SYDNEY, Aug 30 (Reuters) - Australia's sovereign wealth fund missed its return target for the year to June and its chairman warned on Wednesday that markets were downplaying the risks from China's economic slowdown and rising inflation.

Peter Costello, head of the A$206 billion ($133 billion) Future Fund, said that China's "housing investment and debt fuelled growth model" was unravelling, clouding the investment outlook.

Persistent wage and service price growth also meant inflation and interest rates were likely to stay high for longer, a risk for markets pricing in a "Goldilocks" scenario, where inflation faded without a recession.

"We see elevated interest rates, we see the possibility of our largest trading partner continuing in difficult circumstances," Costello told journalists.

"We think they are both risks to the investment climate and we're positioned quite conservatively."

The Future Fund returned 6% in fiscal 2023 compared with a target return of 10%. Australia's similarly sized two largest pension funds, AustralianSuper and Australian Retirement Trust, returned 8.2% and 10%, respectively, over the period.

The fund cut its allocation to developed market equities and added cash in the three months to June 30. Global share markets rose over those three months, with the U.S. benchmark S&P 500 index up 10%.

Cash levels remain significantly higher than at similarly sized Australian pension funds.

Costello said the fund had continued its strategy of cutting equity investments in favour of inflation hedges like gold, infrastructure and inflation-linked bonds.

Strong equity market performance in the first half was driven by a handful of technology companies expected to benefit from artificial intelligence and the fund "did not want to bet the farm on that sole theme", Costello added.

The fund had billions of AI investments through private equity and venture capital which had not risen as sharply as public markets, he said.

The fund expects persistently higher inflation to keep real returns lower than the 8.8% averaged over the past decade.

The Future Fund was established in 2006 to cover escalating pension liabilities for public servants and rivals Australia's largest pension funds in size.

($1 = 1.5434 Australian dollars)

(Reporting by Lewis Jackson; Editing by Leslie Adler and Miral Fahmy)