meaning the path to eventual rates policy easing could be longer in Vanguard’s opinion.

Vanguard expects the unemployment rate may rise to around 4.6% by the end of 2024 as financial conditions tighten in an environment of elevated interest rates.

So, Vanguard’s baseline view is that the RBA is expected to keep its current policy rate the same for some time.

In fact, Vanguard’s view is that Australia may be one of the last of the developed countries to cut its rates. This is simply because Australian inflation did not rise as high as it did in the US and Europe, and hence our lower interest-rate peak here means the RBA could be likely to wait for other central banks to move first.

In the case of the RBA, if inflation moderates and returns to more sustainable levels, Vanguard expects the door will open for monetary policy easing in late 2024. Vanguard expects that the cash rate may be reduced from the current 4.35% to 3.85% by the end of 2024 and could eventually settle in a range of 3%-4%.

In other words, Vanguard holds the view that interest rates could remain at a higher level and may not fall back to the record lows Australia experienced during the peak of the COVID-19 pandemic, as the chart below shows.
 

Interest rates – higher for longer

Source: Vanguard

Lower inflation positive for real returns

The persistence of positive real interest rates [when the nominal interest rate exceeds inflation] provides a solid foundation for long-term risk-adjusted investment returns over the next decade, in Vanguard’s opinion.

Vanguard forecasts that the spread between global equity and global bond returns is expected to be 0-2 percentage points annualised over the next 10 years. As such, Vanguard expects return outcomes for diversified investors to be more balanced over the next decade.

Below is a summary of Vanguard’s latest forecasts generated by the Vanguard Capital Markets Model®.

• In the decade ahead, Vanguard’s forecast is for annualised earnings growth of 1.5% for Australian equities and 4.1% for global ex-Australia equities, supported by an expected growth rate in the U.S. that is well below that of past years but still higher than elsewhere.
• Vanguard’s bond return expectations have increased substantially. Vanguard now expects Australian bonds to return an annualised 4.3%-5.3% over the next decade, compared with the 1.3%-2.3% 10-year annualised returns we expected before the rate-hiking cycle began.
• Similarly, for global bonds, Vanguard expects annualised returns of 4.5%–5.5% over the next decade, compared with a forecast of 1.6%-2.6% when policy rates were low or, in some cases, negative.