Morgan Stanley
  • Thoughts on the Market
  • Jan 14, 2021

Rates and Inflation: Moving for the Right Reasons?

With Andrew Sheets


Welcome to Thoughts on the Market, I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, January 14th, at 2:00 p.m. in London.

At Morgan Stanley we think global growth and inflation will exceed expectations this year. As a result, we think interest rates will keep rising. But there's an old saying, "be careful what you wish for". Following the surprise election results in Georgia, which opened the door for more aggressive financial support from Washington; market expectations for interest rates and inflation are moving higher. And investors are starting to worry - will this be the dynamic that finally upends markets?

Like many things in life the answer isn't black and white. In isolation, much higher rates of inflation or much higher interest rates would be disruptive to how the market sees the present value of a given business. But there are some important caveats - reasons why we think these developments are more likely to drive a shift in market leadership, than a large adjustment overall.

One of these caveats is what we see in historical performance. When interest rates and inflation expectations are rising together, equity and credit markets actually tend to do quite well. The reason, I'd argue, is pretty straightforward: interest rates and inflation expectations rise together when people are getting more optimistic about the economy. Stocks tend to like that.

We see a similar pattern if we look at inflation as a cyclical phenomenon. Imagine the current rate of U.S. inflation oscillating around its longer run average. When inflation is below average but rising, like it is today, historical returns for stocks and high yield bonds tend to be better than average. The reason, we think, is pretty similar to the other example. Low-but-rising inflation often happens as growth improves following recessions. It reflects optimism. Markets frequently like that.

In short, when thinking about the impact of yields and inflation on a portfolio, the reason why they're moving higher, or lower, really matters. If they're rising for the right reasons, which is to say, because investors are feeling more confident about the economy, the impact is generally more benign.

But if it's benign at an overall level, it can be significantly different below the surface. The last 12 months have seen very low levels of interest rates and unusually large differences in relative performance between segments of the market. As interest rates move higher, those divergences should continue to reverse, as previous laggards become leaders and vice versa. This is a theme my colleague Mike Wilson sees as essential to portfolio performance this year.

And it could be challenging to bond returns themselves, and bond-like assets that haven't started to adjust in price. We remain underweight government bonds and think investors should favor shorter duration exposures.

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Rising yields and inflation can create anxiety for investors, but the impact depends on why they’re rising. Chief Cross-Asset Strategist Andrew Sheets explains.

Each week, Chief Cross-Asset Strategist Andrew Sheets, or a member of his team, offers perspective on the forces shaping the markets as well as insights on investment opportunities and risk across global asset classes.

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