Welcome to Thoughts on the Market.
I'm Andrew Sheets, head of corporate credit research at Morgan Stanley.
And I'm Lisa Shalit, chief investment officer for Morgan Stanley Wealth Management.
Today, is inflation really transitory or are we entering a new era where higher prices are the norm?
It's Thursday, December 18th at 4 p.m. in London.
And it's 11 a.m. in New York.
Lisa, it's great to talk to you again.
And we're having this conversation in the fiscal policy remains very stimulative.
And I think there's this real question around whether inflation will moderate or whether we're going to see inflation be higher for longer.
And you know you are out with a new report touching on some of the issues behind this and why this might be a structural shift higher in inflation.
So we'd love to get your thoughts on that.
And we'll drill down into the various drivers as this conversation goes on.
Thanks, Andrew.
And look, I think, as we take a step back, and the reason we're calling this regime change is because we see factors for inflation coming from both the demand side and the supply side.
For example, on the demand side, the role of the infrastructure boom the It has caused material appreciation of many commodities in 2025.
We're seeing it obviously, in some of the dynamics around precious metals, but we're also seeing it in industrial metals things like copper, things like nickel.
We're also seeing demand factors that may stem from the K-shaped economy.
And the K-shaped economy, as we know, is really about this idea that the wealthiest folks are increasingly dominating consumption and they're getting wealthy through financial asset inflation.
On the supply side, there are dynamics like immigration, dynamics around the housing market that we can talk about.
But perhaps the wrapper around all of it is how policy is shifting, because increasingly policymakers are being constrained by very high levels of debts and deficits.
And determining how to fund those debts and deficits actually removes some of the degrees of freedom that central bankers may have when it comes to actually using interest rates to constrain demand.
Well, Lisa, this is such a great point because we're financial analysts.
We're not political analysts.
But it seems safe to say that voters really don't like inflation.
But they also don't like some of the policies that would traditionally be assigned to fight inflation, be they higher interest rates or inflation tighter fiscal policy.
And even some of the more recent political shifts that we've seen I'm talking about the US around say, immigration policy could arguably be further tightening of that supply side of the economy.
Measures designed to raise wages almost explicitly in their policy goals.
So how do you see that dynamic?
And again, kind of where does that leave, you think, policy going forward?
Yeah, I think the very short answer is our best guess is that policy becomes constrained.
So on the monetary side, we're already seeing the Fed beginning to signal that they're going to have to rely on other tools in the toolkit.
And what are those tools in the toolkit?
Well, they're managing the size of their balance sheet, managing the duration or the mix of things that they hold in the balance sheet and its actual returns to how they think about reserve management in the banking system.
All of those things, all of those constraints, may enable the US government to fund debts right by buying the Treasury bill issuance, which is swollen to almost 2 trillion a year in terms of US deficits.
But on the fiscal side right, the interest payments on debt begins to crowd out other government spending.
So policy itself, in this era of fiscal dominance, becomes constrained, both in Washington DC and from Congress what they can do, their degrees of freedom, and what the central bank can do to actually control inflation.
Another area that you touch on in your report is energy and technology, which are obviously related with this large boom that we're seeing and continue to expect in AI data center construction.
This is a lot of spending on the technology.
This is a lot of power needed. to power that technology.
And US data center.
Electricity demand is growing at a rapid rate and transmission constraints are causing prices to go up, a price that is a pretty visible price for a lot of people when they get their utility bill.
So how do these factors, you think, shape the story?
And where do you think they're going to go as we look into the future?
Yeah, 100%.
I mean, I think when we talk about who's going to dominate in generative AI globally, one of the factors that we have to take into consideration is what is the cost of power?
What is the cost of electricity?
What is the age of the infrastructure to both generate that electricity and transport it and transmit it?
This is one of the areas where the U.S. at the minute is facing genuine constraints.
When you think about some of the forecasts that have been put out there in terms of 10 trillion of spending related to generative AI, the number of data centers that are going to be built and the power shortfall that has been forecast, we're talking about someone having to pay the price, if you will, to ration power until you can upgrade, And in the US, that grid upgrade, to be blunt, has lagged some of the rest of the world, not only because the rest of the world was slower to modernize and leapfrogged in many ways, but we know, in China, for example, they have one of the lowest electricity generation costs on the planet.
That is an advantage for them.
So we have to consider that power generation writ large is potentially a force for upward inflation, at least in the short term.
So we have the fiscal policy backdrop.
We have an AI spending backdrop, both contributing to the demand side of inflation.
We have these supply constraints, whether it's housing or finance or labor, also potentially being more structural drivers of higher inflation.
The question I'm sure that investors are asking you is, what should they do about it?
So can you walk us through the key strategies that investors might want to consider as they navigate a new inflationary regime?
Sure.
So the first thing that we think it's really important for folks to appreciate is that typically, when we've been in these higher inflation regimes in the past, stocks and bonds become positively correlated.
And what that means is that the power of a very simple 60-40 or stock bond cash portfolio to provide complete or optimal diversification fades.
And it requires investors to potentially consider investing especially beyond fixed income.
Stocks very often are pro-inflationary assets, meaning many, many companies have the power to pass through price increases.
If you are consuming income from a fixed income or a bond instrument, inflation is your enemy because it's eating into your real returns.
And so one of the things that we're talking with our clients a lot about in terms of portfolio construction is are things like adding real assets, adding infrastructure assets, adding energy, transportation assets, adding commodities, adding gold, even to a certain extent.
Just to play devil's advocate.
You can imagine that some investors might say well, I can look in the market at long-term inflation expectations.
And those long-term inflation expectations have been kind of stable and a bit above the Fed's target, but not dramatically so.
What do you kind of say to that?
And what do you think those markets either might be missing?
Or how could investors kind of leverage that more benign view that's out there in the market?
Yeah, so look, I think here's where the debate is, right?
Our perception has been that inflation expectations have remained extraordinarily anchored, because investors have actually reasonably short memories on the one hand, and we have by and large been in disinflationary times.
Second, there's extraordinary faith in in policymakers, that policymakers will fight inflation.
And I think the third thing is that there's extraordinary faith in the deflationary forces of technology.
Now, all three of those things may absolutely positively be true.
The problem that we have is that the alternate case, right the case that we're making, that maybe we're in a new inflationary regime, is not priced and the risk is non-zero.
And so what we see and what we're watching is how steep does the yield curve get, right?
As we look at yields in the 10 to 30-year tenor, what is driving those rates higher?
Is it a generic term premium, or are we starting to see a unanchoring, if you will, of inflation expectations?
And it takes a while for people to appreciate regime change.
And so, look, as is always the case, there's no absolutes in the market.
There's no one theory that is priced and the other theory is not, but sometimes you want to hedge.
And we think that we're going through a period where diversified portfolios and hedging for these alternative outcomes because there are such powerful structural cross-currents is the preferred path.
Lisa, thanks for sharing your insights.
Of course, Andrew.
That's my pleasure.
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