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Is Inflation Heathy for an Economy?

With Mike Wilson U.S. Equities Research for Investors

While excessive inflation can be disruptive, such as in the 1970’s, a deflationary mindset can often be more destructive—and difficult to reverse. What current inflation trends mean for investors.

Each week, Mike Wilson offers his perspective on the forces shaping the markets and how to separate the signal from the noise. Listen to his most recent episode and check out those of his colleagues from across Morgan Stanley Research.

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Current Episode Transcript

Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, July 6th, at noon in New York. So let's get after it.

A legend is defined as a non-historical or unverifiable story handed down by tradition from earlier times and popularly accepted as historical. To many people, inflation is like a legend that's hard to verify but generally accepted as having existed in the past. As someone who grew up in the 1970s in the United States of America, I can assure you that inflation is a very real thing, even though it hasn't been seen in decades.

My recollection of this period is that inflation can be very disruptive, even destructive, to both businesses and households. Gas lines, food shortages, and other rationings are the most vivid images of that period. However, it was the mindset that sticks with me more than anything else. The expectation that prices would always be higher in the future, and maybe significantly higher, led to a quiet discomfort about whether we would be able to afford the most basic items of life: shelter, transportation, and food.

That mindset is what drives the vicious circle of higher prices. And with that as a backdrop, many individuals often ask me why the Federal Reserve or other central banks are trying so hard to get higher inflation. Aren't stable prices a better thing for most people and companies trying to plan for the future? Why would we ever want higher rates of price inflation?

While inflation at very high levels can be quite destructive, like during the 1970s, modest price inflation is better than outright deflation or price inflation that's too low, often defined as below 2% per year. Over the past decade, both headline and core price inflation have spent more time below this key threshold than above it. The severe demand shock from Covid-19 has put even more downward pressure on inflation in the short term than a garden variety recession would. And this has the Fed very concerned because they don't want a deflationary mindset to develop in America. In their view, a deflationary mindset is much more destructive and difficult to reverse than an inflationary one. And with much of the developed world already in such a state of mind, they're desperate to do whatever is necessary to avoid it here.

When thinking about outright deflation versus modest inflation, we agree the former is much worse for the economy and stocks. If people or businesses think the price of goods or services will be lower in the future, they may decide to put off purchases. This has a negative effect on overall demand, which then causes prices to fall further. This is the same circular loop for inflation discussed earlier, but in reverse. As noted, this can be more damaging to the economy than an inflationary loop, especially one that is already carrying too much debt. Japan has been stuck in this kind of a deflationary trap for the past 20 years, which is a major reason why its economy and equity markets have performed poorly relative to the US.

My view is that this is exactly how major changes occur. A certain view becomes so consensus that not only does it get priced into financial markets, but the consensus can't even fathom a different outcome. That is where we are today with inflation. It's the mirror image of the early 1980s. Just when you think it can't change, it does. What this means for investors is they need to prepare for the other side of the coin: better growth and inflation than expected. More specifically, economically sensitive assets should outperform defensive ones. Another way of thinking about this is assets positively correlated to rising interest rates outperforming those that are negatively correlated to rising interest rates. While modest inflation can be good for equities, it can be quite damaging to bonds, particularly given the very low starting point on 10 year yields. Small changes can have an outsized negative impact on price and can be swift if it comes as a surprise. Therefore, investors should continue to overweight equities and underweight bonds in a broad asset allocation strategy.

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