Diverging Views on Inflation Could Be a Risk for Investors

Today’s market tug-of-war over the durability of inflation has got to be among the most noteworthy investment debates as we emerge from the pandemic. 

The Federal Reserve has maintained its view that price increases are driven by supply-chain disruptions and will prove to be transitory. But inflation is showing some staying power and looks high by a host of measures, whether the data are calculated by government agencies or estimated by the Fed itself.

In the markets, Treasury breakeven rates, a measure of expected inflation, are rising as bond traders accelerate estimates for when the Fed will start to raise interest rates. Meanwhile, stocks continue to chart new highs and see rich valuations sustained by negative inflation-adjusted, or “real,” interest rates.

Such differing investor views are the nature of markets, but given today’s dynamics, we are increasingly concerned that a notable divide is developing between Wall Street and Main Street.

On Wall Street, equity investors seem to inhabit the “nominal” world, where reported revenue and profits are the primary focus and the growing bite of inflation isn’t yet fully appreciated. Stock valuations, especially for large companies, continue to benefit from negative real interest rates, with many investors seemingly unconcerned that financial conditions are poised to tighten and earnings growth rates are apt to slow meaningfully. 

Meanwhile, in the “real” world of Main Street, inflation is being fully taken into account, and both consumers and businesses appear far less sanguine:

• The latest University of Michigan consumer sentiment index plunged to the lowest level in 10 years. Participants noted declining expectations for both their present situation and the intermediate future.

• This is a perspective increasingly shared by small businesses, which employ two-thirds of the U.S. workforce and drive a similar share of gross domestic product (GDP) growth. In October, a National Federation of Independent Business survey of small-business owners found that overall optimism about current conditions declined for the third month in a row on frustrations with inflation, supply-chain issues and difficulty hiring.

The sources of this tension are real. To be sure, GDP is projected to grow an above-average 4.9% in 2022, and pent-up demand for services could combine with a strong labor market to sustain positive retail trends. At the same time, however, consumer purchasing power is diminishing. Even as real spending is estimated to be rising at a 6.5% annualized rate, once inflation is accounted for, real income growth is near a 20-year low, at -1.2%.  

In addition, many households may be closer to depleting their stimulus-fueled savings than many investors realize. Excess savings in the U.S. are estimated at more than $2 trillion, but nearly two-thirds of that sum belongs to the top 20% of earners, while just 4.5% belongs to the bottom 40%.

In this environment, we believe investors should watch for real interest rates to move up, as a cue that stock valuations are vulnerable. Also, we think the risk/reward profile for broad indices is unattractive at this point. Consider replacing passive index exposures in both stocks and bonds with an active strategy, with a focus on selecting securities with valuation support and the ability to grow profits as the economy expands as well as control costs and pricing.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Nov 22, 2021, “A Cacophonous Crescendo.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.