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Featured Explore Our Culture Careers Yes, You Can Be a Tech Innovator at Morgan Stanley Technology CLEAR Wealth Management Rising Inflation May Challenge Stocks Dec 18, 2024

In a major shift, the U.S. may be entering a new era of inflationary growth, posing risks to equities. How can investors prepare?

Author Lisa Shalett Key Takeaways The U.S. appears to be shifting from an era of cooling inflation in a steady economy, to one in which price pressures rise alongside growth. Recent data show inflation is picking back up, challenging investors’ expectations for further Fed rate cuts and equity-market gains. Morgan Stanley recommends maximum diversification among stocks, bonds, real assets, hedge funds and private investments. One of the hallmarks of the last 15 years in U.S. stock markets has been a belief among many investors that the U.S. is operating in a globalized world of cooling inflation and steady economic growth. This “disinflationary” growth trend has come with lower interest rates, solid company earnings and strong consumer confidence, supporting equity valuations.

 

But does that view still reflect reality? Contrary to the popular narrative in markets, Morgan Stanley’s Global Investment Committee believes we are now more likely in a “reflationary” world, in which government policy may spur economic growth but also stoke inflation—posing risks to stocks.

 

Equity investors don’t seem to have embraced that view yet. Heading into mid-December, markets were pricing in a nearly 100% chance that the Federal Reserve would cut its policy rate another 25 basis points, reflecting expectations that inflation would continue to cool while growth would remain solid. While the Fed did indeed make that cut on December 17-18, we believe investors still need to pay attention to several “reflationary” signals.

 

Inflation appears to be heating back up: The headline consumer price index (CPI) rose at a 2.7% annualized pace in November, up for a second consecutive month, driven by higher prices for food and manufactured goods. “Core” CPI, which excludes volatile food and energy prices, rose 3.3% year-over-year for the second month in a row. In addition, the Producer Price Index showed wholesale prices up 3% year-over-year in November, above analysts’ forecasts. And all of this is despite the fact oil prices are down 20% since March and gasoline pump prices—a big portion of U.S. consumers’ budgets—are the lowest they have been since 2021. Small business confidence is surging: According to the National Federation of Independent Business (NFIB), optimism among U.S. small businesses soared 8 points, the most on record, in November to its highest level in more than three years. Such readings are thought to bode well for hiring and capital spending intentions. Taken at face value, they suggest the Fed should not be worried about softening labor conditions, limiting its incentive to cut rates much further.      

A New ‘Reflationary’ World? Those aren’t the only signs that a reflationary shift may be underway. In addition to growth-stimulating fiscal and monetary policies, two major drivers of disinflation – globalization and immigration, which keep prices down by increasing competition and bolstering labor markets – appear to be in retreat. Additionally, two more key developments bolster our confidence in this paradigm change.

 

Gold and silver have outperformed the S&P 500 this year: While the benchmark U.S. stock index is up a remarkable 27% this year, the precious metals have gained 30% and 34%, respectively. When real assets like gold and silver outpace stocks, it suggests investors may anticipate inflation. The economy appears less sensitive to changes in interest rates: For example, recent Fed rate cuts have done little to reinvigorate the U.S. housing market, as the majority of homeowners either own their homes or hold mortgages below 4% while new 30-year mortgages are still pricing well above 6%. This type of “rate insensitivity” constrains policymakers in their efforts to manage price pressures or support economic growth through tools such as rate hikes and cuts.  Massive income disparities exacerbate the challenge: The richest households and largest corporations have more cash to spend, hold greater sway over the economy and enjoy more income from higher rates, which stimulates spending and spurs inflation.  

Portfolio Implications Equity investors and, to a certain extent, the Fed still appear anchored in the presumption of a globalized, disinflationary backdrop. However, the Global Investment Committee is skeptical. The implication is that the potential for policy mistakes is rising and the odds of a “goldilocks” scenario for equity markets are falling.

 

In 2025, it’s unlikely we’ll see both more cuts and disinflationary economic growth accelerate. We think growth will disappoint first, and further Fed action will be constrained, which might open the door for “stagflation,” in which the economy falters as inflation persists.

 

Investors should consider eliminating large portfolio concentrations in the “Magnificent 7” mega-capitalization tech stocks and other recent “Trump Trade” outperformers. Policy dynamism next year is likely to produce new market leadership, and stock picking will be critical.

 

We favor financials, energy, residential real estate and domestically focused manufacturers of industrials and consumer goods. Healthcare now looks to be oversold as well, presenting a potentially attractive entry point for investors.

 

Long-term investors should focus on rebalancing portfolios and pursuing maximum diversification among stocks, bonds, real assets, hedge funds and private investments.

 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from December 16, 2024, “Losing the Plot.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report. 

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Risk Considerations

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.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market.  Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds.  High yield bonds should comprise only a limited portion of a balanced portfolio.

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

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, 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 and frontier markets, since these countries may have relatively unstable governments and less established markets and economies.

Alternative investments may be either traditional alternative investment vehicles, such as hedge funds, fund of hedge funds, private equity, private real estate and managed futures or, non-traditional products such as mutual funds and exchange-traded funds that also seek alternative-like exposure but have significant differences from traditional alternative investments. The risks of traditional alternative investments may include: can be highly illiquid, speculative and not appropriate for all investors, loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than open-end mutual funds, and risks associated with the operations, personnel and processes of the manager. Non-traditional alternative strategy products may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. These investments are subject to the risks normally associated with debt instruments and also carry substantial additional risks. Investors could lose all or a substantial amount of their investment. These investments typically have higher fees or expenses than traditional investments.

Hedge funds may involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager.

REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

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

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Environmental, Social and Governance (“ESG”) investments in a portfolio may experience performance that is lower or higher than a portfolio not employing such practices. Portfolios with ESG restrictions and strategies as well as ESG investments may not be able to take advantage of the same opportunities or market trends as portfolios where ESG criteria is not applied. There are inconsistent ESG definitions and criteria within the industry, as well as multiple ESG ratings providers that provide ESG ratings of the same subject companies and/or securities that vary among the providers. Certain issuers of investments may have differing and inconsistent views concerning ESG criteria where the ESG claims made in offering documents or other literature may overstate ESG impact. ESG designations are as of the date of this material, and no assurance is provided that the underlying assets have maintained or will maintain and such designation or any stated ESG compliance. As a result, it is difficult to compare ESG investment products or to evaluate an ESG investment product in comparison to one that does not focus on ESG. Investors should also independently consider whether the ESG investment product meets their own ESG objectives or criteria. There is no assurance that an ESG investing strategy or techniques employed will be successful. Past performance is not a guarantee or a dependable measure of future results.

Artificial intelligence (AI) is subject to limitations, and you should be aware that any output from an AI-supported tool or service made available by the Firm for your use is subject to such limitations, including but not limited to inaccuracy, incompleteness, or embedded bias.  You should always verify the results of any AI-generated output.

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.

The indices are unmanaged. An investor cannot invest directly in an index.  They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices are not subject to expenses or fees and are often comprised of securities and other investment instruments the liquidity of which is not restricted. A particular investment product may consist of securities significantly different than those in any index referred to herein. Comparing an investment to a particular index may be of limited use.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice.  Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.

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