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Rising yields and inflation can create anxiety for investors but the impact depends on why they’re rising. Much higher rates of inflation or much higher interest rates would be disruptive to how the market sees the present value of a given business. But there are reasons why economists at Morgan Stanley think these developments are more likely to drive a shift in market leadership than a large adjustment overall.

Key quotes

“We think global growth and inflation will exceed expectations this year. As a result, we think interest rates will keep rising.”

“When interest rates and inflation expectations are rising together, equity and credit markets actually tend to do quite well. The reason is pretty straightforward: interest rates and inflation expectations rise together when people are getting more optimistic about the economy. Stocks tend to like that.”

“When inflation is below average but rising, like it is today, historical returns for stocks and high yield bonds tend to be better than average. The reason is low-but-rising inflation often happens as growth improves following recessions. It reflects optimism. Markets frequently like that.”

“The last 12 months have seen very low levels of interest rates and unusually large differences in relative performance between segments of the market. As interest rates move higher, those divergences should continue to reverse, as previous laggards become leaders and vice versa. And it could be challenging to bond returns themselves, and bond-like assets that haven’t started to adjust in price. We remain underweight government bonds and think investors should favor shorter duration exposures.”