More signs that inflation is easing further

• With the March banking crisis fears now seemingly behind us, together with weaker-than-expected US inflation and strong data out of China, risk assets performed well last week. The performance of safer assets such as government bonds, however, have been a mixed bag. US Treasury yields have fallen as economic activity continues to lose momentum and markets are increasingly pricing in interest rate cuts from the US Federal Reserve (Fed) towards the end of the year. In contrast, euro area government bond yields have risen slightly as the European Central Bank (ECB) is expected to continue raising rates even if the Fed pauses.
  
  
• The US inflation report for March showed encouraging signs that price pressures are easing, although the deceleration remains uneven across different products and services. Compared to a year ago, headline inflation has slowed significantly on the back of the fall in energy prices. However, this is partly being offset by stubbornly elevated shelter (housing) inflation, suggesting that underlying inflationary pressures haven’t abated to the same extent. Nonetheless, we expect inflation to continue to moderate as the economy slows following the Fed’s interest rate increases over the past year or so.
  
  
• We believe inflation will remain above the Fed’s 2% target for some time, warranting another 25 bps increase in interest rates in May, taking rates to the 5-5.25% range. This will likely mark the peak in interest rates, according to market pricing. While inflation is moderating, it remains elevated. This is why we think the Fed is likely to keep the key policy rate unchanged this year following the May rise, in an effort to bring inflation closer to its 2% target.
  
  
• Elsewhere, the British economy stalled in February with the services sector and production output contracting outright. In our view, these economic headwinds are likely to bring the peak in the Bank of England’s Bank Rate in sight as well.
  
  
• In China, inflation is very low and not an issue, so Beijing has continued to support its economy, as confirmed by strong credit figures for March. We’ll watch any market reaction to China’s GDP growth data this week, which we think should confirm that the economic rebound post-reopening is happening. Because of this, we continue to believe that the Asia-Pacific region remains the brightest spot to benefit from China’s reopening, as suggested by strong exports data published last week.

Here’s how we are positioned in our flagship portfolios:

• Portfolios showed positive returns year-to-date. The key performance drivers remain:
  • quality within fixed income, with higher-than-normal exposure to government bonds, and reduced exposure to high yield and emerging market debt;
  • our selection of equity investments, as several technology stocks have performed strongly, combined with a low exposure to the banking sector where volatility remains high; and
  • our strategic gold position.
    
    
• Despite the somewhat improved risk appetite in markets last week, we are still defensive in our asset allocation positioning. This means that, versus our typical long-term allocation, we own more high-quality bonds than normal (we remain overweight) and own less equities and low-quality bonds than normal (we remain underweight).
  
  
• While headline inflation is falling, core inflation is stickier than expected, which supports our existing position in inflation-linked bonds (US TIPS). 
  
  
• Similarly, the ongoing reopening of China and strong data releases is underscoring our overweight position in Asia-Pacific (including Japan) equities.
  
  
• Our underweight equity position has been a slight headwind to performance given the rebound of the asset class. However, with central banks weighing up inflation risks versus financial stability risks, we don't believe it is time to add risk to portfolios yet.

Past performance is not a reliable indicator of future returns.