Our Head of Corporate Research Andrew Sheets and Chief Investment
Officer for Morgan Stanley Wealth Management Lisa Shalett unpack
what’s fueling persistent U.S. inflation and how investors could
adjust their portfolios to this new landscape.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Lisa Shalett: And I'm Lisa Shalett, Chief
Investment Officer for Morgan Stanley Wealth Management.
Andrew Sheets: Today, is inflation really
transitory or are we entering a new era where higher prices are
the norm?
Andrew Sheets: It's Thursday, December 18th
at 4pm in London.
Lisa Shalett: And it's 11am in New
York.
Andrew Sheets: Lisa, it's great to talk to
you again. And, you know, we're having this conversation in the
aftermath of, kind of, an unusual dynamic in markets when it
comes to inflation. Because inflation is still hovering around 3
percent. That's well above the Federal Reserve’s 2 percent
target. And yet the Federal Reserve recently lowered interest
rates again. 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.
Lisa Shalett: Thanks Andrew. And look, I
think as we take a step back, and the reason we're calling this a
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 GenAI
infrastructure boom, has become global. 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 are 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 debt 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.
Andrew Sheets: 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 tighter fiscal policy.
And even some of the more recent political shifts that
we've seen – I’m talking about the U.S. 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?
Lisa Shalett: Yeah. I think the very short
answer – our best guess is that policy becomes constrained. So,
on the monetary side, we're already seeing the Fed beginning to
signal that perhaps they're going 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
it's actual, you know, returns to how they think about reserve
management in the banking system. All of those things, all of
those constraints may enable the U.S. government to fund debts,
right? By buying the Treasury bill issuance, which is, you know,
swollen to almost [$]2 trillion a year in terms of U.S.
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,
you know, Washington, D.C. and from Congress – what they can do,
their degrees of freedom – and what the central bank can do to
actually control inflation.
Andrew Sheets: 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 U.S. 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?
Lisa Shalett: Yeah, 100 percent. I mean, I
think, you know, when we talk about, you know, 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 the grid.
And in the U.S., 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.
Andrew Sheets: 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 labor also, you know, 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?
Lisa Shalett: 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, right? 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 are
things like adding real assets, adding infrastructure assets,
adding energy, transportation assets, adding commodities. Adding
gold even, to a certain extent. You know, there may be
cryptocurrencies that have lower correlations to their
portfolios.
Andrew Sheets: 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 say to that? And what do you think those markets either
might be missing? Or how could investors leverage that more
benign view that's out there in the market?
Lisa Shalett: Yeah, so look, I think here's
where the debate, 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 policy makers – that
policy makers 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
10-30-year tenure – what is driving those rates higher? Is it a
generic term premium? Or are we starting to see an 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 crosscurrents – is the preferred path.
Andrew Sheets: Lisa, thanks for sharing
your insights
Lisa Shalett: Of course, Andrew. That's my
pleasure.
Andrew Sheets: As a reminder, if you enjoy
Thoughts on the Market, please take a moment to rate and review
us, wherever you listen. It helps more people find the show.
*****
Lisa Shalett is a member of Morgan Stanley's Wealth
Management Division and is not a member of Morgan Stanley’s
Research Department. Unless otherwise indicated, her views are
her own and may differ from the views of the Morgan Stanley
Research Department and from the views of others within Morgan
Stanley.
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