MORGAN STANLEY: A largely overlooked policy shift by the Fed is setting up investors’ favorite stocks for a major disruption. Here’s how to prepare your portfolio before it occurs.

  • According to Morgan Stanley's Lisa Shalett, the stock market is wrongly ignoring a wave of incoming inflation.
  • She laid out 4 portfolio shifts to make on the heels of the Fed's announcement of their intention to support inflation higher than 2% over the next decade.
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Over the last decade, inflation in the US has hovered below the Federal Reserve's annual target rate of 2%.

But as of August, the central bank has said it will allow inflation to run higher than 2% over the decade to come, seeking to hit their target by way of average.

So far, the market has seemingly shrugged at the announced policy shift. That's a mistake, says Morgan Stanley's Chief Investment Officer for Wealth Management Lisa Shalett.

"Although the market has all but ignored this policy shift, I consider it to be an important historic event," Shalett said. 

She continued: "Essentially, the Fed now believes that if inflation averages below 2% for long periods, as it has for the past 10 years, then it could allow inflation to run well above 2% for long periods to achieve the traditional 2% target, on average. This sounds like a plan not only to embrace inflationary flare-ups, but potentially to stoke them."

Though the market doesn't seem to be preparing for a coming wave of inflation, Shalett is joined by others on Wall Street in her assessment that investors should be prepared for a high-inflation environment. 

Among those in her camp is her Morgan Stanley colleague Mike Wilson, who has been warning since even before the Fed's announcement that the growing money supply from government stimulus will lead to higher inflation, an evaluation Shalett agrees with. 

Shalett also pointed to a weakening dollar and a growing number of breakeven bonds this year as indications that higher inflation is on its way.

Like Wilson, who made the recommendation of shifting to cyclicals to prepare for inflation, Shalett also recommended portfolio shifts investors should be undertaking. The four moves are detailed below.

4 portfolio shifts to make before higher inflation 

Shalett warned that coming inflation will hurt growth stocks, which have led the market's meteoric rise since March.

As such, she recommended investors start stepping into commodities, real estate, and Treasury Inflation-Protected Securities (TIPS).

Investors seeking exposure to these sectors might consider the Vanguard Commodity Strategy Fund Admiral Shares (VCMDX); the Real Estate Select Sector SPDR Fund (XLRE); and the iShares TIPS Bond ETF (TIPS).

Shalett also recommended investors reduce their reliance on "familiar sources of diversification," including longer-term Treasury bonds.

"If this picture plays out as we expect, investors could see both stocks and bonds fall in price at the same time," Shalett said. "That means that traditional portfolio diversification strategies may not work as expected in the next downturn."

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