Inflation’s decline could stall out in mid-2023, potentially keeping interest rates higher for longer and markets stuck in a volatile waiting game.
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After a particularly bruising 2022, investors have begun 2023 with some gains. Over the first nine trading days, the S&P 500 Index rose more than 4%, while the tech-heavy Nasdaq advanced nearly 6%. Treasuries were up about 3%, on average, while yields fell as investors lowered their expectation of how high the Federal Reserve will raise interest rates.
At the heart of this enthusiasm is a belief that inflation is tamed and that the Fed may pause its rate hikes soon. Investors are currently expecting that the Fed will raise rates by just 25 basis points in February, as opposed to the 50- or 75-basis-point hikes it has delivered in recent months. Two points supporting this view:
- The consumer price index (CPI) report for December, as expected, showed headline inflation easing to 6.5% year-over-year and core inflation, which excludes volatile food and energy prices, cooling to 5.7%.
- A recent nonfarm payrolls report suggested that average wage gains decelerated to an annual pace of 4.6% in December.
Morgan Stanley’s Global Investment Committee agrees that inflation has likely peaked and is moving toward a more manageable range. But does this mean “mission accomplished” for the Fed and markets in the inflation fight? We don’t think so, and we believe investors’ recent enthusiasm may be premature. Here are three key risks investors may be missing:
- Energy costs could climb. After surging in early 2022, oil and gas prices plummeted through year-end amid weakening demand. A number of factors drove the decline: recessionary conditions in emerging markets, European conservation efforts against the Russian oil embargo and a mild start to winter in both Europe and the eastern U.S. Looking ahead, however, we anticipate a rebound in oil and gas prices, driven by a re-acceleration in global economic growth and a relaxation of European austerity practices. In fact, Morgan Stanley analysts see crude prices rising from about $80 per barrel today to about $107 by the third quarter.
- Import prices may continue to rise. Last year, the continued strength of the U.S. dollar helped to shelter U.S. consumers from higher prices of imported goods. But that effect may be fading as the Fed’s tightening cycle matures and the dollar depreciates. In fact, December import prices rose 3.5%, more than expected. Excluding energy products, import prices increased by 0.8% for the month, an annualized pace of 9.6%.
- Services inflation could persist. While airline costs fell in the latest CPI report, other factors could slow recent progress in curbing price pressures. These include structural labor shortages, strong owner-occupied housing and rent inflation, and resurgent medical services costs.
The implication of these risks, along with many investors’ failure to acknowledge them, is that core inflation is unlikely to decline in a straight line through year-end toward the Fed’s target of 2%. Rather, the decline is more likely to stall out mid-year, with inflation staying closer to 4%—a development that could keep rates higher for longer and markets possibly stuck in a volatile waiting game.
In this environment, investors should consider keeping their portfolios overweight in fixed income versus U.S. equities. Look to hedge portfolios against inflation that could prove more persistent than currently forecast by owning value-oriented plays in energy, financials, real assets, enterprise technology and consumer services, in addition to gold and non-U.S. stocks.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from January 17, 2023, “An Inflation Boomerang?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
