At the end of 2023, the key economic trend was the broad-based decline in inflation, which led to markets pricing in interest rate cuts from major developed market central banks. Fast forward to the end of the first quarter this year, and recent data releases have raised questions over the disinflationary dynamics.

Unexpected inflation stickiness and labour market strength drove a repricing in the rates markets, with US Treasuries partly retracing their fourth-quarter rally as expectations of rate cuts were pared over the first three months of 2024. At the same time, spread sectors delivered a strong performance on rising expectations for an economic “soft-landing” as macroeconomic data pointed towards a benign growth backdrop and resilient labour market.

While at face value the core CPI (consumer price index) appears to be reaccelerating, our analysis of the underlying details suggests that this strength is narrowly based, and we continue to think personal consumption expenditure (PCE) is the most relevant inflation measure for US monetary policy.

Elsewhere, we see a steady disinflationary narrative in Europe, while growth – though picking up – remains relatively weaker than in the US.

In our March Investment Quarterly meeting, we increased the probability of a “sub-trend growth/soft landing” scenario over the next three-to-six months to 70%, from 60%. We believe this view is well supported by economic data and the willingness of most G10 central banks to initiate monetary easing. At the same time, we made the distribution of our “above-trend growth” and “stressed growth” scenarios more symmetric around our base case, with the probability of markets pricing a recession in the coming three-to-six months reduced to 10% and the probability of a crisis unchanged at 5%, while the probability of above trend growth was increased to 15%.

Consistent with our soft landing base case scenario, we continue to position portfolios with a bias for carry, through overweight positions in agency mortgage-backed securities (MBS), investment grade corporate credit (via banks), covered bonds, European peripheral debt, and supranational bonds, which should all benefit from a soft landing scenario.

We believe a combination of attractive valuations with spreads at elevated levels, and supportive technicals on the back of improved demand-supply dynamics compared to last year, makes a strong case for agency MBS. In the investment grade credit market, we like the attractive all-in yields on offer. Although credit spreads are towards the narrower end of their historical ranges, they could still tighten further and stay tight for years to come. Finally, we have a diversified range of spread exposures in the eurozone via covered bonds, supranational bonds and peripheral bonds in order to benefit from attractive yields and expectations for rate cuts from the European Central Bank (ECB) this year.

In terms of interest rate exposure, we are positioned to take advantage of relative value opportunities, with an overweight to European and Australian duration vs. US duration due to relatively weaker growth and supportive valuations. Within currency overlay, we are underweight the euro as we believe monetary policy divergence between the ECB and the Federal Reserve – with the ECB better placed to ease first – is likely to weigh on the euro relative to the US dollar. At the same time, we hold exposure to diversified emerging market currencies with a bias for carry.