A Whiff of Stagflation

So far, markets have shown resilience, despite the volatility. However, our Head of Corporate Credit Research Andrew Sheets points out that economic data might tell a different story over the next few months, with a likely impact on yields.

Read more insights from Morgan Stanley.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Today – how a tricky two months could feel a lot like stagflation, and a lot different from what we’ve had so far this year.

It’s Thursday, August 7th, at 2pm in London. 

For all the sound and fury around tariffs in 2025, financial markets have been resilient. Stocks are higher, bond yields are lower, credit spreads are near 20-year tights, and market volatility last month plummeted.

Indeed, we sense increasing comfort with the idea that markets were tested by tariffs – after all we’ve been talking about them since February – and weathered the storm. So far this year, growth has generally held up, inflation has generally come down, and corporate earnings have generally been fine.

Yet we think this might be a bit like a wide receiver celebrating on the 5-yard line. The tricky impact of tariffs? Well, it might be starting to show up in the data right now, with more to come over the next several months.

When thinking about the supposed risk from tariffs, it’s always been two fold: higher prices and then also less activity, given more uncertainty for businesses, and thus weaker growth.

And what did we see last week? Well, so-called core-PCE inflation, the Fed’s preferred inflation measure, showed that prices were once again rising and at a faster rate. A key report on the health of the U.S. jobs market showed weak jobs growth. And key surveys from the Institute of Supply Management, which are followed because the respondents are real people in the middle of real supply chains, cited lower levels of new orders, and higher prices being paid.

In short, higher prices and slower growth. An unpleasant combo often summarized as stagflation.

Now, maybe this was just one bad week. But it matters because it is coming right about the time that Morgan Stanley economists think we’ll see more data like it. On their forecasts, U.S. growth will look a lot slower in the second half of the year than the first. And specifically, it is in the next three months, which should show higher rates of month-over-month inflation, while also seeing slower activity.

This would be a different pattern of data that we’ve seen so far this year. And so if these forecasts are correct, it’s not that markets have already passed the test. It's that the teacher is only now handing it out. 

For credit, we think this could make the next several months uncomfortable and drive some modest spread widening. Credit still has many things going for it, including attractive yields and generally good corporate performance. But this mix of slower growth and higher inflation, well, it’s new. It’s coming during an August/September period, which is often somewhat more challenging for credit. And all this leads us to think that a strong market will take a breather.

Thank you, as always, for your time. If you find Thoughts on the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.