Andrew Sheets: Where is Inflation Headed?

Headlines today are focused on US Consumer Price Inflation rising 7.5% versus 1 year ago. The question on the minds of consumers and investors alike is, where will it go from here?

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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 Friday, February 11th at 2 p.m. in London.

This week for the ninth month in the last 10, U.S. consumer price inflation was higher than expected, rising 7.5% Versus a year ago. Investors are currently having a very lively discussion around where inflation is headed, but also how much it matters. And I wanted to share a few of our thoughts.

One important thing about these rising prices is they aren't all rising for the same reason. COVID related disruptions are still impacting the production of everything from meat to automobiles. And say, with fewer new cars being built that means the cost of used cars has risen almost 50%. Now cars aren't a large share of the so-called inflation basket, the collection of goods and services that is used to determine how much overall prices are rising or falling. But if a small share of something rises 50%, the overall number can still rise quite a bit.

Then there are rising prices that we see today, but where the story has been building for some time. The assumed cost of shelter, for example, should be linked to the price of housing. But due to how this data is measured, there can be some pretty significant lags.

Consider the following. From the start of 2017, so about five years ago, U.S. home prices have risen 50%. But the assumed rise in the cost of shelter, that goes into the inflation calculation, suggests that the cost of shelter has risen just 16% over that same period. As this gap closes and shelter costs catch up to where home prices already are, that will get reported as a lot of additional inflation, even if home prices have stopped rising.

Another part of this story is the narrative and the timing of it. Per a quick check of the headlines this morning, Thursday’s inflation data was the top story for The Wall Street Journal and The New York Times.

Yet, based on Morgan Stanley's current forecasts, U.S. inflation is actually peaking right about now. We think the direction of data matters enormously in terms of how it's interpreted because there's a very human tendency to extrapolate whichever direction it happens to be heading. Today, the rate of inflation's been heading up, creating fears that it will continue to move higher. But if we're right that inflation peaks in the next month or two, April or May could feel very different.

Unfortunately, we're not quite there yet. The inflation rate is still rising, creating uncertainty about what central banks will do and how they'll respond. That uncertainty is driving volatility and should warrant lower prices for things that are very central bank sensitive. We think yields for government bonds in the U.S., the U.K., and the Eurozone will continue to move higher, and that spreads on mortgages, sovereign bonds, and corporates can move modestly wider.

On the other hand, we feel better about assets that are less sensitive to this inflation uncertainty, including the less expensive stock markets outside the U.S. Stocks in the United Kingdom which my colleague Graham Secker, Morgan Stanley's Chief European Equity Strategist, discussed on this program recently are one such example.

Finally, keep in mind that the inflation debate could feel very different in just a month or two. If the inflation data peaks soon, as our economists expect, it could provide some relief as we look ahead to April or May.

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