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Morgan Stanley lays out why it thinks inflation is cooling — which should ease investors' fear of an extreme 1970s-style shock

Jun 4, 2022, 14:40 IST
Business Insider
Food prices have risen due to supply problems.Frederic J. Brown/AFP/Getty Images
  • Morgan Stanley economists expect inflation to moderate for the rest of 2022.
  • They attribute their more optimistic outlook in part to the easing of supply chain disruptions.
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Investors have gripped by recurring worries about "stagflation" for months now — but rocketing inflation is now set to moderate, giving markets a reason to focus elsewhere, Morgan Stanley has said.

Andrew Sheets, the Wall Street bank's chief cross-asset strategist, said 2022 has given investors a lot to chew on, speaking in a recent podcast,

"Out of the many developments of this year, one really stands out. It's inflation, and the impact that high inflation has had on central bank policy," he said. "But now this story may be changing again — away from inflation and back towards growth."

Inflation has soared in the US and elsewhere, fueled by pandemic-era stimulus, the impact of COVID restrictions, and more recently, by the fallout of sanctions on Russia over its war on Ukraine.

Disruptions to the supply of oil and agricultural products like wheat have driven up the price of fuels and food, and of industrial input goods.

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The Federal Reserve, like central banks elsewhere, has turned to monetary tightening to tame rampant inflation. It has begun a series of aggressive interest-rate hikes and cutting back its balance sheet.

"After rocketing higher over the first five months of the year, Morgan Stanley's economists do expect U.S. inflation to moderate for the rest of 2022," Sheets said.

That should give investors more confidence about the economic outlook in the long term, Sheets said, and reduce their jitters over stagflation – a toxic mix of low or no economic growth at the same time as high inflation — which plagued the US economy in the 1970s, in particular.

Economists such as Allianz's Mohamed El-Erian have argued that while the US economy could avoid a recession, a period of stagflation is inevitable.

The investment bank's view is based on several factors, including the easing of supply-chain disruptions and the way inflation is measured. Today's rate looks high because it's compared with a year before, when the world was in a pandemic and people weren't out spending.

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"Some of this is that we're passing the peak rate of change," Sheets said. "Recall that on a year-over-year basis, prices today are being compared to May of 2021 — a time when the U.S. vaccination rate was still low, and activity was a long ways from being back to normal."

In the longer term, headline inflation will start falling, because it will be compared with rates in periods when there was more economic activity and so it was higher.

Morgan Stanley is also seeing encouraging signs that some of the worst supply-chain disruptions are improving.

"Fewer ships are sitting off of U.S. ports, unloaded. The cost of freight is declining. Many retailers are now reporting plenty of inventory," Sheets said.

That should mean prices driven higher by shortages from the disruption start to fall. The strategist noted that market-based estimates of future inflation have been dropping in the US and Europe over the past month.

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If this trend of moderating inflation can hold, there are some important implications, according to Sheets.

"First — at a very simple, but very important level — inflation that is high, but falling, is much less frightening to the market than inflation that's high, but rising," he said. "This should help reduce the market's fear about a more extreme, 1970s-style scenario."

Second, it means investors' expectations for central bank interest-rate hikes don't need to rise much further, he argued. That should bring stability to bond yields, which could feed through to fixed-income products like mortgages and municipal bonds.

There is a flipside, Sheets warned: Markets are likely to focus more on economic growth as inflation fears recede — and Morgan Stanley sees a sharp slowdown ahead.

"While short term bounces are possible, we'd like to see more conservative estimates for earnings before assuming that the market's challenges are truly behind it," he cautioned.

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