Quarter in review

Inflation and central bank policy remained the focus for markets over the third quarter. Equities and bonds rallied through July over hopes of a soft landing and a slowing of rate hikes by central banks. However, markets reversed course and closed the quarter lower as central banks rapidly raised interest rates and reaffirmed their commitment to cool inflation.

Equity markets remained volatile as rising interest rates weighed on global growth and corporate earnings. Optimism in July spurred global equity gains of over 7% for the month in local currency terms, before retreating to end 4.7% lower quarter-on-quarter. The Australian equity market meanwhile managed a modest gain of 0.5%. Energy stocks globally continued to benefit from elevated commodity prices, with few other sectors producing a positive return over the period.

Bond markets followed a similar trajectory as yields fell (prices rose) through July before returning to their highs for the year. The quarter ended on a volatile note as a poorly received U.K. budget sent yields higher and prompted the Bank of England to intervene in the market by buying U.K. government bonds.

Global bonds fell 3.8% and Australian bonds fell 0.6% as 10-year government bond yields finished 82 basis points higher in the United States and32basis points higher in Australia.

Economic outlook

Over recent months inflation has remained elevated across advanced economies, fuelled by tight labour markets, rising wage growth and elevated global commodity prices. Inflation was initially isolated to a small number of categories such as oil, gas and physical goods, but has become more broad-based over the course of 2022.

Vanguard has modestly upgraded its near­ term inflation projections and now forecasts inflation at 6.4% by the end of 2022 in the United States, 7.5% in Australia, 8.3% in the euro area, and 2.3% in China. China stands out as having an unusually low inflation rate due to ongoing COVID lockdowns and property market weakness, which have weighed on the economy.

Central banks are acutely aware of the risks associated with more entrenched inflation. Some of the underlying drivers of inflation may prove temporary, including commodity price rises following the Ukraine crisis, a booming economy post lockdowns, and record low unemployment. However, if tern pore ryfactors boost inflation for an extended period, there is a risk that inflation psychology switches, with households anticipating higher inflation on average. If this were to occur, and more households start to negotiate wage indexation into employment contracts, the situation risks turning inflation into a wage inflation spiral, in which higher wages feed into higher inflation and vice versa. Indeed, this was a key feature of the 1970s and early1980s inflation spell and is an important risk that central banks are currently trying to stem.

Interest rates may need to rise above their long-run equilibrium (or neutral rate) this cycle to quell inflation. Given increasing evidence that inflation is becoming broad­ based, Vanguard expects interest rates to rise to 3.5%-4.0% in Australia, 4.75%-5% in the United States, 2.5% in the euro area, and 5.0% in the United Kingdom.

Central bank tolerance for rate rises will be tested

As rates rise, central banks remain cognisant of downside risks such as slowing growth or even recession. On balance, central banks seem willing to stomach some pain to overcome inflation, but there are no doubt limits to their tolerance level, and public backlash could make it more challenging for central banks to raise rates too high. What seems clear is that central banks will face an increasingly difficult trade-off in 2023 between dampening inflation and averting a downturn.

The good news is that this may mean inflation pressures subside in 2023 as higher interest rates take effect. There is evidence that inflation expectations are falling and remaining anchored close to central bank targets. This is a key signal that inflation psychology has not shifted, so more entrenched inflation is less likely.

A positive takeaway from the decline in markets year-to-date is that valuations across equities broadly appear more attractive. The market appears significantly less overvalued than a year ago, and closer to historical averages. This may lead to improved returns moving forward, although the market still appears stretched with further room to fall towards fair value.

Overall, with improved outlooks for equities and fixed income, return expectations for

a balanced portfolio are gradually normalising back to historical averages. For most investors, staying balanced and diversified across asset classes and geographies remains a prudent course of action.