Morgan Stanley
  • Wealth Management
  • May 18, 2021

Rising Inflation: More Than Just Transitory?

Why investors shouldn’t dismiss recent upside surprises in U.S. inflation as a temporary phenomenon and how they can recalibrate their strategy.

Lisa Shalett Chief Investment Officer, Wealth Management

Investors who braced for a sharp rise in April’s U.S. inflation readings from last year’s muted levels early in the pandemic were still surprised by the 4.2% year-over-year surge in the consumer price index (CPI)—double the highest projection in a Bloomberg survey of economists, even after hints in March of a coming uptick.

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The CPI data released last week weren’t the only concerning indicators of inflation’s resurgence. The producer price index, which tracks wholesale and manufacturing costs, increased by 6.2% year-over-year in April—the highest reading since the U.S. Bureau of Labor Statistics started tracking the data in 2010—after rising 4.2% year-over-year in March. Perhaps most concerning, these moves came with strong gains in the “core” readings, which strip out volatile commodity-related drivers, such as food and energy prices.

While many, including the Federal Reserve, see the jump in prices as “transitory,” we believe it’s much more than just a blip. To be sure, some short-term inflation drivers, such as supply-chain bottlenecks, are likely to subside. However, we believe this post-pandemic business cycle has ushered in a new period of sustained higher fiscal spending, higher inflation and rising long-term interest rates. In particular, we see five secular shifts that could contribute to this dynamic, each of which can be summed up using terms that begin with the letter D:

  • Deglobalization: In the past decade, globally optimized supply chains helped to check price inflation. Now, the COVID-19 pandemic has likely sped up a shift toward deglobalization that could return supply chains to the U.S., which could contribute to consumer price inflation.
  • Deficits: Federal debt and deficits are exploding in the wake of unprecedented amounts of stimulus meant to counter pandemic disruptions. With the Fed essentially buying new government debt, dramatic growth in the money supply could be inflationary.
  • Dollar debasement: More stimulus to keep long- and short-term rates low would likely drive inflation through further declines in the value of the dollar against other major currencies.
  • Demographics: More Baby Boomers are retiring, and the hiring of Millennials and Gen Z has accelerated, creating conditions for a wealth transfer to a younger workforce entering its peak spending years.
  • Digitization 2.0: The need for contactless business models arising from the pandemic coincides with a completely different set of maturing technologies that could help drive robust capital spending, including artificial intelligence, robotics and distributed-ledger technology known as blockchain.

Investors should consider positioning their investments for higher interest rates and inflation. Portfolio adjustments shouldn’t be confined to fixed income. With volatility likely to stay high, as rates normalize, we suggest trimming holdings that may have run their course, in terms of high price-to-earnings multiples, in favor of quality value stocks and equities that offer growth at a reasonable price.  

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 17, 2021, “Unmoored.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

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Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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