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The value of pricing power: Equity positioning in a time of inflation
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The Russia-Ukraine conflict: What does it mean for inflation?
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INFLATION, RECESSION AND BEYOND
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Global equities have historically generated positive returns when US inflation is between 2-6%
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It’s mostly at the extremes — when inflation is above 6% or negative — that financial assets have tended to struggle
But sustained periods of elevated inflation are rare – the ultra-high inflation of the 1970s was a unique period
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In this Q&A, Robert Lind shares his views on the impact of the conflict on markets and the global economy
The conflict has been a profound shock. It will have a significant impact on European economies and to a lesser extent the US as well as the rest of the world. At the start of the year, we were looking at an economy that was recovering from the Omicron COVID variant. Activity was picking up; we were seeing a recovery in consumer spending and business investment. This all now looks in doubt. We are now facing an environment of significantly higher commodity prices, which could persist for longer than many would anticipate. This represents a significant negative supply shock for the world economy. It will raise inflation and reduce economic growth, posing an extremely challenging problem for policymakers.
This current situation is incredibly challenging for central banks such as the Federal Reserve and the European Central Bank: they are dealing with a shock that can create higher inflation and weaker growth. As a result, they can't rely on the policy models that they have used over the last 20 years. I believe central banks are worried about the potential lessons of the 1970s when we last saw significant energy price shocks created by geopolitical turbulence.
We are now facing an environment of significantly higher commodity prices, which could persist for longer than many would anticipate
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Chief European Economist at Capital Group
Robert Lind,
How will the war impact the global economy and the recovery from the COVID pandemic?
How has the road map for central banks been impacted by the conflict?
How could Europe potentially fix or rectify the dependency on Russian energy?
In the short term, very little can be done to change Europe’s demand for Russian gas. While countries have been gradually shifting away to other sources such as Norway (which supplies 20-25% of the EU gas demand) and increasing the use of LNG (liquefied natural gas), there are capacity constraints in both. That said, it is entirely possible that over the next few months, Europe could still cope if there was a blockage in the gas supply from Russia. The much bigger question would come as we look out to the winter this year and into 2023. The situation will become far more challenging by then if we are still looking at significant gas supply disruption from Russia. For example, I think the introduction of energy rationing in the EU is a very real possibility. There is clearly going to be an acceleration of the plans that were already in place to shift the energy transition in Europe onto a faster pathway. However, this requires large scale investment and significant changes in infrastructure, which can optimistically only be delivered over the course of the next three to five years.
1 Data as at 10 March 2022. Source: Norwegian Ministry of Petroleum and Energy
Theoretically, most central banks would advise against doing too much in the face of shocks like these, and instead look through a temporary increase in inflation caused by energy prices. But I think there are two problems with that in the current environment. The first is we're starting from a period of very low interest rates. Monetary policy has been extraordinarily loose over the last couple of years. Therefore, there is a risk that this inflationary impetus from high commodity prices could prove longer lasting. The second issue is we don't know how long energy prices are likely to stay at these elevated levels. I'd like to believe that energy prices will start to fall back if we see a cessation of tensions in Ukraine. But even if we see a temporary ceasefire, that doesn't mean the pressure in energy markets is going to go away. In addition, governments, particularly in the EU, are starting to accelerate their plans to reduce their dependence on Russian energy, which also means there is going to be continued upward pressure on energy prices. It is hard to see the inflationary pressure from commodity and energy prices going away soon.
I think the introduction of energy rationing in the EU is a very real possibility
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Russia’s military aggression against Ukraine, which has become Europe’s largest ground war in generations, has impacted millions of people and triggered a large-scale humanitarian crisis as vulnerable Ukrainians take shelter or flee their homes. The intensification of the conflict is deeply troubling and is having a devastating impact on those people caught in the crisis.
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April 2022
Companies with pricing power could be well placed to achieve results during times of inflation, says Christophe Braun
Global equities have done well in multiple inflationary environments. If inflation is organic, it may be consistent with the economy expanding. In such an environment, companies tend to benefit from economic growth and strong underlying fundamentals. Some inflation can be beneficial for companies. It allows them to raise prices and protect profitability in ways they may not have been able to do in recent years. It also helps banks and commodity-linked companies that struggle in a low inflation, low interest-rate world. Even during times of higher inflation in the US, stocks have generally provided solid returns as shown in the following chart.
Global equities have historically generated positive returns when US inflation is between 2-6%. In other words, not too little, not too much. Of course, raising interest rates at the right pace is equally important, as history has taught us. It’s mostly at the extremes — when inflation is above 6% or negative — that financial assets have tended to struggle. That said, sustained periods of elevated inflation are rare. The ultra-high inflation of the 1970s was a unique period, while deflationary pressures, such as during the Great Depression, have often been much more difficult to tame.
Many household and personal products companies have the ability to pass on higher costs to consumers due to their strong brands
Investment Director at Capital Group
Christophe Braun,
Pricing power helps companies mitigate inflation
Dividends are staging a comeback of global proportions
Not only are companies with pricing power well positioned to do better in a higher inflationary environment, they are also more likely to improve their capital allocation by expanding the return on equity (ROE) for shareholders and consequently improving dividend potential. While a lot of companies had to suspend, postpone or even cut dividends during the pandemic, many are now starting to shift back from dividend zeros to dividend heroes. Moreover, the recent volatility in growth stocks has brought dividend equities back into focus. Dividend-paying stocks have outpaced their growth counterparts by a substantial margin year-to-date, as fears of rising interest rates and worries about the pace of economic growth in the US and China have raised concerns over the elevated valuations of many previously high-flying growth stocks. We saw a similar market rotation in the first quarter of 2021, which fizzled out as growth stocks made a strong comeback. But this year the macroeconomic backdrop is different, with rising bond yields and higher inflation playing a key role. As market volatility increases due to monetary tightening, elevated levels of inflation and geopolitical tensions, dividend-income investment could play a more important role in the total return of a portfolio. Investors are likely to pay greater attention to dividend payers as companies reinstate or continue to raise their dividends, albeit at a gradual pace.
1 Average and standard deviation of gross margins calculated for the five-year period ended 30 September 2021. Reflects industries within MSCI World Index. Sources: Capital Group, FactSet, MSCI
With inflation currently more persistent than initially thought, it is likely that rising costs will linger in the months ahead, making it one of the biggest risks investors face in 2022. That’s why our investment professionals are increasingly focused on uncovering pricing power, as it allows companies to protect their profit margins by passing those cost increases to their customers or to simply raise prices to enhance profitability. High and stable margins can be an indication of pricing power, as illustrated by the following examples:
Many companies are now starting to shift back from dividend zeros to dividend heroes
Businesses that provide essential services, like health care giants Pfizer, UnitedHealth Group and Abbott Laboratories. The average gross margin in the pharma/biotech sector tends to be around 70% and is very stable with little fluctuation. Consumer businesses with strong brand recognition, like beverage makers Coca-Cola and Pepsi, or food and drink processing conglomerates Nestlé and Unilever. Many household and personal products companies have the ability to pass on higher costs to consumers due to their strong brands, robust pricing power and growing market share. Companies offering staple-like services such as Netflix, where a string of hits like Squid Game and seemingly insatiable viewer demand have enabled the streaming giant to raise subscription fees four times over the past 10 years. Companies in industries with favourable supply and demand dynamics. Semiconductor and chip makers like TSMC and ASML are experiencing huge demand with limited supply. TSMC’s pricing power was evident in August 2021 after it announced it would raise chip prices by as much as 20%. Businesses serving customers who are relatively insensitive to changes in price, like luxury goods companies LVMH and Kering.
• • • • •
2 As at 30 September 2021. Based on standard subscription price in the US. Source: Netflix
3 As at 23 October 2021. Source: Reuters
Average annual real returns at different inflation rates (1970-2021)
Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor’s. Data as at 30 November 2021. All returns are inflation-adjusted real returns in USD. Global equity returns represented by MSCI All Country World Index from 30 September 2011; previously MSCI World Index. Inflation rates are defined by rolling 12-month returns of the Ibbotson Associates SBBI US Inflation Index.
Past results are not a guarantee of future results.
-9.6%
9.1%
12.1%
10.4%
6.0%
-5.0%
Below 0%
0% - 2%
2% - 3%
3% - 4%
4% - 5%
6% or above
Rolling 12-month inflation rate
Global equity
2
3
Look for opportunities in high-yield corporates and US TIPS, says Flavio Carpenzano
High yield is a growth-sensitive asset class, which should continue to benefit from a still positive global growth backdrop. High-yield bonds have typically done particularly well during the recovery phase of the business cycle as default rates fall. They have also done well during the later stages until default rates start to rise again. The shorter duration of the high-yield bond market versus investment grade means it is less sensitive to the higher interest rates that often accompany strong GDP growth. The historical correlation of high-yield bonds with interest rates has been relatively low as high yield has tended to be driven more by credit risk than interest-rate risk. The US high-yield market continues to evolve. Today’s market is bigger, more diverse and has the highest average credit rating level since at least 2000. As a result of the pandemic, fallen angels have increased the percentage of BB-rated credits in the high-yield index; BBs now represent more than half the market, up from around a third 20 years ago. On the other hand, CCC-rated companies, which made up nearly a quarter of the market at the height of the global financial crisis in 2008–2009, now account for approximately 12%, the lowest level in almost two decades. However, there are headwinds. Geopolitical risk and tightening financial conditions by hawkish developed-market central banks may continue to weigh on high-yield credit spreads and cause volatility.
Emerging market (EM) local bonds are attractive, offering value after 2021’s aggressive rate hikes. EM reflation is more controlled than in the US and there is no stimulus hangover. EM central banks hiked decisively ahead of the US Federal Reserve (Fed), and fiscal policy is normalising. EM inflation may peak in 2022, especially since EM policymakers have a track record in managing cost pressures. In terms of EM hard currency bonds, we remain cautious on EM investment-grade sovereigns where valuations are stretched. EM high yield could be more attractive. We favour idiosyncratic issuers that have ample risk premia (e.g. Argentina, or sub-Saharan Africa) rather than a general indiscriminate carry approach. EM corporate credit, meanwhile, offers value. Fundamentals are healthy, and the sector provides carry and diversification. EM corporate bonds have been resilient year to date, benefitting from their shorter duration, higher yields and a higher concentration in Asia relative to the sovereign/quasi benchmarks. Asian corporate spreads are little changed year to date and have not been sensitive to global rates volatility. This echoes greater past resilience to rising rates than EM investment grade or US credit. For EM currencies, cheap valuations, attractive real interest rates and current account surpluses should provide support. Higher yielding EM currencies, in particular, should be generally stable against the US dollar this year. Overall, EM countries have some solid fundamentals, capital and policy buffers. This may help to counter the headwinds of aggressive Fed hikes, a synchronised developed market (DM) monetary tightening, China’s slowing growth and geopolitical risks (Russia/Ukraine).
We favour idiosyncratic issuers that have ample risk premia (e.g. Argentina, or sub-Saharan Africa) rather than a general indiscriminate carry approach
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice.
Investment Specialist at Capital Group
Flavio Carpenzano,
1. Favour asset classes such as high-yield corporates, which have tended to do well in higher inflationary environments
2. Diversify in countries with different inflation dynamics
3. US TIPS offer select opportunities as an inflation hedge, though valuations are less compelling after 2021’s strong rally
US Treasury Inflation-Protected Securities (TIPS) may offer some value focusing on shorter maturities. Front-end TIPS should continue to be supported by high realised Consumer Price Index (CPI) as carry matters more for front-end TIPS. In contrast, long-dated US TIPS have been mainly driven by changes in breakevens and inflation expectations. Given the US central bank’s hawkish pivot, we expect long-dated TIPS may underperform as the Fed increasingly focuses on keeping inflation under control. However, long-dated US TIPS can also be used as a hedge in a portfolio for an underweight in US duration, in case the Fed hikes less than the market expects.
1 Fallen angel: bond downgraded from investment grade to high yield. 2 Sources: Bloomberg, Capital Group
Inflation and rising interest rates present challenges for fixed income investors because they tend to lead to lower prices and falls in the real value of returns. With this in mind, the following are strategies that investors can consider to safeguard their portfolios over the coming months.
Secular trends
In addition, over the secular horizon, there are a few trends to highlight for fixed income: Bond yields will likely increase but should remain at relatively low levels We expect yields to remain low compared to previous cycles, as there are large secular disinflationary forces that have been entrenched for decades and it will likely take more than a temporary supply-demand imbalance to stop or even reverse these. There is still a lot of debt in the economy; inequality remains a big problem and it tends to be disinflationary because money that flows into the wealthiest hands tends to be money that is saved rather than consumed. Technology is another strong long-term trend that could bring inflation down. Demographics: a tailwind for bonds Ageing populations globally should continue to support the search for a stable and consistent income. Pensioners and people close to retirement prefer investing in higher income bonds, such as high-yield corporates or emerging markets debt, which can provide a stable income. China can be expected to play a bigger role in the economy and in the fixed income markets China’s transition into a new growth model based on quality and internal demand through the creation of a larger middle class, the so-called “common prosperity”, may slow the economy in the short term but will likely be positive in the long term as it would create a more sustainable economy. China’s bond market is a big and growing part of global indices. Bonds will remain important for diversification Bonds will continue to provide diversification from equity, as well as capital preservation, income and inflation protection depending on the type of bond.
CCC-rated companies made up around a quarter of the US high-yield market at the height of the global financial crisis
They now account for just 12%, the lowest level in almost two decades
c.25%
12%
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The need for continued public spending is augmenting the impact of supply and demand imbalances, says Flavio Carpenzano
UK inflation could reach 10% this year, and underlying wage growth of 4-4.5% is too high for the Bank of England (BoE), forcing more aggressive policy tightening in 2022. The BoE appears less convinced that the current surge in inflation will be temporary, and there are rising concerns that higher headline inflation rates could push up expectations, shifting economies into a higher inflation regime. Aside from higher energy prices, the following are the main factors influencing the level of inflation in the UK.
Since the start of the pandemic, mobility restrictions have severely depressed private demand, with significant contractions in household consumption and business investment. Yet substantial fiscal support from the government has insulated households, as well as corporate incomes and balance sheets, from negative shocks. In aggregate, the household sector has experienced a sharp increase in its saving ratio and has run a financial surplus. As the economy re-opens, households should start to run down their saving rates to more normal levels, which is likely to be a powerful stimulant to consumption. However, as demand collapsed in 2020, the economy sustained a sharp fall in its estimated potential supply. The pandemic was a substantial contributor to this drop in supply potential, and it’s likely that Brexit further aggravated the situation.
UK inflation could reach 10% this year, and underlying wage growth of 4-4.5% is too high for the Bank of England, forcing more aggressive policy tightening in 2022
Forecasts shown for illustrative purposes only. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice.
Demand/supply imbalances
The BoE cut its forecasts for real GDP growth in 2022 and 2023, but further revised up its inflation projections. Headline Consumer Price Index (CPI) inflation is now expected to peak at a figure “several percentage points” higher than the 7.25% that had been previously forecast. While inflation has been expected to drop back near to its 2% target by late-2023, the BoE is worried about near-term upside risks. As a result, it has turned more hawkish, and its projections imply a need for further monetary tightening. Following a surprise rate hike in December, the BoE raised rates by a further 25 basis points (bps) in February, and again in March, this time by a majority vote of eight to one.
Increasing wage pressures
In contrast to Europe, wage pressures are high in the UK. Labour shortages, partly due to the impact of Brexit, have boosted wages, increasing the risk of a more sustained increase in inflation. The labour supply dropped sharply below trend in 2020 and many workers who lost their jobs during the pandemic have opted to leave the labour market (and the UK) which has further reduced the labour supply.
In February, Andrew Bailey, the BoE Governor, acknowledged deep uncertainty around inflation projections. Underlying wage growth is already running at around 4%, which is inconsistent with the BoE’s inflation target at 2%, and there is intensifying pressure on pay/wages given labour-market tightness. Companies expect to increase pay substantially this year and intend to pass these higher labour costs on to their customers.
The need to maintain public spending
In 2020, the UK recorded its largest primary budget deficit since the late-1940s, largely as a result of massive emergency fiscal support provided during the pandemic. While the budget deficit has been reduced as the economy re-opened and emergency support measures withdrawn, we expect the UK government will likely continue to run structurally looser fiscal policy in the medium term. Higher levels of public spending in health and other public services (such as education) will be needed to help these sectors recover from the pandemic. The need for higher spending coupled with limited room to raise taxes implies the UK’s structural budget deficit is likely to persist and the debt ratio will remain close to recent highs. Unlike in prior decades, with interest rates effectively at zero and no windfall from oil revenues, there are no obvious policy actions that could compensate for tighter fiscal policy to tackle the budget deficit. For this reason, we expect the UK faces a protracted period of structurally looser fiscal policy as the economy adjusts to the pandemic and Brexit shocks. This means there will be increasing pressure on the BoE to accommodate larger budget deficits and higher government debt by maintaining ultra-loose monetary policy. Inevitably, this implies the BoE will be more tolerant of an inflation overshoot and there is the risk the UK is set to move into a higher inflation regime in the medium term.
1 Source: Financial Times, 23 March 2022 2 Source: Office of National Statistics for period September – November 2021
While inflation has been expected to drop back near to its 2% target by late-2023, the BoE is worried about near-term upside risks
Sources: HMRC, ONS and Bank calculations
Underlying pay
Furlough effects
Compositional effects
Underlying pay growth is somewhat above pre-pandemic rates at around 4% to 4.5%...
Contributions to private sector regular pay growth
Economically active working-age population
Source: Office for National Statistcs
Private sector regular pay growth (per cent)
Actual less trend, as % of trend
Dividends are making a comeback. In this article, Hilda Applbaum, Alfonso Barroso and Marc Nabi highlight four emerging trends
The recent volatility in growth stocks has brought dividend equities back into focus. Dividend-paying stocks have outpaced their growth counterparts by a substantial margin for the year-to-date, as fears of rising interest rates and worries about the pace of economic growth in the United States and China have raised concerns over the elevated valuations of many previously high-flying growth stocks. We saw a similar market rotation in the first quarter of 2021, which fizzled out as growth stocks made a strong comeback. But this year the macro-economic backdrop is different. Inflation is at a multi-decade high, and the US Federal Reserve (Fed) plans to raise interest rates and wind down its quantitative easing programme. Earnings reports from some of the larger growth companies, like Netflix and Meta, have disappointed versus expectations. And the value of the more distant cash flows of growth companies makes them more vulnerable to a rise in interest rates.
Amid rising bond yields and higher inflation, the market rotation into dividend stocks may still be in the early stages. Along those lines, dividend-income investment could well play a more important role in the total return of a portfolio. Against this backdrop, we explore four emerging trends in the dividend universe.
Dividend-paying stocks have outpaced their growth counterparts by a substantial margin for the year-to-date
CONTRIBUTORS
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein.
Dividend stocks have rebounded
2. Dividends are making a comeback, but at a measured pace
We expect a steady increase in global dividends, but at a measured pace. Many companies are taking a more deliberate approach after their experience in the depths of the COVID-19 pandemic, when they were forced to substantially cut or eliminate their payouts. Now, amid a deceleration in global economic growth, some companies want to preserve cash in case of a greater-than-expected downturn. Some industries, such as travel, continue to face a high level of uncertainty. Boeing, one of the world’s largest makers of airplanes, and cruise line operator Carnival are still struggling with depressed travel and have not resumed dividend payouts. Overall, however, dividends continue to recover. Of the 242 companies that either suspended or cut their dividend in 2020, 98 have reinstated payments and only three companies cut their dividend in 2021, according to Wolfe Research data as of 15 February. Companies with pricing power are likely to be better positioned to increase dividends. Household products giant Procter & Gamble, for example, has already raised prices across some of its product lines to help hedge itself against inflation. Consumer staples makers are often hurt when inflation begins to move higher and input costs go up. However, after a period of three to six months, these companies often seek to reprice contracts with retailers and grocers. This ultimately puts them in a better position to recoup those raw material costs, grow their earnings and potentially increase their dividend at a commensurate rate. Dividend acceleration is also anticipated in Europe, where governments have eased pressures on dividend payments. During the pandemic, governments and regulators had pressed some companies to refrain from making payments as part of a social solidarity movement.
1. Positive correlation between dividend yields and bond yields
For most of the past 30 years, the relative returns of high dividend-yielding stocks and changes in US Treasury yields had a negative relationship. That relationship reversed in the past two years and high-yielding stocks have exhibited a positive correlation to bond yields. If this trend continues, a rise in interest rates may not dampen prospects of dividend stocks as they have in the past. Partly, it’s because interest rates are rising, but from a very low base. Even as the Fed begins to raise policy rates, our fixed income rates team expects the 10-year Treasury yield to remain within a range of 2% to 3%, with a further flattening of the yield curve led by a rise in short-term rates. Against this backdrop, dividend-paying stocks provide a combination of income and potential for capital appreciation, especially since the valuations of many of these companies appear reasonable following a long bull market for growth stocks. That said, it’s important to identify companies with heavy debt loads or excessive leverage on their balance sheets in a rising rate environment.
3. Highly cyclical firms take innovative approach with variable dividends
Some companies, especially those in cyclical industries, are adopting innovative approaches to balance their business needs and a commitment to dividend payouts. Take the mining sector, which in 2021 witnessed a boom in dividend payouts. Over the past few years, many large mining companies, such as Rio Tinto and Vale, have switched from progressive dividend policies to a payout ratio. In these arrangements, dividend payouts are determined by a formula tied to certain operating metrics. This shift results in a variable dividend yield over time. But it also gives these companies an enhanced ability to manage their balance sheet and cash flows in a sustainable manner through multiple commodities cycles. In the past, miners often struggled to maintain a regular dividend during market downturns and would either cut the dividend or be forced to raise debt to cover the payout. Exploration and production (E&P) companies are also pivoting their dividend strategies. Historically, E&P companies have not been dividend payers, choosing instead to reinvest in the business to pursue more growth in production. But growth backfired at times when fluctuating energy prices hurt investment returns on projects and led to financial troubles. This is starting to change as firms have become more disciplined. Companies have begun to initiate a regular dividend at a low base, supplementing them with variable or special dividends depending on commodities prices and the strength of cash flows. For instance, Pioneer Natural Resources last November declared a quarterly cash variable dividend of US$3.02 per share, representing approximately US$740 million of capital returned to shareholders. EOG Resources has increased its dividend over the past five years and announced a special dividend last July. Companies hope this newer approach can lead investors to adopt a more benign valuation framework in which to view them and thus avoid excessive stock price volatility.
Portfolio Manager at Capital Group
Hilda Applbaum,
EQUITIES
Our fixed income rates team expects the 10-year Treasury yield to remain within a range of 2% to 3%, with a further flattening of the yield curve led by a rise in short-term rates
Sources: Capital Group, MSCI, Datastream. Data as of December 31, 2021. Yield factors are constructed by ranking dividend yields within a region and then breaking them into terciles, rebalanced monthly. The return reflects the average return of the high-yielding cohort minus the average return of the low-yielding cohort. Returns are market cap weighted. The change in the 10-year Treasury is measured as the monthly basis points change in the 10-year Treasury yield. The correlation is calculated over 24 months and rolled forward on a monthly basis.
Historical relationship between bond and dividend yields has turned positive
Rolling correlations of yield factor with change in U.S. 10-year Treasury yields
Source: Bloomberg. Data as of February 15, 2022, and based on style factor strategies created by Bloomberg. Factor investing is an investment approach that involves targeting specific drivers of return across asset classes (including macroeconomic, fundamental and other statistical measures for building a strategy).
Gérant de Portefeuille at Capital Group
Alfonso Barroso,
Marc Nabi,
Bloomberg U.S. style factor returns – year to date (%)
Past results are not a guarantee of future results. Forecasts shown for illustrative purposes only.
Sources: Capital Group, FactSet, MSCI, RIMES. Data for 2022–2024 are estimates by FactSet as of February 2, 2022.
Dividends per share (MSCI ACWI)
Global dividends are projected to rise
In the past, miners often struggled to maintain a regular dividend during market downturns and would either cut the dividend or be forced to raise debt to cover the payout
Boeing, one of the world’s largest makers of airplanes, and cruise line operator Carnival are still struggling with depressed travel and have not resumed dividend payouts
4. Financials, energy and health care are areas of dividend opportunity
Financials, energy and health care represent a substantial chunk of the dividend-paying universe, and a confluence of factors appear to support the case of rising dividends from each of these areas. Financials Rising rates should help the more rate-sensitive banks in the US and Europe expand their net interest margins, which have been suppressed for many years by persistently low interest rates. This could potentially result in stronger earnings, improved dividend streams and higher valuation multiples. Banks have been building up excess capital on their balance sheets since the Great Financial Crisis and most are now well-capitalised, having undergone a number of regulatory stress tests. And some banks in the US and Europe are poised to redeploy surplus capital in the form of regular and catch-up dividends after facing regulatory limitations during the pandemic. For example, Dutch banking giant ING has committed to a minimum 50% dividend payout ratio (the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage) of earnings. CaixaBank, one of Spain’s largest banks, stated it would boost its payout ratio to as much as 60% from 50% previously. It’s possible that other European banks could follow a similar course of action as regulatory pressures ease, making this sector a potential source of more consistent dividend income. Energy Large integrated oil companies have long been good sources of consistent dividends for income-oriented investors. They’ve also become more disciplined on supply, having curtailed investment in existing reserves and pursuing new sources of oil. US oil giants Chevron and Exxon Mobil have demonstrated a steadfast commitment to paying dividends despite some dramatic swings in the price of oil over the past decade. Chevron recently increased its dividend for a 35th consecutive year. But dividend policies have diverged in the oil sector and calibrating the dividend streams of oil companies has become more challenging. Over the past couple of years, European oil majors BP and Royal Dutch Shell have cut their dividends amid their transition to investing in renewable energies that are capital intensive and where the return on invested capital is still uncertain. Having reset their dividends to lower payout ratios, the European oil majors have left sufficient room to increase dividends over time.
Health care Health care companies could be a potential source of both earnings and dividend growth in the current inflationary environment. Pharmaceutical companies historically have exhibited relatively strong pricing power. While the industry has faced political pressures on drug prices, the more innovative pharmaceutical companies will likely be positioned to raise prices at modest levels. Like the energy companies, the major pharmaceutical companies recognise that a sizeable portion of their value proposition with the investor base is the dividend payout. That, combined with the potentially robust pipeline over the next few years at several major pharmaceutical companies across all geographies, gives us confidence that this could be another area that may be considered a well-diversified source of equity income.
US oil giants Chevron and Exxon Mobil have demonstrated a steadfast commitment to paying dividends despite some dramatic swings in the price of oil over the past decade
Sources: MSCI, RIMES. Data as of January 31, 2022.
MSCI ACWI
Dividend payout ratio (%) >
Commodity companies offer some of the highest yields
Bottom line
Over the past decade, many growth companies have been rewarded in an environment of modest global economic growth, very little inflation and ultra-low interest rates. We appear to be in the beginning stages of an equity market that is starting to show some breadth after a heavy focus placed on the technology-related growth stocks, especially those in the United States. As market volatility increases due to monetary tightening and elevated levels of inflation, dividend-income investment could play a more important role in the total return of a portfolio. Investors are likely to pay greater attention to dividend payers as companies reinstate or continue to raise their dividends, albeit at a gradual pace. Furthermore, long-term investors have an opportunity to get in at the ground level amid this changing landscape; many companies currently trade at attractive valuations that may not be fully reflecting their upside potential as economies continue to normalise.
Share buybacks
15.0
9.7
9.1
7.3
2.6
Growth
Dividends
Leverage
Value
< Dividend yield (%)
May 2022
Commodity prices are set to remain elevated yet the mining sector continues to be undervalued, say Lisa Thompson, Douglas Upton and Stephen Green
For a glimpse of just how volatile commodities currently are, look at nickel markets. Prices doubled in early March. Then they plunged. Then the London Metals Exchange halted trading. This week, the market for nickel — a key component in electric vehicle batteries and stainless steel products — reopened but with strict trading limits. It’s just one example of how the global economy is being disrupted by Russia’s invasion of Ukraine. Russia provides about 20% of the world’s nickel supply. The threat of losing it roiled trading markets and sent buyers scrambling for other sources.
Commodity prices have climbed sharply since the 24 February invasion, especially for materials produced in Russia and Ukraine. That includes wheat, oil and natural gas, as well as other key metals such as aluminium, palladium and copper. But prices were rising long before the start of the conflict, contributing to inflationary pressures not seen since the early 1980s. So, the crucial question for investors is: Are these price spikes sustainable? “In the short term, the answer is no,” says portfolio manager Lisa Thompson, “The market has overreacted, and we’re already seeing prices come back down a bit. But, compared to where we were a year ago, commodity prices are significantly higher — and I do think that’s a durable trend.” “Over the long term,” Thompson adds, “prices are likely to remain elevated due to a number of factors, including rising demand, supply shortages and deglobalisation forces symbolised by the war in Ukraine and strained US-China relations. Higher prices should be expected in a world where free and open trade is in retreat.”
Russia provides about 20% of the world’s nickel supply. The threat of losing it roiled trading markets and sent buyers scrambling for other sources
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein.
In addition to underinvestment, another factor that could lead to higher commodity prices over the long term is the worldwide push for sustainable energy sources, Upton adds. Electricity, in particular, has become a favoured resource. The expansion of the power grid — along with the rapid adoption of electric vehicles — will require lots of copper, nickel and other key metals.
Metals industry poised to shine
From an investment perspective, this has clear implications for the metals and mining sector. It has been a neglected area of the market for more than a decade — even longer if you exclude the last major price spike during the 2008 global financial crisis. The sector has been undervalued for years and remains so today despite a recent rally in mining company stocks, says Douglas Upton, a Capital Group equity analyst who has covered commodity markets for more than 30 years. Upton thinks many commodity prices will remain high for years due to chronic underinvestment by the industry since 2015. The problem is exacerbated by the fact that it takes more time than it did in the past to launch new mining projects. “It’s a multiyear process,” Upton explains. “Discovery, permitting and funding all take much longer. In price terms, that points to higher highs and lower lows until new investments start to produce results.” This dynamic doesn’t apply to food and other crops, Upton notes, because production in those areas can be ramped up much faster. “All of the big mining companies are undervalued in my view,” he says. “The market is not thinking enough about the consequences of the underinvestment theme. Valuations, and consensus earnings estimates, assume that commodity prices will decline over the next few years, closer to historical averages. I think that is quite wrong.” Case in point: Look at the market capitalisation of the world’s seven largest mining companies. Even combined, they do not come close to the market value of a new-economy company such as Tesla. The automaker needs certain refined metals, including nickel, to produce its lithium-ion batters. So much so that Tesla CEO Elon Musk cited access to nickel as one of his biggest production concerns long before Russia invaded Ukraine.
China: A counterbalance to rising prices?
On the flip side, China’s slowing economy could act as a counterbalance to keep commodity prices in check. As the largest importer of raw materials, China consumes more than half the world’s iron ore, coal and copper supplies. China’s close trading relationship with the European Union could also expose it to a wartime recession in Europe if the Ukraine war drags on. Moreover, China is dealing with a COVID-19 resurgence that could further hamper the economy as the government renews restrictions on travel and entertainment. “Even before the latest COVID outbreak, China’s economy was decelerating or at least stabilising at a very low rate of growth,” says Stephen Green, a Capital Group economist who covers Asia. “Things are likely to get worse before they get better, and a sufficiently bad recession could cause commodity prices to fall.” China’s central bank will probably cut interest rates soon, Green notes, while most other central banks around the world are moving in the opposite direction.
asset allocation
Even combined, the world’s seven largest mining companies do not come close to the market value of a new-economy company such as Tesla
Source: RIMES. As at 16 March 2022. Mining companies represented (from largest to smallest) include BHP, Rio Tinto, Vale, Glencore, Freeport, Anglo American and Newmont.
Mining companies toil in obscurity despite key role in global economy
Market capitalisation of the world's 7 largest companies vs. Tesla (USD)
Commodity prices skyrocketed amid the Russia-Ukraine conflict
Sources: Capital Group, London Metal Exchange, Refinitiv Datastream, US Department of Agriculture. As at March 16, 2021.
YTD change across select commodities exposed to Russia (%)
Equity Portfolio Manager at Capital Group
Lisa Thompson,
Equity Investment Analyst at Capital Group
Douglas Upton,
Economist at Capital Group
Stephen Green,
Investment implications: Inflation hedge
Regardless of where markets go from here, the current price surge confirms, once again, that commodities are an effective hedge against inflation. That’s not surprising since those very commodities — oil and gas, for instance — feed into many aspects of the global economy and can help to fuel higher inflation, which is currently running at a 40-year high. Historically speaking, energy — especially oil — has moved closely in line with inflation, as measured by the US Consumer Price Index. Since oil is usually a major component of commodity-related indexes, the long-term correlation between commodity prices and inflation is high.
Sources: Capital Group, Bureau of Labor Statistics, Refinitiv Datastream, Standard & Poor's, US Department of Labor. Data shown from 1/31/89 to 2/28/22.
Commodity index returns vs. inflation (y/y %)
No surprise: Commodities are an excellent hedge against inflation
However, it’s also important to note that there are big differences between major categories of commodities. Oil and gas, metals, food and agricultural products often follow their own cycles. Investors seeking an inflation hedge should keep that in mind, says Capital Group economist Jared Franz. “It all depends on the source of the inflation,” he notes. “Unsurprisingly, the energy sector tends to do well when inflation is rising because energy price increases, especially for gasoline, can be quickly passed on to consumers,” Franz says. “That’s not always the case with other commodities, where price increases can be absorbed as they move through the production chain.”
7 MINING COMPANIES COMBINED
$648bn
TESLA
$844bn
Central banks around the world have committed to interest rate hikes, but they won’t be able to go too far before the real economy starts hurting, according to David Hoag, Darrell Spence and Diana Wagner
With interest rates trending downward for more than 40 years, investors enjoyed a powerful tailwind driving one of the greatest bull markets in history. But what happens when rates suddenly start moving up as inflation soars to levels not seen since the 1980s? We’re about to find out. Now that the US Federal Reserve (Fed) and many other central banks around the world have committed to hiking rates and cutting stimulus measures, investors face an important question: Is the era of easy money coming to an end? As usual in the financial markets, the answer isn’t a simple yes or no. “It's probably the end of free money, but I don't think it's the end of easy money,” says David Hoag, a keen Fed watcher and portfolio manager. “Central banks will do what they need to do to get inflation under control, but I don’t think they will be able to go too far before the real economy starts hurting.”
Over the past 14 years, the Fed has taken the previously unprecedented step of slashing its key policy rate to near zero — first as a reaction to the 2007–2009 global financial crisis and then to help support the US economy during the COVID-19 crisis. Massive bond-buying stimulus programmes also served to keep longer-term interest rates artificially low. “You can’t keep money at zero interest rates forever,” says Capital Group economist Darrell Spence. “We are seeing the end of this current period of zero rates and balance sheet expansion, but I’m not convinced that we won’t be back here again.”
“It's probably the end of free money, but I don't think it's the end of easy money”
Pushing the “easy button”
The Fed, European Central Bank (ECB) and other central banks have found the “easy button” when it comes to addressing periods of severe financial crisis, Spence explains, and it would be naïve to think they won’t use it when the next crisis comes along. “I’m sure history will look back at this period and find many reasons to argue that it was a bad idea,” he adds. “But, in the moment, it’s difficult to say what else we could have done or what we might do differently in the future. When you let the genie out of the bottle on this type of monetary policy, it’s hard to put it back in.” In the meantime, investors should brace for further volatility as high inflation, tighter monetary policy and the war in Ukraine continue to disrupt markets. Recession risk is higher in Europe, Spence says, because of its closer proximity to the war and dependence on Russian energy, but the US economy is also slowing under the weight of broken supply chains and higher consumer prices. Spence doesn’t think a US recession is imminent, but he puts the chance of an economic downturn at 25% to 30% by 2023, particularly if the Fed follows through with a full complement of rate hikes between now and then. What, then, does an environment of low growth and rising rates mean for investing?
The Fed, for instance, isn’t likely to raise the federal funds target rate to anywhere near the long-term historical average of just under 5.0%, Hoag notes. The Fed’s key policy rate — which guides overnight lending among US banks and influences many other forms of borrowing — currently sits in a range between 0.25% and 0.50% following the rate hike in March. Hoag thinks the Fed will stop hiking somewhere around 2.0%. “That’s a significant increase from where we are today,” he acknowledges, “but it’s still very low on a historical basis. Anything higher than that, in my view, risks pushing the US into a recession.” At the moment, market expectations are higher, thanks to recent hawkish comments from Fed officials. The futures market is pricing in a rate of 3.0% by March 2023, including a 50-basis-point hike at the Fed’s next two-day meeting beginning 3 May.
Consider building an “all-weather” portfolio
Despite investor fears of tighter monetary policy, US stocks and bonds have powered through previous periods of rising interest rates. During 10 such periods since 1964, the S&P 500 has posted an average return of 7.7%. Bonds have also held up well, with the Bloomberg Barclays US Aggregate Index returning an average of 3.9% during seven rate-hiking cycles dating back to 1983. The initial adjustment period can be tough, as we saw in the first quarter of this year, with the S&P 500 down 4.6%. Bonds suffered their worst quarter in 20 years, with a 5.9% decline. But over longer time periods, markets have tended to adjust, and bond investors in particular have benefited from the opportunity to reinvest at higher yields.
interest rates
“When you let the genie out of the bottle on this type of monetary policy, it’s hard to put it back in”
Sources: Capital Group, Chicago Mercantile Exchange. As at 14 April, 2022. Federal funds target path based on probability analysis of fed fund futures contract prices as calculated by the Chicago Mercantile Exchange.
Fed rate hike expectations have risen dramatically
Federal funds target path based on futures market pricing
Free fall: Interest rates have plummeted in the era of easy money
Sources: Federal Reserve, Refinitiv Datastream. As at 4 November 2022.
Fixed Income Portfolio Manager at Capital Group
David Hoag,
Darrell Spence,
Diana Wagner,
10-year U.S. Treasury yields
US stocks generally have done well during past rising rate periods
S&P 500 index returns in rising interest rate environments
Sources: Capital Group, Refinitiv Datastream, Standard & Poor's, US Federal Reserve. S&P 500 returns represent annualised total returns.
Of course, this data comes with the usual caveat that past results are not predictive of future returns. And, in fact, we’ve never experienced a period where central banks are unwinding massive balance sheets — much larger than they were following the global financial crisis — while raising interest rates from zero (or even negative territory in the case of the ECB). A lot can go wrong. Such uncertainty makes building an “all-weather” portfolio all the more important, says portfolio manager Diana Wagner. For active investors, the key to navigating difficult periods is finding attractively valued companies that can generate earnings and profit growth regardless of the economic environment, she explains. “In this environment, there's going to be less tolerance for business models that can’t demonstrate a path to profitability in some reasonable time frame. That’s in contrast to last year when unprofitable tech companies rallied. That doesn’t mean tech stocks can’t do well. In fact, the information technology sector has generated solid returns during the last four periods of rising rates. But it’s important to be selective.”
Rate hike reference periods include February 1994–February 1995, June 1999–May 2000, June 2004–June 2006, and December 2015–December 2018. Average return calculations are based on annualised total returns. Sources: Capital Group, Refinitiv Datastream, S&P 500
Which sectors have performed best when interest rates rise?
Average S&P 500 sector returns across prior four rate hiking cycles
Wagner cites Microsoft, UnitedHealth and Marsh & McLennan as examples that have exhibited “all-weather” capabilities in the past. “In a market where growth may be scarce,” she adds, “I prefer companies that have a demonstrated track record of making their own growth happen — companies with high return on equity, low commodity input costs and strong pricing power.” Moreover, valuations are paramount. “I think the era of not paying attention to valuations is gone,” Wagner says.
Darrell Spence, Economist at Capital Group
David Hoag, Fixed Income Portfolio Manager at Capital Group
Interest rate tightening is likely to continue well into 2023, while predictions for earnings growth are too optimistic, say Robert Lind and Darrell Spence
Darrell: There were some significant base effects that rolled off in the US during April, so peak inflation is likely to occur in the US in the next couple of months. The real issue is not about when peak inflation is coming but how fast and far it is going to fall once we get past the peak, because that is going to be the key driver of the Federal Reserve’s (the Fed) policy. There are many things occurring under the surface, whether it is rental inflation (starting to pick up) or medical care inflation (starting to turn the corner). It is no longer just about new or used car prices, the effects of inflation have become broader and even in categories where prices do not tend to change quickly. So even though I expect US inflation to peak in the next month or two, I think the decline is going to be slower than what the Fed would wish it to be. In terms of monetary response, markets are pricing in about 250bps of interest rate hikes in 2022, which would propel the Fed fund rate to a little over 2.5%. There is not a lot to disagree with there. Where I do deviate from the consensus is our expectations for 2023. The market is not pricing a great deal of further tightening in 2023 and expects the Fed fund rate to peak at 2.5% to 3%. That is not that high considering the inflation issues we are dealing with right now. I think the Fed might have to do more and for a longer period if they are truly intent on bringing inflation back down to 2%. It is rather unfortunate that lowering interest rates and reducing the balance sheet are blunt tools for controlling inflation, but they are also the only tools we have. It is a question of how hard the central bank must push down on the economy for them to eventually be effective. One of the reasons why the US entered recession following past periods of Fed tightening is because of that lag. The Fed keeps raising rates and it doesn’t seem to have a material impact. But when the impact finally hits, the Fed then realises it has gone too far. I feel the Fed is keenly aware of the effects of those lags and are therefore hesitant to act too quickly.
Robert: I did not expect inflation in Europe to be quite so high. Even though we are starting to see wholesale prices for electricity as well as oil and gas stabilise, higher energy prices are still going to be feeding through to consumer prices over the next six months or so. As a result, I expect the maximum impact of energy prices on household bills to hit in the autumn, which is later than the US. The hostage to fortune, however, is whether we could see an EU embargo on Russian energy, which would obviously push prices up further and result in an even more delayed peak. Similar to Darrell, I think investors need to consider to what extent inflation is going to fall back after the peak. There is an increasing sense that inflation in Europe could be significantly higher for longer and that will be challenging for the likes of Bank of England (BoE) and the European Central Bank (ECB). Despite all the hawkish comments from policymakers over the last few months, there is still a reluctance to act too aggressively. But we are starting to see inflation eroding real incomes in the UK (biggest fall in real incomes in around 70 years) and across many other European countries. This big squeeze on real incomes suggests the central banks would have to do more in terms of monetary tightening. The BoE probably needs to raise interest rates another two to three times this year while the ECB would also need to wind up its asset purchases and start raising interest rates for the first time in 2022.
There is an increasing sense that inflation in Europe could be significantly higher for longer
Forecasts shown for illustrative purposes only. Past results are not a guarantee of future results. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice.
When is inflation likely to peak in Europe and the US? What sort of monetary response could we expect?
What is the impact of inflation on corporate earnings and stock valuations? Should investors be concerned?
Darrell: The silver lining to inflation is that it can actually boost corporate earnings, in particular companies within the S&P500. We have seen earnings pick up enormously coming out of the COVID-19 recession for consumers as well as corporate facing companies, which have been backed by strong pricing power. Despite that silver lining, inflation does eventually elicit a policy response (monetary tightening) that puts downward pressure on growth. This is the scenario we are facing now. However, one myth that I would like to dispel is the notion that monetary tightening is always bad for markets. Using the S&P500 as an example, that is not true and there is no consistent pattern to the movement of the index during the initial 12 to 18 months of a Fed tightening cycle. That said, stock valuations almost always contract when monetary policy is tightening. So what happens to the market is going to be dependent on how the tug of war between earnings growth and lower valuations plays out. The current market consensus for the S&P500 is about 10% earnings growth for 2022 and another 10% growth for 2023, which works out to an average price-to-earnings ratio of around 17x on 2023 earnings. That is slightly above the historical average but not that stretched considering where interest rates are. Of course, there is always the risk that if rates go up significantly from here, there will be further downward pressure of valuations. But where I am disagreeing more is less on the level of interest rates but on the potential earnings growth that we are likely to get. My feeling is that 10% earnings growth for 2022 and 2023 is perhaps too optimistic. I believe the only way for the Fed to bring inflation down to their target in a reasonable timeframe is to create slack in the labour market, which is to push the unemployment rate up. That is basically the definition of a recession. And you know what earnings do in a recession? They tend to go down.
One myth that I would like to dispel is the notion that monetary tightening is always bad for markets
Robert Lind, Chief European Economist at Capital Group
June 2022
North American railroads and US ‘dollar’ stores are two sectors that are well positioned for the current inflationary environment, say Jonathan Knowles, Andrew Suzman and Diana Wagner
Fast-growing digital and tech companies generated a lot of investor excitement over the past decade, not to mention an outsized share of market returns. Since the start of 2022, however, many of these market darlings have taken a beating. Amid slowing economic growth, soaring inflation and the fear of rising interest rates, investors may be taking a second look at the high valuations many digital platform and software stocks command. “This is one of the most complex environments for investing we have seen in years,” says equity portfolio manager Jonathan Knowles. “With questions lingering over the persistence of inflation and shifts in the geopolitical landscape, I am looking to invest in an ‘all weather portfolio’ with the potential to withstand a variety of potential risks.” That’s why boring is beautiful according to Knowles. “I'm looking to invest in dull and dependable companies with the potential to generate solid cash flows and continue growing regardless of the direction of the economic cycle or macroeconomic developments.” Here are some investment themes that cautious investors may want to consider.
Long-term shifts toward a digital future, the rollout of electric vehicles and the transition to clean energy will likely continue to drive opportunity for innovators in those areas. But these trends are also providing tailwinds for old industries like mining and rail transportation. Nickel, for example, is a key component in electric vehicle batteries. So is copper, which is necessary for updating the electric grid. And while software is becoming an increasingly essential player in the production of modern cars, steel remains a required component. Indeed, prices for select commodities have skyrocketed in recent months, a trend amplified by the war between Russia and Ukraine — major producers of nickel, copper and grains. “People have underappreciated how much copper is needed to rewire and modernise the electric grid as demand rises,” says equity portfolio manager Andrew Suzman. “Businesses like Canadian metals and mining company First Quantum Minerals, which focuses on copper, and Brazil’s Vale, a producer of iron ore, could benefit.” Rising demand for commodities and energy could also boost demand for North America’s railroads, which are the most cost-effective way to transport heavy materials. Railroads have pricing power potential as well, which is important in today’s inflationary environment. They typically base their pricing on the cost of the underlying commodities they are hauling, so revenues rise with commodity prices. Rising fuel costs also prove beneficial, as the difference between the cost of road and rail transportation is at its widest gap in years. “A railroad like Canadian Pacific, which has the only tri-coastal Canada-US-Mexico network, could do well under a variety of economic circumstances,” Suzman adds.
People have underappreciated how much copper is needed to rewire and modernise the electric grid as demand rises
Past results are not a guarantee of future results. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein.
Jonathan Knowles,
North American railroads are riding a commodities boom
Bargain hunters find treasure at US ‘dollar’ stores
When economic conditions become challenging, consumers may naturally become more careful about spending. Many shoppers shift their spending to discount merchants known as treasure hunt retailers. These stores offer clothing, personal care items and household products at relatively low prices, as well as some higher quality products at bargain prices. “In a slowing economic environment, many people will be trading down to dollar stores,” says portfolio manager Diana Wagner. “Such stores have held up well in past recessions.”
In a slowing economic environment, many people will be trading down to dollar stores
Andrew Suzman,
Andrew Suzman, Equity Portfolio Manager at Capital Group
Diana Wagner, Equity Portfolio Manager at Capital Group
Source: Capital Group, Association of American Railroads, US Bureau of Transportation. Data shown from January 1990 through December 2018. The rail category refers to Class 1 rail, or carriers earning more than US$505 million in annual revenue. Pricing per ton-mile refers to the pricing charged for transporting one ton of freight across one mile.
Average pricing per ton-mile
US railroads have room to increase pricing amid a commodities boom
Average relative return vs. S&P 500 during three recent recessions
Treasure hunt retailers have outpaced the market in recessions
Source: Capital Group, National Bureau of Economic Research, Refinitiv Datastream, Standard & Poor’s. Reference periods for recessions are March 2001 to October 2001, December 2007 to May 2009, and February 2020 to March 2020. Consumer discretionary category refers to the S&P 500 Consumer Discretionary Index.
What might be less intuitive is that well-run treasure hunt retailers often have pricing power potential when inflation is rising. For example, Dollar Tree, which offers a wide variety of items for US$1, recently launched its “breaking the buck” strategy. The company initially offered a US$5 category of goods, followed by a category for US$1.25. “This same approach has helped other treasure hunt retailers generate multiple years of strong same-store sales growth and margin expansion,” Wagner says. A change in senior management at the company could prove to be another tailwind. “Dollar Tree has been undermanaged relative to its competitor Dollar General,” Wagner observes. “But recently Rick Dreiling, the former CEO of Dollar General, was named chairman of Dollar Tree. I think this could be an important turning point for the company. “In today’s environment, I look for companies that can improve their businesses and make their own growth happen regardless of what the economy does,” Wagner explains. “Dollar Tree could be one of those self-help stories.”
Jonathan Knowles, Equity Portfolio Manager at Capital Group
I am shifting my focus towards companies that actually make stuff and tend to hold their ground during all types of markets
The bottom line
Investors may be wondering if the digital transformation has run its course. “Not at all,” Knowles says. “Leading digital platform companies, cloud software and autonomous vehicle technology continue to reshape the way we work, live and shop. But many of these companies may have gotten ahead of themselves.” With inflation rising and the earnings potential for many of these companies still years away, valuations may be extended. “Leading technology companies continue to look promising over the long term,” Knowles says. “But in this environment, I am shifting my focus towards companies that actually make stuff and tend to hold their ground during all types of markets.”
A number of trends suggest that cautious optimism may be merited, says Harry Phinney
The Russia-Ukraine conflict, a spike in commodity prices and rising global inflation have raised fresh questions about the outlook for emerging market (EM) debt. Recent forecasts from the International Monetary Fund and World Bank suggest global growth is slowing. And the US Federal Reserve (the Fed) appears set to front-load interest rate hikes in this tightening cycle, heightening the risk of a recession. Against this backdrop, it’s no surprise that the asset class has been under pressure. But are we at a point of maximum pessimism, where much of the risk is priced in? With the average yield on benchmark EM indexes in the 6% to 7% range, is now a good entry point into the asset class? While this is a heterogenous universe that demands discrete analysis for each sovereign and credit instrument, our investment team’s research shows that many developing economies are now in better shape than they have been in the past. Therefore, a cautiously optimistic view may be warranted for emerging market debt. Here are a few broad trends that support that conclusion.
Many emerging market central banks began raising interest rates much earlier than their developed-market (DM) counterparts in this cycle. Policymakers are keenly aware of the detrimental economic impacts caused by structurally high inflation, having dealt with it frequently in the past. While higher inflation is mainly being driven by more volatile factors (food and energy) across these economies, EM central banks have to work harder at proving their credibility and to avoid inflation expectations becoming entrenched. Higher interest rates also help protect EM countries against capital outflows as the Fed starts to raise rates.
A cautiously optimistic view may be warranted for emerging market debt
Fixed Income Investment Director at Capital Group
Harry Phinney,
Heading down the right path on inflation
Valuations in some markets provide fair compensation for elevated inflation
Nominal and real yields in a number of developing countries appear to provide fair compensation for elevated inflation. Interest rate differentials between EM and DM countries have moved back in line with historical averages on both a nominal and real basis, while analysis shows EM currencies to be cheap.
Latin American commodity exporters stand to gain the most from higher commodity prices, especially as they have few direct trade links with Russia and Ukraine
Sources: JPMorgan, Bloomberg US dollar EM debt, represented by JPMorgan Emerging Markets Bond Index (EMBI) Global Diversified; local EM debt, represented by JPMorgan Government Bond Index — Emerging Markets (GBI-EM) Global Diversified; US core debt, represented by Bloomberg US Aggregate Index. Data as at 31 March 2021
Yield to maturity (%)
EM local, hard currency bond yields have outpaced those of US core bonds
Many EM countries have aggressively hiked policy rates
Source: Bloomberg. Data as at 27 April 2022.
Past results are not a guarantee of future results. Emerging markets are volatile and may suffer from liquidity problems.
The combination of relatively weak global growth and high inflation remains a challenging backdrop for EM debt, especially with a more front-loaded Fed hiking cycle
Stronger balance of payments despite higher fiscal deficits
Fiscal deficits rose in many emerging economies during the pandemic but appear largely manageable as these countries’ stimulus measures tended to be limited compared to those implemented across developed markets. Broadly speaking, EM public debt levels have also remained well below those of developed markets. Many balance-of-payment positions (a measure of the difference between all of the money flowing in and out of a country) improved during the pandemic, as Covid-19-related restrictions weakened domestic demand and undervalued exchange rates helped EM countries’ competitiveness. Some emerging markets even have current account surpluses.
As valuations have cheapened and yields have risen, potentially negative outcomes appear to be at least partially priced in across some EMs. As the chart below indicates, historically, two-year returns have been positive when yields reached 6.7% or higher. The current yield level, based on a 50/50 blend of the EM hard and local currency sovereign bond indexes, stands at approximately 7.07%, as of 29 April 2022. High starting yields can help offset subsequent price volatility and may signal an attractive entry point for investors seeking to add income-generating bonds to their portfolios.
Sources: Bloomberg, JPMorgan, Morningstar. Data as at 5 April 2022. Yield-to-worst and forward returns callouts shown are for 50% JPMorgan EMBI Global Diversified Index (hard currency) / 50% JPMorgan GBI-EM Global Diversified Index (local currency). Callout dates for yield peaks are: 31/5/2010,30/9/2015, 31/12/2015, 31/10/2018, 30/11/2018 and 31/12/2018. Forward returns based on annualised returns. EM: emerging markets. YTW: yield to worst. Yield to worst is the lowest yield that can be realised by either calling or putting on one of the available call/put dates, or holding a bond to maturity. Calling and putting refer to features of some bonds that enable an issuer to redeem the bond early, or a bondholder to demand early repayment from the issuer.
Medium term (2-year) forward return when EM yields peaked above 6.7%
EM yields have risen and fundamentals appear stable
For illustrative purposes only. Past results are not a guarantee of future results. Emerging markets are volatile and may suffer from liquidity problems.
Commodity exporters benefiting from favourable prices
The recent spike in commodity prices is supportive of many commodity-exporting EM countries. They are benefiting from gains in terms of trade, which in turn can help correct external and fiscal imbalances as well as mitigate the impact from weaker global growth. Latin American commodity exporters stand to gain the most from higher commodity prices, especially as they have few direct trade links with Russia and Ukraine. Most EM Asian countries are net commodity importers and so may see external balances deteriorate, although many are running current account surpluses. The EMEA region (Europe, the Middle East and Africa) is mixed, including some countries that are likely to be hit the hardest by the spike in commodity prices, such as Turkey, and some that will benefit the most, like oil-exporting countries in the Middle East. That said, commodity prices are only one factor affecting these economies. For instance, political risk can become a dominant factor in an election year. This and other drivers of volatility may temper any near-term upside.
The technical backdrop is supportive
Primary market issuance has slowed since mid-March, while interest payments and principal redemptions have exceeded the amount of new issuance, contributing to a supportive technical backdrop. Meanwhile, investors appear to have taken a less favourable view of EM debt recently. According to Barclays, EM debt mutual funds and exchange-traded funds saw US$13.5 billion in outflows from January to 19 April 2022. As EM central banks continue to raise rates, widening the interest rate differential with developed markets, we could potentially see a meaningful turnaround in flow activity.
Current volatility could create an opportunity
Our investment team favours a well-diversified portfolio in our core emerging market debt strategies, with exposure to local currency and dollar-denominated sovereign debt as well as corporate bonds. We don’t like to stack risks to any one view or belief, and that’s even more true in this market environment. The combination of relatively weak global growth and high inflation remains a challenging backdrop for EM debt, especially with a more front-loaded Fed hiking cycle. On a more positive note, proactive central bank actions, fundamentals and technical factors look attractive on a historical basis and relative to developed markets. From a valuation perspective, acknowledging that past results are not indicative of future performance, when yields have been at or near current levels, long-term returns in EM debt have historically been positive. With this in mind, the current volatility in the asset class could be a good entry point for long-term investors.
We’re heading for a fundamentally different marketplace where new leadership will emerge, says Rob Lovelace
The world has changed. We are living through a pivotal time in history, marked by geopolitical realignment, high inflation, volatile financial markets and the end of a 40-year period of declining interest rates. The title of this new era could be Brave New World or Back to the Future. But I think the title I would select is Revenge of the Boomers, because a lot of these events rhyme with the past, particularly the early 1960s. That’s when we saw interest rates bottom out after decades of decline, as well as the rise of the Cold War era, which is unfortunately rearing its head again in some respects. Despite these challenges, I remain optimistic about the investing environment for several reasons. First, there are still signs of growth as the global economy recovers from the pandemic. Second, I believe corporate earnings will be the driving force of equity markets going forward, as opposed to multiple expansion, and that signifies a welcome return to fundamentals. Multiples needed to contract, and that is what we’ve seen over the past few months. Third, I think we will experience a healthy recession in the next year or two. That’s right, a healthy recession. Despite all the worry about it, I see a moderate recession as necessary to clean out the excesses of the past decade. You can’t have such a sustained period of growth without an occasional downturn to balance things out. It’s normal. It’s expected. It’s healthy.
This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice.
Vice Chairman, at Capital Group
Rob Lovelace,
What this means for stock markets
In my view, we are heading into a period of real change, a fundamentally different marketplace where different leadership will emerge. That’s in sharp contrast to the 2020 COVID-19 downturn, which was really just a temporary blip in a decade-plus bull market. We know this because the same stocks that led the bull market — a relatively small group of tech-related companies — did so on the way back up. In a true market shift, the leadership coming out of a bear market is usually a new sector or a new group of companies. And it’s not necessarily the same group that led on the way down. For instance, in the current environment, energy stocks have staged a remarkable rally. Do I think the energy sector is going to drive the next bull market? I do not.
I expect a broader mix of stocks to lead us out of this downturn
Data as at 30 April 2022. MT FAANG represents the collective price performance of shares of Microsoft, Tesla, Meta (Facebook), Amazon, Apple, Netflix and Alphabet (Google). Defensive stocks typically generate relatively stable returns regardless of the state of the economy or the overall markets. Cyclical stocks tend to move up or down roughly in line with economic growth or contraction cycles. Index values do not reflect the impact of dividends. Sources: Capital Group, FactSet, MSCI, Standard & Poor’s
S&P 500 Index
We’ve seen a strong US market leadership change in recent months
The world has changed dramatically. But, for selective investors, change creates opportunity
What this means for bond markets
We are also seeing a profound shift in bond markets as we reach the end of a 40-year path of falling interest rates. Sharply higher inflation levels, not seen since the 1980s, are forcing the US Federal Reserve (Fed) and other central banks to aggressively tighten monetary policy. The Fed is behind the curve, which means rates are probably going to move higher from here. However, that doesn’t mean we are going back to exceedingly high inflation and interest rates. It just means that, for decades, we have lived in a declining rate environment that has been highly supportive of markets. That’s all changed. Things are likely to be more difficult going forward. But even amid these headwinds, opportunities will emerge.
Returns are absolute total returns in US dollars. The periods covered are: the tech bubble, 31 December, 1996 to 31 May, 2000 (before bear market) and 30 September 2002 to 30 December 2005 (after bear market); the global financial crisis, 31 December 2003 to 28 September 2007 (before) and 31 May 2009 to 31 December 2013 (after); and the current market, 31 December 2021 to 31 May 2022. Sources: Capital Group, MSCI, Refinitiv Datastream
MSCI USA sector returns (%) – Before and after bear markets
US market leaders before and after a bear market are rarely the same
What this means for investors
Maintaining a balanced, “all-weather” portfolio makes sense in any environment, but particularly this one. Earlier this year I reminded investors to keep an eye on valuations and prepare for a market correction. I remarked that I was buying a raincoat, but not putting it on yet. Turns out, it’s nice to have that raincoat handy. Market volatility has returned, but that’s no reason to be discouraged. At Capital Group, our fundamental, bottom-up investment approach leaves us well positioned to identify specific companies that can generate strong earnings growth. We remain confident that we have the right people in place making decisions based on deep, company-specific research, which has always formed the basis of our long-term investment philosophy. Indeed, the world has changed dramatically. But, for selective investors, change creates opportunity.
That said, I wouldn’t count out the FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks, but I think it’s going to be a very different market going forward. It won’t be driven by a small set of stocks anymore. It won’t be characterised by growth vs. value, or US vs. the rest of the world. Those binary concepts don’t make sense in this environment. I think the market will be less one dimensional, and I expect a broader mix of stocks to lead us out of this downturn.
Data as at 23 June 2022. Sources: Capital Group, Refinitiv Datastream
U.S. 10-year Treasury yield (%)
Is this the end of a 40-year declining rate period?
That’s one reason I like to call this era “Revenge of the Boomers,” because it’s so reminiscent of the 1960s. Interest rates moved higher, but they didn’t spike to 16% overnight. It took decades for that to happen, and there were many policy mistakes along the way. Throughout the 1960s, rates stayed in the 3% to 6% range. It was a volatile period, but overall it was still a good environment for investing. The real trouble came later. Hopefully we’ve learned some lessons from the past and we won’t repeat the 1970s. In the meantime, it’s important to remember that higher nominal interest rates are good for savers. This is a novel concept for younger people, but boomers grew up in a world where interest rates were sufficient to earn a decent return on savings accounts and money market funds. That’s a positive change. It makes people feel better about saving, and I see it as a solid underpinning for the market. Over time, higher rates will also bring income back to the fixed income markets — something that has been sorely missed in the era of easy money. The importance of that shift cannot be overstated. It should eventually restore bonds to their rightful role providing diversification from equity risk. Along those same lines, some inflation is actually a good thing. It allows well-positioned companies to raise prices, and it results in generally higher wages. That makes people feel better about their jobs and progress. It is hard to predict what will happen to real purchasing power, but we have seen in the past decade that without a little inflation, people feel like they’re not getting ahead.
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July 2022
Investors now have several reasons to own bonds despite higher interest rates, say Ritchie Tuazon, Rob Neithart and Tara Torrens
The path to higher interest rates is painful, but it should ultimately benefit bond investors over the long haul. The US Federal Reserve (Fed) raised its benchmark policy rate by 0.75% to 1.50%–1.75% in June, the biggest increase since 1994. The central bank also signalled an additional 1.75% of increases ahead. Policymakers specifically raised the median year-end projection for the Fed funds rate to a range between 3.25% and 3.50%. US bonds have tumbled more than 10% so far this year, but there are signs the worst may be over. Investors have three reasons to own bonds as the Fed attempts to steer the economy toward a much-debated soft landing.
Equity market swings will likely continue, but bond markets are unlikely to decline another 10% from here
1. Big declines may bring opportunities
Bond investors have snapped up debt as prices declined sharply on fears the Fed’s effort to tame inflation could severely strain economic growth. The buying spree helped most bond sectors post positive returns in May. Questions that drove volatility remain, but now may be an opportune time to turn anxiety into action. “Equity market swings will likely continue, but bond markets are unlikely to decline another 10% from here,” says portfolio manager, Ritchie Tuazon. The downward selling pressure has brought valuations for most bonds back to Earth and more in line with expectations. This may provide an attractive entry point for investors. Exposure to high-quality bond funds can again offer the diversification investors want, especially amid heightened equity volatility. Investors can also seek opportunities across bond sectors to achieve investment goals such as income and inflation protection.
There’s a lot to be positive about despite all the negative headlines
As at 31/05/22. Source: U.S. Bureau of Labor Statistics
Contribution to Core Consumer Price Index, month-over-month change (%)
Prices for services sector soar, which may be harder to tame
3. Income is back in fixed income
Investors may soon be able to cash in on higher rates. Yields on bonds have risen sharply since the lows experienced in recent years. Yields, which rise when bond prices fall, have jumped across bond sectors. Over time, rising yields mean more income from bonds.
Data as at 15/06/22. Source: Bloomberg
Change in 10-year Treasury yields (%)
Treasury yield expectations show rate hikes largely priced-in
Current yields have delivered attractive returns
At today’s yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including high yield (see chart below). “Average annual returns for the US high-yield market historically are approximately 6% to 8%. We are again at a starting yield level where these returns could be achieved, with a multi-year investment horizon, which is the first time this has been true in a while,” Torrens says.
The overall number is worrisome. “I think the Fed is still behind the curve on rate hikes,” Tuazon adds. Prices likely peaked for some items that surged in demand during COVID lockdowns. Case in point: Lumber prices jumped alongside home sales and renovations during the pandemic but have slid 50% from the start of the year. However, prices for services and necessities such as food, housing and energy have skyrocketed. “It may be a case of one replacing the other, keeping inflation high,” Tuazon notes. Persistent inflation may force the Fed to revise its rates path higher. However, since investors have mostly priced bonds to account for the more aggressive plan, future adjustments are unlikely to result in as much bond market turmoil. Over the next year, bond yields are less likely to climb as much as they have since July 2021, when markets began to worry about elevated inflation.
Data as at 15/06/22. Sector yields above include Bloomberg Global Aggregate Index, Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index and 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index blend. Period of time considered from 2020 to present. Dates for lows from top to bottom in chart shown are: 04/08/20, 31/12/20, 06/07/21 and 04/01/21. Sources: Bloomberg, JPMorgan
Yields of key fixed income markets (%)
Income opportunity in bonds is the brightest in years
There are still pitfalls ahead, so an active approach might help. While a US recession does not appear imminent, credit spreads may widen as investors forecast the likelihood of one, says portfolio manager, Tara Torrens. Certain industries that are defensive in nature, such as health care and food, may offer more value in this environment. Commodities companies can also offer refuge in a late-cycle period. “There are always opportunities, but I’m maintaining a lot of liquidity that could then be redeployed if we see the type of spread widening that I’m expecting,” Torrens says. Emerging markets debt — a corner of the bond market that has been especially volatile — offers some opportunities as well. Several countries have raised rates ahead of the Fed and are on good financial footing, according to portfolio manager Rob Neithart. Given the nuances of emerging markets investing, an active approach can help steer investors toward select investment ideas.
Ritchie Tuazon,
Rob Neithart,
Tara Torrens,
2. Current bond yields largely account for inflation-driven rate hikes
The Fed’s rate hikes and balance sheet reductions suggest a focus on bringing down inflation. But there is still work to do. The US consumer price index jumped 8.6% for the year through May and is up 1% from April. Core inflation, which excludes food and energy, rose 0.6% from the prior month.
Yields as at 15/06/22. Returns as at 31/05/22 in USD terms. Data goes back to 2000 for all sectors except for emerging markets debt, which goes back to 2003. Based on average monthly returns for each sector when in a +/- 0.30% range of yield to worst. Sector yields above include Bloomberg Global Aggregate Index, Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index and 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index blend. Sources: Capital Group, Bloomberg
Average five-year forward returns at recent yield levels (%)
Higher yields have boosted total returns
Why own bonds now?
Investors have a lot to be pessimistic about: war in Ukraine, inflation and fears of a looming recession. Big declines occurred as investors feared the Fed could crimp growth as it raises rates and ends its asset purchases. Although risks remain, bond investors have largely priced in rate hikes. Now could be an attractive entry point, particularly for those using bonds to buffer equity volatility. “There’s a lot to be positive about despite all the negative headlines,” Tuazon says. “While past results are no guarantee of future outcomes, a long-term perspective can help investors recognise that yields at current levels have historically delivered more income and attractive returns.”
Starting yield-to-worst
3.09%
4.43%
7.71%
4.4
5.0
8.3
9.8
8.75%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
31/-7/21 - 15/06/22
1-year forward
Ritchie Tuazon, Portfolio Manager at Capital Group
While a US recession does not appear imminent, credit spreads may widen as investors forecast the likelihood of one
Tara Torrens, Portfolio Manager at Capital Group
Caution is still warranted, but the entry point is now arguably much more attractive, say Flavio Carpenzano and Peter Becker
It has been a difficult start to the year for investment grade corporate bonds, which returned -16.1% year to date. As inflation jumped to the highest levels seen in decades in developed markets, major central banks have turned increasingly aggressive in their attempts to control it, gradually removing stimulus measures and raising interest rates. This has caused interest rate-sensitive bonds, such as investment grade corporates, to sell off. The Russia-Ukraine conflict has also contributed to an overall very volatile macroeconomic environment. As a result of the drastic revaluation, though, there is now arguably a much more attractive entry point for investors in investment grade corporate bonds.
Past results are not a guarantee of future results. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is not intended to be comprehensive or to provide advice.
Investment Director, at Capital Group
Companies also generally remain in good shape from a fundamental point of view. They continue to display healthy revenues and profit margins despite a higher inflationary and slowing growth environment. Yields have reached levels not seen in more than 10 years although this was mostly driven by the rise in interest rates rather than spreads, which represent the perceived credit riskiness of bonds. At these higher yields, investors now have the potential to earn more income from bonds in the future. Higher income can also offer more cushion for total returns over time, even if price movements remain volatile. In addition, over a longer time frame the yield of a bond has turned out to be a good approximation of the total return that could be achieved. Therefore, at these levels, history would suggest potentially higher total returns over the next few years. The following chart shows the average 2-year and 5-year forward return (percent per annum) that has been achieved corresponding to the starting yield as at 15 June 2022. The total return on a bond is the function of price changes and interest paid — and the higher the starting yield of a bond, the more it is cushioned from rising interest rates. However, the ride along the way could turn out to be a little bumpy.
Data as at 15 June 2022. Index used is the Bloomberg Global Aggregate Corporate Bond Index. The yield-to-worst is the lowest possible return over a particular period of time that can be received on a bond that fully operates within the terms of its contract without defaulting. The option-adjusted spread is the spread that accounts for the embedded optionality of some bonds. Source: Bloomberg
Global investment grade spreads and yields
More attractive valuations could present a good entry point for investors
Yields as at 15 June 2022. Returns as at 31 May 2022 in US dollar terms. Data goes back to 2000 for all sectors except for emerging markets, which goes back to 2003. Based on average monthly returns for each sector when in a +/- 0.30% range of yield to worst. Indices used (left to right) are Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index, and 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index blend. High yield: lower quality bonds rated BB or below. Sources: Capital Group, Bloomberg, JPMorgan
Average forward returns (% p.a.) at recent yield levels
Higher starting yields have boosted returns in the past
The current macroeconomic environment, however, remains highly volatile and an overall cautious and slightly defensive stance is still warranted. Careful selection in companies and sectors remains key.
Peter Becker,
1 As at 15 June 2022 in USD terms. Index used is the Bloomberg Global Aggregate Corporate Index. Investment grade: higher quality bonds rated BBB or above. Sources: Barclays, Bloomberg
6.2%
5.0%
8.4%
8.3%
13.1%
9.8%
Today’s starting yields could offer an attractive entry point for investors, says Mike Gitlin
Rising inflation and slowing global growth are two dominant themes casting a pall over the current market environment. With increasing geopolitical uncertainty, tightening monetary policy, supply chain challenges and higher commodity prices at play, a period of global stagflation could potentially be on the horizon. Navigating the foggy road to normal has never been more challenging, but with a long-term lens one can better understand the strong normalising effect that disinflationary forces such as rising debt levels, technological advancements and aging demographics could have. Having a clear understanding of these can help investors better find their way. Investing in fixed income during a time of a high inflation and rising rates can seem worrisome. However, today’s starting yields offer an attractive entry point for investors. Yields across fixed income sectors are sharply higher than their lows over the past few years. For example, global investment-grade (BBB/Baa and above) corporate bonds currently offer a yield of 4.51%, which is higher than the 4.12% yield offered by global high-yield corporate bonds during their recent lows.
Sector yields above include Bloomberg Global Aggregate Index, Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index and 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index blend. Period of time considered from 2020 to present. Dates for lows from top to bottom in chart shown are: 04/08/20, 31/12/20, 06/07/21 and 04/01/21. Sources: Bloomberg, JPMorgan
Rising yields reflect more income potential across bond markets
Despite current volatility, the broad credit universe provides ample opportunities for investors to add value through bottom-up research and security selection in each of the four primary credit sectors — high yield, investment grade, emerging markets and securitised debt (or debt backed by auto loans, credit card receivables or other assets). Keeping a long-term view and employing balance can help smooth the way. Notably, investment-grade corporate bonds have become more attractive as corporate fundamentals continue to improve, with relative debt levels falling across both European and US investment-grade bonds. Valuations also look attractive as global investment-grade corporate yield has increased alongside higher government bond yields and wider spreads. US high-yield fundamentals have also been improving. The credit quality of the market has improved with a higher proportion of BB-rated companies and a lower share of CCC-rated bonds, which could potentially make the market more resilient to a slowdown in growth. Defaults are currently very low, and although they may pick up should we enter a recession, we believe the yield cushion and active security selection can offset the potential risks. Yields have also become more attractive, rising from the low levels reached in 2021. However, as volatility is expected to remain high and a higher degree of uncertainty in the economy persists, we position our credit portfolios defensively focusing on fundamentals and bottom-up research.
Head of Fixed Income at Capital Group
Mike Gitlin,
As at 30/06/2022. Sources: Capital Group, Bloomberg, JPMorgan, Morningstar
Romania
1.25
3.75
Poland
0.10
6.00
Hungary
0.60
7.75
Czech Republic
0.25
7.00
Peru
5.50
Colombia
1.75
7.50
Chile
0.50
9.00
4.00
Mexico
2.00
13.25
Brazil
12/31/20
06/30/22
Emerging markets central bank policy rates (%)
Many EM countries have aggressively hiked interest rates
Emerging markets local currency debt has been the fastest-growing segment of the EMD asset class for quite some time and is now the largest part of the universe
Yields and returns as at 31/08/22 in USD terms. Data goes back to 2000 for all sectors except for emerging markets debt, which goes back to 2003. Based on average monthly returns for each sector when in a +/- 0.30% range of yield to worst. Sector yields above include Bloomberg Global Aggregate Index, Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index and 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index blend. Sources: Capital Group, Bloomberg
Historically, at current yields, longer term returns have been strong
3.1%
4.5%
9.0%
7.5%
Global aggregate
Global investment grade corporates
Global high yield corporates
Emerging market debt
10
8
6
4
0
5.4
8.7
9.6
At current yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including investment grade, high yield and emerging markets (EM). This higher income can offer more of a cushion for total returns over time, even if price movements remain volatile. In fact, a greater portion of investors’ income needs could potentially be met with traditional fixed income than would have been the case in recent years.
The emerging market debt (EMD) universe has broadened and deepened significantly in the last few decades and, as the asset class has developed, it has become more appealing to a broader investor base. Issuance has increased thereby improving liquidity. That said, rising inflation, slowing global growth, tightening US monetary policy and a soaring US dollar have all weighed on the sector. The Russia-Ukraine conflict has created an additional headwind relative to other comparably rated developed market corporate debt. However, there is reason to be optimistic about the future of emerging markets. Current yield levels can provide significant cushion to further volatility. Emerging markets local currency debt has been the fastest-growing segment of the EMD asset class for quite some time and is now the largest part of the universe. We have a preference for local currency bonds. Compared with developed markets, EM central banks are much more advanced in their policy tightening. In addition, the increase in core inflation in emerging markets has generally been more modest than in developed markets. More aggressive rate hikes coupled with more muted inflation suggest good value in EM duration. In most of these markets hedging costs are high, so our duration exposure is primarily on an unhedged basis.
Overall EM currencies remain undervalued, but selectivity remains crucial in assessing mainly those currencies from commodity exporters countries. We still have a constructive view on commodity prices because supply shortages haven’t been alleviated. In many cases, supply issues have actually deteriorated yet global activity is still reasonable. As such there is still a structural tailwind for commodity prices. Securitised credit can also offer a diverse array of investment opportunity across asset-backed, commercial real estate, non-agency mortgage and collateralised leveraged loan sub-sectors. Many of the fundamental drivers of these sectors are distinct from corporate and sovereign credit. This brings diversity to a portfolio. We are currently finding good value in the single-asset single-borrower (SASB) market. These niche investments create more concentrated risks than traditional commercial mortgage-backed securities (CMBS), but the market largely consists of very high-quality properties and lends itself to deep, property-specific fundamental research. This presents an opportunity for investors to gain access to specific assets that they find attractive. This sector is under-researched by many market participants, and this enables our team of securitised credit analysts to identify numerous mispriced investment opportunities. Uncertainty will remain in markets for the foreseeable future, and the investment environment will be challenging for investors globally. However, there will continue to be opportunities for active managers with strong research capabilities to navigate these headwinds, and allocations to fixed income assets will remain as crucial as ever.
Opportunities across the spectrum
October 2022
Czech Rep
Dividend stocks appear well suited for the current environment but they’re not just for tough markets either, says Nisha Thakrar
Growth strategies have long overshadowed dividend strategies. However, changing macroeconomic conditions have turned the tables and dividend investments are enjoying their time in the sun. While this coincides with value’s long-awaited comeback, value and dividend stocks have distinctive characteristics. We believe that dividends deserve to stay in a portfolio even when economic conditions improve. By adopting a fundamental approach to identify companies that can consistently pay and grow their dividends, investors could achieve long-term real return generation throughout the investment cycle.
Dividend payers have had a higher frequency of delivering excess returns with lower risk over value stocks
Client Solutions Specialist at Capital Group
Nisha Thakrar,
1. Based on S&P 500 total returns in US$ from 1930 to 2021. Source: Ned Davis Research 2. Based on returns from 31 January 1938 to 28 February 2022 in US$ for S&P 500. Sources: Capital Group, Standard & Poor’s, Robert Shiller, Morningstar Direct, FactSet 3. Based on MSCI World dividends-per-share and earnings-per-share drawdowns in US$. Sources: FactSet, Capital Group 4. Based on year-to-date returns for MSCI AC World, MSCI AC World Value, MSCI AC World Growth, MSCI AC World High Dividend Yield, MSCI AC World Quality and MSCI AC World Small/Mid Cap with net dividends reinvested in US$ to 30 June 2022. Source: Refinitiv, Capital Group
5. MSCI AC Word Value and MSCI AC World High Dividend Yield are both market cap weighted indices derived from MSCI AC World but with some differences in methodology. The Value index applies z-scores to securities based on their characteristics, which are then aggregated to inform composition. The High Dividend Yield index applies a 5% issuer cap and includes sustainability and persistence of dividend criteria as well as yield to inform composition. Cyclical and defensive references are based on MSCI’s Cyclical and Defensive indices, which divide sectors accordingly. Source: MSCI 6. Period following the GFC is from 30 April 2010 to 30 June 2022. Sources: Refinitiv, MSCI, Capital Group
7. For more discussion on this topic see: Time to Rethink Value versus Growth, May 2021. Source: Capital Group
Based on monthly price and total returns for MSCI All Country World from 31 July 2012 to 31 July 2022 in US$. Real returns are nominal returns adjusted for inflation based on US CPI All Items. Sources: FactSet, Capital Group
Dividend investment has been important for long-term real returns
Cumulative growth rebased to 100 as at 31 July 2012
MSCI AC indices returns from 31 December 1998 to 31 July 2022, shown in US$ and with gross dividends reinvested. Sources: Refinitiv, Capital Group
MSCI AC indices returns from 31 July 2012 to 31 July 2022, shown in US$ and with net dividends reinvested. P/E: price to earnings. Sources: Refinitiv, Capital Group
13
27
47
82
-5
40
42
37
45
36
41
55
28
17
19
23
More than half of the MSCI AC World High Dividend Yield return has come from dividend reinvestment…
… In contrast, more than 40% of the MSCI AC World return has come from earnings growth
Dividend-focused strategies can complement growth-focused strategies
In short, although value’s latest bounce-back since the GFC has been pronounced, it remains unclear whether this will lead to a decisive rotation. To avoid the pitfalls of timing rotations and value traps, investors can instead consider dedicated dividend strategies. In doing so, they could still benefit from select value stocks but with potentially smoother returns.
Conventional wisdom suggests that value stocks and dividend payers appear well-suited to the current environment, given their heavy reliance on dividend reinvestment for return generation (see graph below). Dividends have typically been the more stable component of equity returns over the years, relative to earnings growth and multiple expansion, making it comparable to the tortoise in the well-known “Tortoise and Hare” fable. There is evidence of dividends’ steady but meaningful return profile throughout the last century; the average contribution to 10-year returns has been 40%, (although this decreased in recent decades as companies prioritised putting capital back into businesses and share buybacks over returning it to shareholders). Furthermore, except for the 1970s, dividend reinvestment has consistently kept pace with inflation. Dividends’ resilience can be seen in stressed markets as dividend payments have shown themselves to be less susceptible to deep cuts than earnings growth. In fact, although past results are not a guarantee of future results, when we compared year-to-date equity returns, value (as represented by MSCI All Country (AC) World Value) and dividend payers (as represented by MSCI AC World High Dividend Yield) outperformed other styles significantly in the bear market.
The road to resilience begins with dividends
It is important to be aware that value stocks and dividend payers feature distinctive characteristics and behaviours. MSCI AC World Value, for example, has high cyclical exposure (based on MSCI’s methodology ) due to the consistently large weighting in financials over the past 20 years. In contrast, high dividend payers, as measured by MSCI AC World High Dividend Yield, have traditionally been more defensive given the index’s large position in health care and consumer staples. These significant differences have meant that value stocks on aggregate have experienced weaker profitability, dividend growth and earnings growth compared to dividend payers. When it comes to downside characteristics, MSCI AC World Value has outperformed MSCI AC World in only one out of the six market corrections (defined as declines less than 20%) since the global financial crisis (GFC). In contrast, MSCI AC World High Dividend Yield has fared better on four occasions. The greater resilience of dividend payers can be attributed to the higher contribution of dividend reinvestment on the returns of these companies, as well as to their lower earnings growth volatility. That said, in a bear market, dividend payments have been known to be subject to the same macroeconomic risks that affect capital gains. Over key investment periods such as three, five and 10 years, MSCI AC World High Dividend Yield has delivered excess returns (relative to MSCI AC World), lower volatility and positive returns over MSCI AC World Value more often than MSCI AC World Value, as shown below.
Value stocks and dividend payers are not synonymous
All that said, dividend investing isn’t just for tough markets. It could play a powerful role in the generation of long-term returns (see graph below), qualifying it to have a strategic place in investors’ portfolios. However, unlocking its potential may require investors to go beyond high yielding stocks to include dividend growers – stocks that pay and consistently grow a dividend. These companies have historically been a compelling source of portfolio returns because of their risk-return characteristics. As expectations for weaker economic growth and asset returns set in, dividend growers could become increasingly relevant.
Dividend growers: a source of long-term return generation
Dividend growers have typically been higher quality firms over high yielders, given their strong histories of profit and earnings growth as well as higher returns on assets, equity and invested capital. Their solid fundamentals have enabled them to compound their growing income stream at levels greater than high yielders, rewarding investors with strong gains.
Ongoing macroeconomic uncertainty and volatile markets are dividing investors on the subject of future equity leadership. Whether growth stocks return, or value stocks persist, current conditions present an opportunity to build resilience through dedicated dividend strategies. However, dividends strategies aren’t just for tough markets, they can also play a valuable role in long-term return generation. Unlocking their potential, though, requires a fundamental approach to capture the compelling dividend growers.
Conclusion
5
7
8. Dividend Aristocrats Viewpoint, July 2022. Source: Proshares
3 years 5 years 10 years
Frequency of (%)
Outperformance relative to MSCI AC World
MSCI AC World Value
MSCI AC World High Dividend Yield
33 32 39
55 57 52
70 62 35
26 17 5
Lower volatility than MSCI AC World
84 94 100
75 91 99
Positive returns (above 0%)
Five portfolio managers with 171 years of experience between them give their insights into investing during a bear market
Stock markets around the world have entered bear territory. The MSCI ACWI slid over 20% for the six months ended June 30, 2022. Today, many investors are focused on the likelihood of recession and more pain ahead. “No one knows when this decline will end, but I am confident it will end, so I encourage you not to get caught up in pessimism,” says equity portfolio manager Don O’Neal, who has 36 years of investment experience and has navigated several bear markets. “Declines create opportunities for investors who remain calm. If we make good decisions in times of stress, we can potentially set up the next several years for strong returns.” In unnerving times like these, it’s helpful to hear from veterans like O’Neal who have survived numerous bear markets. At Capital Group, 31% of portfolio managers have more than 30 years of investment experience while 84% have 20 or more. We asked O’Neal and four of his colleagues, each of whom has been investing for more than three decades and 171 years collectively, to share lessons learned from past bear markets and how they are applying those lessons today.
Outlook
Don O'Neal,
MSCI All County World Index
Market disturbances are a fact of life for investors
Sources: MSCI, RIMES. As of 6/30/22. Data is indexed to 100 on 1/1/87, based on the MSCI World Index from 1/1/87–12/31/87, the MSCI ACWI with gross returns from 1/1/88–12/31/00, and the MSCI ACWI with net returns thereafter. Shown on a logarithmic scale.
Sources: Capital Group, MSCI, Refinitiv Datastream. Returns shown are from the MSCI USA Index and are absolute total returns in US dollars. For the tech bubble the dates represented are December 31, 1996, to March 31, 2000 (before bear market), and September 30, 2002, to December 30, 2005 (after bear market). For the global financial crisis the dates represented are December 31, 2003, to September 28, 2007 (before bear market), and March 31, 2009, to December 31, 2013 (after bear market).
Market leadership often changes after a bear market
I think people may have underappreciated how much nickel and copper are needed to build their batteries
When there are regime shifts in the market, the stocks that represent the former leadership can take a long time to recover
As long as I’ve been in this business, I’ve seen the market swing from excessive enthusiasm to extreme pessimism. An investor with a reasonable degree of objectivity can benefit from selling the former and buying the latter. It’s an approach that frequently causes pain and tends to pay off mostly during the early stages of market upturns, as pessimism gives way to optimism. Warren Buffett said it best: Be fearful when others are greedy and greedy when others are fearful. Put another way, bear markets are an investor’s friend, provided they remain calm, patient and focus on the long term.
Lisa Thompson, Portfolio Manager My experience has taught me that markets have long cycles. I believe the pandemic marked the end of the post-global financial crisis cycle — a cycle dominated by deleveraging, demand shocks and expanding globalisation. These conditions led to looser monetary and fiscal policy, low cost of capital and stock price inflation. Today we are at the beginning of a new cycle, one that I expect will be marked by deglobalisation, a shrinking labour supply and decarbonisation — conditions that will lead to a shift from asset price inflation to goods inflation. Profit margins and highly valued stocks will face continued pressure. Because I expect generally higher inflation during this period, I want to steer clear of many of the fast-growing primarily US companies that were the winners of previous cycle.
Separate the wheat from the chaff
Don O'Neal, Portfolio Manager First, it’s important to recognise that things have changed. What used to work for stock picking won’t work in the same way, possibly for years. Holding the best companies with the best growth stories seemed to be a good approach over the past 10 years. But I believe the last decade was too easy. Whenever retail investors get hyped up and day traders abound via trading apps such as Robinhood, that is a sign. Going forward it will likely be harder to generate good returns, and the factors that drive returns most likely will change. For example, you can no longer buy and hold the fastest growers without regard to profits. I see this as a welcome return to fundamentals. You may hear the current decline described as a correction of high multiple growth stocks. While this is generally true, it is incomplete. The stocks that have fallen the most all had fundamentals that disappointed versus expectations. Stocks with continued good fundamentals have held up better. A lot of stocks have plummeted, but that doesn’t mean they are all bad investments. Consider this example: In the 2000 bear market, both Amazon and Pets.com declined more than 80%. Pets.com went on to become a poster child for irrational exuberance as its stock went to zero. Meanwhile Amazon went on to become …. Amazon.
Avoid the winners of the last cycle
Trade the intangible for the tangible
Carl Kawaja, Portfolio Manager For the last 10 years the stock market placed a lot of value on companies that offer intangible things like software. But we've recently seen it demonstrate a greater embrace of companies that make tangible things. We all know and appreciate how rapidly electric vehicles are growing, but I think people may have underappreciated how much nickel and copper are needed to build their batteries. That’s why demand for some commodities, like nickel, is benefiting from secular tailwinds, and markets are starting to recognise this. Of course, to succeed in a commodity investment, you need to identify a company that has an enduring resource or a cost-effective means of finding and producing more of it. Consider iron ore, a key ingredient in steel. One of the reasons it has been important since the Iron Age — that’s a long time — is that we haven't really found another material that replaces it in terms of strength, cost, weight, flexibility and ability to be moulded and transported. This substance underpins so much of the world’s progress. Brazil is home to a unique source of high-quality iron. You can't invent that somewhere else. I’m not worried about Silicon Valley disrupting iron ore or some brilliant scientists in Switzerland discovering a different way to produce it. The market moves in cycles, so it will fall in and out of favour, but I feel reasonably confident that 50 years from now, production of iron ore will remain important.
Steve Watson, Portfolio Manager Over my career I have experienced 21 market shocks, including the collapse of the Soviet Union, the bursting of the technology bubble, the global financial crisis and now Covid-19. I mention these events only to highlight the fact that market disruptions are a fact of life. It’s just a matter of time before the train goes off the rails. My list suggests it happens every 18 months or so.
Ride supertankers, limit moonshots
Jody Jonsson, Portfolio Manager One observation over my career is that when there are regime shifts in the market, the stocks that represent the former leadership can take a long time to recover. Rotation away from the dominant companies can go on much longer than you think it can or should. In the late 1990s-early 2000s period, some of the largest tech stocks went down 80% or more and stayed down for five to 10 years. And these were the strong companies that survived; many others went to zero. In periods like these, you must consider that something has changed beyond just the valuation for these former leaders. Usually, the valuation corrects first and the fundamentals follow. So how am I thinking about investing in today’s environment? I believe that we are experiencing “climate change” in the market, not just a passing storm. We need to avoid anchoring on past growth rates, profit margins or stock prices. Given the high level of uncertainty, I focus primarily on “supertankers” — dominant companies in their industries that generate solid cash flow, have strong competitive moats and can fund their own growth. I am investing more sparingly in what I would call “moon shots” — higher risk, higher reward companies that are more volatile — because in a rising interest rate environment, investors are less forgiving on valuations for more speculative companies.
Bear markets can be your friend
Carl Kawaja,
Jody Jonsson,
Steve Watson,
2 / 2
1 / 2
Carl Kawaja, Portfolio Manager at Capital Group
Jody Jonsson, Portfolio Manager at Capital Group
Bear markets last 18 months on average but do ultimately right themselves, according to our panel of economists
As stocks and bonds continue to tumble a week after the Federal Reserve’s latest rate hike, investors are understandably asking how long this painful bear market will persist. “It’s been a difficult year, and the pain may continue,” says Capital Group economist Darrell Spence. “But it’s important to keep in mind: One of the things that all past bear markets have had in common is that they eventually ended. Ultimately, the economy and the markets righted themselves.” While past market results are not predictive of future results, it can be constructive to look at history. Based on the trajectory of past downturns, bear markets that were associated with a recession tended to last, on average, about 18 months, Spence notes. So it wouldn’t be unusual for this one to continue well into 2023. With a recession looming in the US — and probably already underway in Europe — it’s tough to see a catalyst for a near-term rebound, Spence says. Stocks and bonds are likely to come under further pressure as long as the Fed continues to aggressively tighten monetary policy in an attempt to curb inflation, which is hovering around 8%.
Sources: Capital Group, Bloomberg Index Services Ltd., Refinitiv Datastream, Standard & Poor’s. As of September 23, 2022.
Stocks and bonds have tumbled this year as the Fed fights inflation
Last week, the Fed raised its benchmark interest rate by 75 basis points for the third time since June. That hike brought the federal funds rate to a target range of 3.00% to 3.25%, the highest level since 2008. Based on the latest Fed projections, the central bank intends to take that rate above 4.50% in the months ahead. Confirming the central bank’s hawkish stance, Fed Chair Jerome Powell said tighter financial conditions are necessary to achieve the goal of restoring price stability. That means bringing the inflation rate closer to the Fed’s 2% target. “We have got to get inflation behind us,” Powell said during the Fed’s September 21 policy announcement. “I wish there were a painless way to do that. There isn't.” Financial assets have declined sharply since then, weighed down by the realisation that the Fed and other central banks around the world may have to raise interest rates more than previously expected. The S&P 500 Index, the Dow Jones Industrial Average and the tech-heavy Nasdaq Composite are all in bear market territory, defined as a decline of 20% or more from a recent high. The US bond market, as represented by the Bloomberg US Aggregate Index, is down about 14% on a year-to-date basis, as of September 23.
The depth and duration of the recession in Europe will depend largely on two factors: the war and the weather. Both are impossible to predict
Fed rate hikes shift into overdrive
Jared Franz,
Markets have also come under pressure due to events including Russia’s escalation of the war in Ukraine, an economic downturn in Europe and a controversial UK tax-cut proposal that has triggered fears of a fiscal crisis. A European recession may already be underway due to the impact of higher energy prices, which have been exacerbated by the war, according to Capital Group European economist Robert Lind. A harsh winter could make matters worse, sending energy prices even higher. “The depth and duration of the recession will depend largely on two factors: the war and the weather,” Lind says. “Both of which are impossible to predict.” At the same time, Lind adds, the European Central Bank and the Bank of England have no choice but to continue raising interest rates since they face the same elevated inflation levels as the United States. He expects the ECB and the BoE to raise rates through the autumn and winter months.
Mounting troubles in Europe
Fed officials will be forced to choose between fighting inflation and pushing millions of Americans out of work
Looking ahead to 2023, investors will turn their focus to another key question: When will the Fed stop raising rates or even start cutting again? At the moment, there is little pressure for the Fed to change course, says Capital Group economist Jared Franz. Consumer spending is relatively healthy. The US job market is extremely strong. And the unemployment rate remains near a record low of 3.7%. But when the unemployment number starts moving higher — as it typically would during a recession — Fed officials will be forced to choose between fighting inflation and pushing millions of Americans out of work, Franz explains. “It’s easy to talk tough on inflation when your unemployment rate is under 4%,” Franz says. “But what happens when it climbs to 6% or 7%? In my view, that’s about as much pain as the Fed is willing to accept. At the current pace of rate hikes, we’re on course to hit 7% unemployment in the second half of next year. I think it would be very tough to keep monetary policy tight in that environment.”
The Fed pivot
+25 bps
+50 bps
+75 bps
Jan
Feb
Mar
April
May
June
July
Aug
Sept
0.25%
0.50%
1.00%
1.75%
2.50%
3.75%
2022 has been a tough year for bonds but today’s starting yields offer an attractive entry point, says Flavio Carpenzano
2022 has not been a great time for bonds. Year-to-date, the Bloomberg Global Aggregate Index and Bloomberg US Treasury Index returned -20% and -13%, respectively . Meanwhile, risky asset classes also sold off significantly, which has led to many investors questioning the role of bonds as a diversifier to equities. While we acknowledge the frustration and the stress investors face in such a volatile market environment, it is important to avoid acting on impulse. Instead, investors should reflect on recent events to understand what has caused this massive drawdown in markets and then act accordingly by positioning their portfolios for the current economic backdrop. As always, it is important to take a long-term view.
Return distribution of US Treasuries since 1973
While the Fed’s current hiking cycle remains uncertain, current bond prices already anticipate most of the increase. Looking at the Bloomberg Global Aggregate Index, the percentage of negative yielding assets has fallen from 16.5% at the end of 2021 to 7.8% at the end of September 2022 . At this point, the market has priced in a significant number of short-term rate increases in the coming months and longer-dated US Treasury yields (e.g. 10-year) already reflect that. In fact, forward rates suggest relatively limited moves on longer-dated yields in the next year, which should lessen the negative impact on bonds. Today’s starting yields also offer an attractive entry point for investors. Yields across fixed income sectors are sharply higher than their lows over the past few years. For example, high quality global investment grade corporate bonds currently offer a yield of 5.4%, which is higher than the 4.1% yield that was offered by global high yield corporate bonds during their recent lows in 2021 . At current yields, history suggests higher total returns over the next few years. This means that investors could benefit from holding bonds across fixed income asset classes, including high yield. This higher income can offer more of a cushion for total returns over time, even if price movements remain volatile.
3.7%
5.4%
10.3%
8%
5.6
7.0
11.3
10.1
Act: look forward and have a long-term view
Bond markets were affected by a sharp and rapid increase in interest rates, triggered by increasingly hawkish developed market central banks, whose priority suddenly shifted to fight multi-decade high inflation levels. However, the extent to which bonds are impacted by an increase in interest rates depends on three main factors: 1) the magnitude of the increase, 2) the speed of the increase and 3) the starting level of yields. The slower the pace of rate hikes, the more income fixed income assets can accrue to offset the loss from rising rates. For example, during the 2015 to 2018 rate-hiking cycle, it took a year before the Fed undertook its second hike and a total of 36 months for rates to be hiked by 225 bps . On the contrary, 2022 has been the perfect storm for fixed income markets where all the three factors mentioned above represented a headwind. To put it into perspective, since the beginning of the year, the yield on the US two-year Treasury – used as proxy for expected future Fed hikes – has increased 1) significantly (354bps), 2) rapidly (in only nine months) and 3) from a very low starting yield (only 0.73%) . As a result, fixed income assets were unable to accumulate sufficient income to help cushion the losses from rising rates. The combination of these three factors has been the main reason for the extreme market-to-market losses bonds have experienced so far this year.
Reflect: understand what has happened so far
Forward rates suggest relatively limited moves on longer-dated yields in the next year, which should lessen the negative impact on bonds
Average five-year forward returns at recent yield level(%)
Yields and returns as at 30 September 2022 in USD terms. Data goes back to 2000 for all sectors except for emerging markets debt, which goes back to 2003. Based on average monthly returns for each sector when in a +/- 0.30% range of yield-to-worst. Sector yields above include Bloomberg Global Aggregate Index, Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index, 50% J.P. Morgan EMBI Global Diversified Index / 50% J.P. Morgan GBI-EM Global Diversified Index blend. Sources: Capital Group, Bloomberg.
Return distribution of the Bloomberg US Treasury Index from 31 December 1973 to 30 September 2022. Based on monthly data. Source: Bloomberg.
12
Frequency (%)
6-Months rolling return
-10
-8
-6
-4
-2
-
14
16
18
20
22
0.2%
1. As at 30 September 2022. Source: Bloomberg.
2. Source: Bloomberg. 3. As at 30 September 2022. Source: Bloomberg.
4. As at September 2022. Source: Bloomberg.
5. Current yield as at 30 September 2022. Date of recent low is 6 July 2021. Source: Bloomberg.
4. As at September 2022. Source: Bloomberg. 5. Current yield as at 30 September 2022. Date of recent low is 6 July 2021. Source: Bloomberg.
Trying to time the market is often ill advised but that doesn’t mean doing nothing, according to Jared Franz and Darrell Spence
Recession risk is clearly elevated around the world following the Covid pandemic and Russia’s invasion of Ukraine, especially as central banks are forced to hike interest rates as they try to control spiralling inflation. So what do we know about investing during a recession?
Investment strategy
Recessions are painful, but expansions have been powerful
With tougher times expected, investors may wish to consider companies with strong balance sheets, consistent cash flows and longer-term growth prospects as a possible route to withstanding short-term market fluctuations. Meanwhile, fixed income can often prove integral to successful investing during a recession or bear market, offering essential stability and the potential for capital preservation. The market sell-off in the first half of 2022 was unusual in that bonds did not play their perceived safe-haven role – with inflation and interest rates rising, fixed income markets fell alongside equity markets and diversification benefits broke down. In the six previous equity market corrections between 2010 and 2018, however, global bond markets – as measured by the Bloomberg Global Aggregate Index – were able to post positive returns in all but one. Even during the broad sell-off in January/February 2018, as markets reacted badly to concerns over US inflation and possible interest rate rises, global bonds were only down 1.4% versus 9.0% from the MSCI World Index.
With tougher times expected, investors may wish to consider companies with strong balance sheets, consistent cash flows and longer-term growth prospects
Through recent declines, some sectors have consistently beaten the market
Data as at 30 June 2022 and shown on a logarithmic scale. The expansion that began in 2020 is still considered current as at 30 June 2022 and is not included in the average expansion summary statistics. Since National Bureau of Economic Research announces recession start and end months, rather than exact dates, we have used month-end dates as a proxy for calculations of jobs added. Nearest quarter-end values used for GDP growth rates. Sources: Capital Group, National Bureau of Economic Research, Refinitiv Datastream.
Although historical trends are not a guide to future ones, data shows that recessions tend not to last very long. Our analysis of 11 business cycles in the US since 1950 shows recessions have ranged from just two to 18 months, with the average lasting about 10. Moreover, the overall economic impact of most recessions is also relatively limited: the average expansion has increased economic output by close to 25%, whereas the average recession only reduced it by 2.5% . For anyone directly affected by job loss or business closures, 10 months of recession can clearly feel like a long time. But investors with a long-term investment horizon might consider looking at the full picture: over the last 70 years, the US market has been in official recession less than 15% of the time.
Downturns aren’t forever
Investors do not necessarily need to consider increasing their bond exposure ahead of any forthcoming recession, but it is worth them assessing whether their overall asset allocation mix provides elements of the four roles that fixed income might fulfil: diversification from equities, income, capital preservation and inflation protection.
Despite the pain they cause, recessions are relatively small blips in economic history and equity returns can even be positive over the full length of a contraction, with some of the strongest rallies occurring during the late stages of a recession. Equities typically peak around seven months before recession starts but can bounce back quickly. Aggressive moves into cash or other assets therefore have the potential to backfire and, in some circumstances, it might be better to stay invested to avoid missing out on the eventual upswing. This is exactly why many seasoned market watchers prefer an averaging strategy, where they invest equal amounts at regular intervals whatever the conditions. This approach not only allows investors to buy more shares at lower prices but also positions them to benefit when the market eventually rebounds. That said, averaging strategies do not ensure profits or protect against losses and investors should consider their capacity to keep committing capital to markets while prices are falling.
Trying to time the market may often be ill advised, particularly during volatile periods, but that does not necessarily imply that investors should do nothing. While goals vary by individual, as a first step, investors with equity and bond holdings might take the opportunity to review their overall asset allocation, which may have changed significantly during recent strong periods of equity market returns, and assess whether their portfolio is still broadly diversified. From an equity perspective, not all sectors respond the same during periods of economic stress. Looking at the eight largest equity market declines, using the MSCI World Index between 1997 and 2022, some sectors have held up more consistently than others. Consumer staples and utilities, for example, outperformed the index in all eight of these periods. Adding in healthcare as well, which outperformed in seven of the eight, companies in these sectors often pay out meaningful dividends, which can offer more stable return potential when stock prices are broadly declining.
Implications for asset allocation
Includes the eight largest declines in the MSCI World Index on a total return basis since 1997. The 2022 bear market (extended period of falling market prices) is considered current as at 30 June 2022 and is included in the analysis. Sources: Capital Group, Factset.
Past results are not a guarantee of future results. For illustrative purposes. Investors cannot invest directly in an index
High-quality bonds have shown resilience when stock markets are unsettled
Returns are based on total return in USD. Source: Bloomberg. Includes all completed corrections between 01/01/10 and 31/12/18. Flash crash: A flash crash happens when the value of a market plummets in a short period of time due to electronic, automated trading. Debt downgrade: debt ratings agencies such as Moody's or Standard & Poor's (S&P) issue downgrades as a signal that an issuer has become more likely to default on its debt.
While signs of an economic slowdown are already evident in some parts of the world, our view is that recession still appears unlikely until later in 2022 or early 2023. In the US, high inflation has had a major impact on consumer sentiment and corporate earnings, but a strong labour market continues to support the economy in the near term. Conditions are obviously different around the world, with the UK struggling with a cost-of-living crisis, while Europe is far more exposed to energy supply risk due to its reliance on Russian oil. The exact timing of a recession will likely depend on the pace and magnitude of central bank moves as they attempt to bring inflation back to target levels. In our view, the only way to break the spiral of escalating wages and prices – particularly in the US – is to create slack in the labour market (the shortfall between the volume of work desired by workers and the actual volume available). But given disruptions caused by the pandemic, unemployment may have to climb as high as 5% or 6% before wage growth starts to moderate. We believe this will make recession very hard to avoid by 2023. Further geopolitical shocks – such as escalation of the war in Ukraine or new variants of the Covid pandemic – are even harder to predict and could quicken the timeline.
Where are we now?
Utilities
Health Care
Consumer staples
Communication services
Energy
Consumer discretionary
Real Estate
Industrials
Information technology
Materials
Financials
SECTOR
NUMBER OF PERIODS SECTOR FINISHED
Below MSCI World
Above MSCI World
-1
10.0
-5.0
-10.0
-15.0
-20.0
-25.0
1.2
0.2
3.6
0.3
-14.9
-21.8
-12.2
-14.1
-9.0
-17.5
-1.4
23/4/2010- 2/7/2010
US debt downgrade
China economic slowdown
Oil price shock
US inflation/ rate scare
Global sell-off
Flash crash
29/4/2011- 3/10/2011
21/5/2015- 25/8/2015
3/11/2015- 11/2/2016
26/1/2018- 8/2/2018
20/9/2018- 24/12/2018
Total return (%)
1. Data as at 30 June 2022. Sources: Capital Group, National Bureau of Economic Research, Refinitiv Datastream.
Bloomberg Global Aggregates MSCI World
Cumulative US GDP growth (%)
50
30
1950
1956
1962
1968
1974
1980
1986
1992
1998
2004
2010
2016
2022
Months
GDP growth
Net jobs added
69
24.6%
-2.5%
12M
-3.9M
AVERAGE EXPANSION
AVERAGE RECESSION
Capital Group portfolio managers and economists discuss how the ongoing fight against inflation could impact fixed income and equity portfolios
At its November meeting, the US Federal Reserve hiked its benchmark interest rate by 75 basis points (bps) for the fourth consecutive time, as inflation has remained stubbornly high. This move, which brings the federal funds rate to a range of 3.75% to 4%, comes after a stronger-than-expected Consumer Price Index (CPI) report for September. The latest numbers indicate that inflation has yet to peak. Led by rent and owners' equivalent rent, inflation for services notably accelerated month over month. Coupled with strong employment data, persistent inflation has left the Fed with little choice but to press on. The Fed has hinted it may soon consider slowing the pace of its rate increases, noting that it would "take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”. However, Fed Chair Jay Powell reiterated that the central bank would “stay the course until the job is done” and said it is “very premature” to talk about pausing rate increases. “Incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected,” Powell said. “The question of when to moderate the pace of increases is now much less important than the question of how high to raise rates and how long to keep monetary policy restrictive, which will be our principal focus.”
Source: Capital Group, FactSet.
Fed funds future rate (%)
Rate hike expectations have risen substantially
I think we are likely to see shorter-term Treasuries rally and longer-term bonds lag
High yield has typically not done well in monetary tightening cycles. Therefore, I prefer to wait for a more attractive entry point
Darrell Spence and Jared Franz, Economists The market has made progress in raising its expectations for the peak fed funds rate, but still may not be fully prepared for how far the Fed needs to go, nor the likely economic impact of doing so. It’s worth remembering the fed funds rate was 5% to 6% for much of the mid-1990s when inflation was much lower than it is now; most historical tightening cycles have not ended until the Fed funds rate was solidly higher than inflation. Heightened rate expectations in recent months have already caused a sharp increase in bond yields and a resumption of the decline in equity prices, but we could still have further to go. Inflation may remain stubbornly higher than the market and the Fed anticipate. Weakness in the housing sector and other areas suggests price pressures should be easing, but inflation reports for the past few months have surprised to the upside. There appear to be numerous longer-term drivers of structural inflation that could persevere, including elevated inflation expectations, the lingering impact of household savings accrued during the pandemic, the climate transition, geopolitical risk, and companies bringing supply chains closer to home. It is a realistic scenario that inflation could remain above the Fed's target of 2% for an extended period. In the extreme, inflation could persist at 5% structurally.
Lacklustre earnings could continue to drag equities down
Darrell Spence, Economist Historically, bear markets associated with a recession have had a median decline of 35% and a median duration of 17 months. If there is a recession in the US, the slump could persist well into 2023. We have seen the valuation contraction part of the bear market, but not the part associated with a decline in earnings per share (EPS). EPS projections have come down in recent months. However, consensus estimates for 2023 EPS growth are still around 6%, which seems too optimistic to me. In prior recessions, it has been normal for corporate earnings to fall by 15% to 20%. Given slowing economies around the world, a strong US dollar and margin pressures from rising labour costs, it is not a stretch to think that we could see another leg down in equities. If EPS dropped 15%, the S&P 500 would need to trade at nearly 20.6 times price to earnings to maintain its current level. This does not strike me as cheap in an environment where 10-year bond yields are around 4% (and perhaps heading to 5%). On average, the S&P 500 Index has tended to peak seven months before the economic cycle has peaked (as measured by industrial production). Following a peak in production, the market has tended to fall for another four to six months, and then has started to rise in advance of the turn in economic activity and corporate earnings. We have yet to see a peak in production.
Market may be underestimating how high rates will ultimately go
Core bonds: shifting to the front end of the yield curve
Pramod Atluri, Portfolio Manager The yield curve has inverted as the market prices in the Fed’s increasing short-term rates to fight inflation and a rising chance of a recession. With yields now reflecting a Fed funds rate of 5% by mid-2023, I think there is compelling value at the front end of the curve; thus, we have moved our core bond portfolios from an underweight position in shorter-term Treasuries to overweight. The overall duration of the portfolios is still neutral as the near-term outlook for inflation remains uncertain. Many real-time and forward-looking indicators show signs that Fed rate hikes have had a dampening impact on the economy. An increasing number of voices are suggesting the Fed should slow and ultimately pause rate hikes in 2023 in the 4.5% to 5% range to assess the impact of its actions before potentially hiking further. But ultimately, the next few inflation reports will determine if Fed officials have the luxury of doing this. I think an extended pause at around 5% would be reasonable given what we know today, which implies interest rates may only drift modestly higher from current levels. The risk to this view is if inflation continues to grow more quickly than expected in the months ahead. When the Fed pauses its hiking cycle, I think we are likely to see shorter-term Treasuries rally and longer-term bonds lag, which would lead the yield curve to quickly pivot from being inverted to positively sloped. This potential yield curve steepening could be quite significant. Given the prospective opportunity and the difficulty predicting when this transition will occur, I would rather be a little early than late.
Economic resilience buoys credit assets
Damien McCann, Portfolio Manager The continued resilience of the consumer is supportive of credit assets. This is due, in large part, to low unemployment and bank account balances that still show some benefits from Covid-era stimulus. Investment-grade (BBB/Baa or higher) credit spreads could widen from current levels as the economy weakens. Corporate balance sheets are currently in decent shape and can likely withstand some bumps in the road before they become overly stressed. Aggregate leverage in the credit universe is not high. I expect deterioration in corporate fundamentals to be a function of the severity of the economic downturn. My base case is we won’t experience a severe recession (a more moderate recession seems more likely to me). The banking system is also well capitalised. I am somewhat defensively positioned in the portfolios I manage, but not in a bunker, holding a slight relative underweight to corporate credit. In multisector credit portfolios, I see select investment opportunities in securitised credit and some areas of emerging markets (EM) debt. Some EM issuers that our analysts believe to be resilient look appealing at current valuations as broad-based weakness in the sector has pushed their spreads wider than may be warranted. I remain cautious on high yield even though yields have risen substantially, fundamentals have improved, and default rates remain low by historical standards. High yield has typically not done well in monetary tightening cycles. Therefore, I prefer to be patient and wait for a more attractive entry point.
December 2022
Pramod Atluri, Portfolio Manager at Capital Group
Damien McCann, Portfolio Manager at Capital Group
There’s a high bar to clear for the Fed to fully stop quantitative tightening. It will likely cease only in the event of extreme market turmoil. A recession is not likely to trigger the Fed to stop shrinking its balance sheet, although it could slow the pace. Some Fed governors want to get out of the quantitative easing business altogether. Doing so would neutralise an important criticism that the central bank is exerting undue influence on markets by holding so many fixed income securities as well as overstimulating the housing sector through its holdings of $2.6trn in mortgage-backed securities.
Damien McCann,
Pramod Atluri,
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December 2021
Portfolio manager at Capital Group
Darrell Spence, economist Historically, bear markets associated with a recession have had a median decline of 35% and a median duration of 17 months. If there is a recession in the US, the slump could persist well into 2023. We have seen the valuation contraction part of the bear market, but not the part associated with a decline in earnings per share (EPS). EPS projections have come down in recent months. However, consensus estimates for 2023 EPS growth are still around 6%, which seems too optimistic to me. In prior recessions, it has been normal for corporate earnings to fall by 15% to 20%. Given slowing economies around the world, a strong US dollar and margin pressures from rising labour costs, it is not a stretch to think that we could see another leg down in equities. If EPS dropped 15%, the S&P 500 would need to trade at nearly 20.6 times price to earnings to maintain its current level. This does not strike me as cheap in an environment where 10-year bond yields are around 4% (and perhaps heading to 5%). On average, the S&P 500 Index has tended to peak seven months before the economic cycle has peaked (as measured by industrial production). Following a peak in production, the market has tended to fall for another four to six months, and then has started to rise in advance of the turn in economic activity and corporate earnings. We have yet to see a peak in production.
Shifts are happening that could define the next decade for investors, says Jody Jonsson
ECONOMIC OUTLOOK
Is this the end of a 40-year disinflation cycle?
The last decade was dominated by a handful of tech stocks that you basically had to own to keep up with the market. I don't think that's going to be the case anymore
Sources: Capital Group, Refinitiv Datastream. As of 10/26/22.
There’s a new reality taking shape in global markets. Commentators have in the last few months mostly focused on a rotation from growth to value, but I think that view is too simplistic. I see many shifts happening simultaneously that could likely define the next decade in markets around the world. Many investors are expecting a return to normal after inflation subsides and central banks stop raising rates. But I believe the world is undergoing significant changes and that investors will need to reset their expectations about how a typical investing environment will look. Here are five seismic shifts happening in economies and markets right now, as well as the long-term investment implications of each:
After the market’s dive in 2020, I expected leadership to broaden, and it has done so. In my view, this is a healthy development and supports why I have been trying to de-concentrate my own portfolios. In theory, it should be a positive backdrop for stock pickers over indexers.
It’s easy to assume these are market dislocations that will quickly reverse — bond markets are currently pricing a return to 2% inflation within two years, for example. But these cycles often last much longer than people anticipate, and there is reason to believe higher inflation is structural and likely to persist. In this new environment, I’m especially cautious of highly levered companies or those raising new debt. Money isn’t “free” anymore, so a larger slice of earnings will go to service debt. Companies with the ability to fund their own growth as well as those with strong pricing power and dependable cash flows will remain attractive in a high-inflation, higher-cost-of-capital world.
I think we're going to be in a much less narrowly concentrated market in future. The last decade was dominated by a handful of tech stocks that you basically had to own to keep up with the market. I don't think that's going to be the case anymore. I expect opportunities to arise from a variety of companies, industries and geographies. Well-managed companies beyond the tech sector may have their chance to shine again. For example, e-commerce companies have gone from being the disruptors to being challenged themselves. They’re often very low margin and expensive to scale with difficult delivery logistics to manage. Very few have done it well. Some traditional retailers that have combined the benefits of brick-and-mortar stores with a compelling online shopping experience are starting to take share from pure e-commerce companies.
2. From narrow to broader market leadership
Many newer investors got comfortable with stocks being very expensive over the last five to 10 years and now assume stocks will return to those levels during the next bull market. When rates were near zero the market could support loftier multiples, but I think those days are over. An exercise I’m trying to apply when evaluating my portfolio is to ask: “What if stocks don’t return to 25x earnings in 2027? What if they only trade at 15x earnings?” If I can make a stock work at that level, then I can probably limit my downside. Using that lens, I'm trying to find emerging and growth-oriented companies that are not valued as such. I like those that may also offer potential upside to the valuation, but where the investment thesis doesn’t depend on it. If multiple expansion is limited in the next bull market, stock returns will have to be powered by earnings growth. That means markets aren’t likely to be as patient with unprofitable companies. Stocks whose business models depend on cheap money are going away. Companies that funded losses while trying to scale rapidly even where the economics didn’t work are going away. Markets once paid up heavily for future growth, but now with higher interest rates they are less willing to do so. The market is calling time on business models that don’t work when money is no longer free.
4. From multiple expansion to earnings growth
US 10 year Treasury yield (%)
The market is grappling with a macro environment it hasn’t seen in a long time. Inflation is its highest since the early 1980s. And until recently we've had 40 years of declining interest rates. That’s longer than most investment managers’ careers, if not lifetimes. That’s part of the reason we see a market struggling to adjust to this new reality.
1. From falling rates to rising rates and higher inflation
Market leaders are becoming less concentrated
Ratio of the S&P 500 Equal-Weighted Index to S&P 500 Index (%)
Sources: Capital Group, Refinitiv Datastream, Standard & Poor's. As of September 30, 2022. Indexed to 100 as of 1/1/05.
Capital spending super cycle could power a new industrial renaissance
Capital expenditures across MSCI ACWI sectors (USD billions)
Sources: Capital Group, FactSet, MSCI. In current US dollars. As of December 31, 2021.
The last bull market was dominated by tech companies that made their fortunes on digital assets, such as online marketplaces, streaming platforms, search engines and social media. This overshadowed the fact that you can’t build a new economy without older industries. Not that digital-first companies are going away, but I think investors will start to place greater emphasis on commodities and producers of physical assets.
3. From digital to physical assets
Some might assume that trends like the shift to renewable energy will squeeze out incumbents in traditional sectors like industrials, materials or energy. On the contrary, there may be winners among businesses that are helping other companies be more energy efficient — whether that's smart buildings, power management or HVAC systems that reduce gas emissions. Other global trends such as grid modernisation, reshoring and energy security may cause a boom in capital investment across industries. These are areas where smartly managed industrial companies might have a real renaissance.
Rising geopolitical tension and pandemic-induced disruptions have led companies to consider bringing supply chains closer to home
The globalisation of supply chains is another multi-decade trend that is shifting. For a generation, companies moved manufacturing to foreign soil to cut costs and boost margins. But the limitations of placing efficiency over resilience are now clear. Rising geopolitical tension and pandemic-induced disruptions have led companies to consider bringing supply chains closer to home. While bottlenecks caused by Covid shutdowns have improved, many companies are still being impacted. The auto industry is a prime example. Major automakers have tens of thousands of unfinished cars waiting for final parts, and that missing component is often as minor as an inexpensive semiconductor chip. Now companies are creating supply chain redundancies so that a single disruption doesn’t derail their entire operation. Even as pandemic-related issues ease, I believe increased geopolitical conflicts are here to stay and will continue to fuel this change. The current environment reminds me of the 1970s, with tension between Russia and the West, more aggressive confrontations with China, the rise of authoritarian leaders around the world and less global cooperation. Since the fall of the Berlin Wall, we’ve had more than 30 generally peaceful and prosperous years. But there are more risks now, and this backdrop suggests lower valuations are warranted and “surprises” should feel less surprising.
5. From global supply chains to regional supply chains
Higher global tensions have increased risk of relying on international supply chains
Geopolitical Risk Index
Sources: Capital Group; Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk,” American Economic Review, April, 112(4), pp.1194-1225. The Geopolitical Risk Index is a measure of adverse geopolitical events and associated risks based upon the tally of newspaper articles covering geopolitical tensions, using a sample of 10 newspapers going back to 1985. Index level values reflect a 12-month smoothed average of monthly data. As of September 2022.
Consider Taiwan Semiconductor Manufacturing Company (TSMC), the world’s dominant manufacturer of cutting-edge semiconductors. After having concentrated the bulk of its capacity in Taiwan — a focal point of geopolitical concerns — the company is building its first manufacturing hub in the United States. It’s also constructing a new plant in Japan. That regionalisation should create a more efficient supply chain for some of its top US-based clients, including automakers and technology companies like Apple, Qualcomm and Broadcom.
The combination of low rates and rising markets made the last 10 years feel like one long sunny day at the beach. While some rain showers have now driven beachgoers indoors, they’re still looking out the window waiting for the storm to pass. They don’t realise that there’s a new weather system upon us with more clouds, colder temperatures and much stronger winds. The world’s not ending, but it may be a wetter, cloudier and colder place — and life won’t be a day at the beach. That may sound like a dark outlook, but I actually see this as a really exciting time to be an investor. New market environments present new opportunities, and that’s where experience and flexibility can be essential.
A flexible investment approach can help weather the storm
Market breadth declining
Market breadth increasing
There is likely to be a significant slowdown next year, says Anne Vandenabeele
While recession risk is clearly elevated around the world, recessions are notoriously hard to predict with any accuracy, in terms of timing, duration or impact. Rather than forecasting exactly when global markets might fall into recession this time, the following Q&A examines what is triggering current conditions, and the outlook for inflation and interest rates.
The European Central Bank has perhaps the toughest job as it looks like fiscal policy will be eased at the same time as rates are rising
The European Central Bank (ECB) has perhaps the toughest job as it looks like fiscal policy will be eased at the same time as rates are rising; this can be inflationary, which is exactly what the ECB is trying to counteract. Ultimately, if we continue to see episodes of financial market volatility (as we have over the last few weeks in the UK), and there is risk of contagion to Italy, for example, I think the ECB will relent and stop quantitative tightening, perhaps even reversing rate hikes depending on how significant recession is next year. The Fed’s job is a little less complicated as there is no fiscal stimulus in the US The Fed has announced it will keep raising rates but, at some point early next year, things will start looking softer in the US economy. At that stage, especially if there is a lack of liquidity in some markets, policymakers will stop quantitative tightening (QT) and maybe even cut rates. This is the so-called central bank put, which is what they have done for the last 20 years. Ultimately, we cannot read the minds of (respective ECB and US Fed chairs) Christine Lagarde or Jerome Powell so are trying to stay open minded as to what may happen.
Will we see central banks adopt a uniform response or are there likely to be differences across regions?
Anne Vandenabeele,
The short answer is yes. We think there is going to be a significant slowdown next year but keep in mind there are many factors at work, so there is uncertainty around exactly what recession might look like. We expect this slowdown to be driven by recession in the US and Europe, caused by sticky inflation and higher interest rates, and a Chinese economy that remains weak. Japan will follow these three, so activity in the world’s largest economies will be flat or contracting. The trigger for this is all about inflation and interest rate hikes in response to it. Inflation started post-pandemic with goods prices leading to supply chain bottlenecks, then the commodity and energy shock caused by the war in Ukraine, and finally service price inflation rising fast, driven by strong wage growth, especially in the US. In response, central banks have raised rates incredibly fast. That will clearly start to bite and the US housing market is already in recession. Mortgage rates have risen so fast that pending house sales have started to drop and houses are sitting on the market for a long time. That will start affecting company earnings, capex, employment spending and so on.
Is the global economy entering a recession and what are the likely triggers?
Stagflation as a term was used a lot in the 1970s and 80s when we had a combination of low growth and high inflation, and there is a lot that rhymes with that situation today. Whether we end up there again depends on a few things, such as whether inflation proves persistent and whether central banks can ultimately live with higher inflation to revive growth. For service companies, labour accounts for most of their costs so when wage growth is strong, service inflation follows and can stay elevated. In the US, we think wage growth will stay high even as the Fed raises rates and unemployment goes up. The reason behind this is a huge shortage of workers, with at least four million people lost from the labour force due to various reasons, including long Covid, less immigration, early retirement or seeking a different work/life balance. So there are a lot of mismatches pushing prices up. If wages continue to climb even as the unemployment rate rises, the question is what central banks do in that environment. Do they ease policy to contain recession and lower financial volatility, or keep raising rates like then Fed chair Paul Volker did in the 1980s to lower inflation? Easier policy, whether monetary or fiscal stimulus as has been talked about in Europe, would keep inflation high and that is also part of the equation. My overall view is that inflation will be more persistent as a lot is coming from wage, which tends to be stickier. But I also think central banks will be quick to ease policy to limit any damage from recession or resulting volatility – that’s what they have done in the last 20 years. One last thing to stress: we will get through this; recessions end and we need to think about this when we plan our investments.
Could we actually be facing stagflation rather than inflation?
In the US, we think wage growth will stay high even as the Fed raises rates and unemployment goes up
Stephen Green discusses the economic prospects of China and other emerging markets
EMERGING MARKETS
Asia wants to contain inflation but is not dealing with the same circumstances as the US
Across emerging markets (EM), we are seeing quite a lot of inflation so there are some similarities but also significant differences. Across Asia, headline inflation rates in countries like Korea, Thailand and Indonesia are around 6-8% with core inflation running at 4-5%. These numbers are fairly high but EMs are used to that when it comes to inflation, so this is not unusual. EM central banks are raising rates but not as aggressively: as outlined, the US Fed has hiked by 300bps over the last year whereas most EMs across Asia have increased by 100-200bps. Asia wants to contain inflation but is not dealing with the same circumstances as the US; we are not seeing rapidly rising wages, for example, which means inflation will probably not be as long lasting. At the same time, everyone is looking at the US and Europe heading into recession so if you are an Asian central bank, you don’t want to overtighten going into that.
Are Asian and other emerging market economies facing the same concerns regarding inflation and rate hikes?
We are on the verge of contraction today, with China’s economy hit by at least three big shocks. One is the housing market: over the last three years, the government has tried to contain the bubble and that is causing short-term pain for developers and households. Then you have the dynamic zero-Covid policy: the government is committed to eliminating Covid from the economy, which means rolling lockdowns of city districts and transport disruptions, and a hit to consumption each time. In addition, with the US/Europe having their own economic difficulties, China’s export engine is beginning to sputter. We had a great 2020/2021 where China’s export engine really took advantage of the Covid situation but are now on the brink of going into negative export growth. These three shocks will continue to feed through in the next six to 12 months and, interestingly, there is no big stimulus from Beijing expected this time as they want these bubbles to wash out of the system.
We cannot talk about global growth without discussing China. How far is that economy from recession?
Sentiment could improve if we see housing sales pick up, but everyone is waiting to see if prices correct downwards
I have been analysing China’s economy for 20 years and the two most important indicators for me are credit growth and housing sales. With credit growth, it is slower than it has been for the last 10 to 20 years, running at around 10%, and on our forecasts, is not going to pick up that much. Contrast that with 2009 and 2017 when Beijing was in stimulus mode. Banks were lending more and there was more government bond issuance to drive infrastructure spending. Mortgage loans were also higher as people were eager to buy a house. Right now, we are seeing far less of this activity. Housing sales are declining: they are contracting around 30% YoY and that has been going on for around the last 15 months . Housing in China is very important: housing sales are around 14% of GDP but when you include all the associated activities, such as roads, pipes, utilities, leasing services, management services and so on, you get to around 25% of GDP . A quarter of the economy contracting at these levels year on year is a huge downdraft and will continue to feed into commodities and consumer sentiment. We are already seeing several developers defaulting on their debt obligations and going bankrupt. That could mean unpaid bills for construction equipment, materials, and workers’ wages. Right now, the government is trying to support the housing market cautiously, allowing cities to lower mortgage rates, but such measures are not as effective when people are cautious. Sentiment could improve if we see housing sales pick up, but everyone is waiting to see if prices correct downwards and more developers go under, so we could be in for another six to 12 months of a fragile housing market.
What are your expectations for growth in China next year and will sentiment continue to weaken?
Key to this is what’s happening with the US and, as a team, we don’t think that will change much for another six to eight months into the middle of 2023. The dollar looks overvalued on our models, with the country running an ever-bigger current account deficit, but everything is being driven by rate expectations, and US yields have moved up aggressively. EMs have also not been experiencing strong productivity growth over the last few years and, over the long term, that is what drives your real effective exchange rate. Weaker productivity growth across Asia and other emerging markets, China in particular, means there is no fundamental economic reason for exchange rates to appreciate. By the middle of next year, maybe the story will have changed if inflation starts to come down. If the Fed can end the hiking cycle or even reverse some of the rises, that would be the key reason for the dollar to start to fall. In that environment, assuming EMs are not hit too badly by recession in Europe and the US, we would expect to see those currencies start to recover.
What is the outlook for EM currencies versus the US dollar?
1. stats.gov.cn 2. nber.org
Investors need to distinguish which distortions will persist and which will recede, but opportunities do exist, say our panel of experts
The last time US inflation spiked above 9%, Ronald Reagan was the newly elected president of the United States. IBM was selling its first personal computer using Microsoft software. And stainless-steel DeLorean sports cars were rolling off the production line. Perhaps that’s why 2022, in some ways, feels like taking a trip back in time. High inflation, rising interest rates, a bruising bear market and a proxy war with Russia seem all too familiar to anyone who lived through the early 1980s. Today’s market environment, however, has been shaped by an entirely different event. The Covid-19 pandemic and, crucially, the response to the pandemic have created large distortions in the economy and markets — from sky-high inflation to chronic labour shortages to broken supply chains. Which of these Covid distortions will fade over time and which will remain long term? That is a key question for investors. “There are some aspects of the pandemic that are fleeting and some that will persist,” says Alan Wilson, an Equity Portfolio Manager. “That’s the issue we are grappling with today. We need to get the answer right because it will likely determine which companies thrive in a post-Covid world and which fall behind.”
MACROECONOMICS
Alan Wilson,
Sources: Capital Group, Refinitiv Datastream. Money supply growth above is represented by the annual change in M2 (encompassing currency and coins held by the non-bank public, checkable deposits and travelers' checks, plus savings deposits, including money market deposit accounts, small time deposits and shares in retail money market mutual funds). Inflation figures above refer to the change in the consumer price index across selected countries. The original Capital Group analysis of this data included 22 countries or regions; some were removed from the chart for ease of reading. Inflation figures are current as of August or July of 2022, reflecting the latest available data as of September 14, 2022.
Excess inflation (latest minus prior five-year average) (%)
Growth in the money supply has contributed to high inflation
The US should have four to five million more workers than we have today
There’s already been a great deal of price destruction, and I think a lot of the excesses have been wrung out of the market
With elevated inflation representing the most impactful distortion, a team of Capital Group portfolio managers, analysts and economists decided to study consumer price levels in 22 countries in relation to the growth of the money supply, or M2 (this is a broad measure of money that includes currency, coins, checking and savings deposits, as well as shares in money market funds). The team looked at many other Covid-related distortions, some of which are covered in more detail below. But since inflation touches virtually all parts of the economy, it makes sense to start there.
Why is inflation so high?
The great resignation
Another Covid distortion that remains entrenched is the severe labour shortage. In 2021, a popular media narrative developed around the idea of “the great resignation”, inspired by US government data showing that roughly 47 million people voluntarily quit their jobs that year and seemed to disappear from the workforce. Further data and myriad surveys helped shed light on the reasons. Many quit to ultimately take better-paying jobs. Some older workers opted for early retirement. And roughly 600,000 Americans decided to start their own small businesses, a trend which is hard to track through monthly employment data. So why is the labour market still extremely tight? That’s because the US economy — and many other developed economies around the world — have not kept up with pre-pandemic growth trends, says Capital Group Economist Jared Franz. “Given the average annual growth in the labour force pre-Covid, we should have four to five million more workers than we have today,” Franz estimates.
Julian Abdey,
Pramod Atlur,
Nick Grace,
Jared Franz, Economist at Capital Group
Nick Grace, Equity Portfolio Manager at Capital Group
As it turns out, the basic laws of economics proved correct. A rapidly growing money supply — boosted by pandemic-era government stimulus measures, aggressive bank lending and ultra-low interest rates — coincided with drastically higher inflation. In other words, the countries that stimulated the most during the pandemic generally wound up with the highest rates of inflation. In fact, one could argue that today’s high inflation is not the biggest distortion, but rather it was the unprecedented monetary and fiscal stimulus undertaken by the United States and Europe, among others, says Julian Abdey, an Equity Portfolio Manager. “I am reminded of the famous Milton Friedman quote: ‘Inflation is always and everywhere a monetary phenomenon,’” Abdey notes. “In other words, inflation is caused by too much money chasing after too few goods, and that is exactly what we are seeing today.”
Sources: Capital Group, Bureau of Labor Statistics, Refinitiv Datastream, US Department of Labor. Labor force participation rate above reflects the monthly total US civilian labour force participation rate; the five-year average includes the average monthly participation rate between February 2015–February 2020; the post-Covid average reflects the average monthly participation rate between March 2020–August 2022.
US labour force participation rates, pre and post-COVID-19 outbreak
Labour crunch: Where did the employees go?
This imbalance in the labour force hit some industries harder than others, particularly those most affected by the pandemic-era lockdowns. Those include travel, hospitality, manufacturing and education. The labour imbalance also has significant implications for the Fed’s rate-hiking path, given the central bank’s desire to cool down the red-hot job market, which adds to inflation through wage increases. “If these shifts in the labour force persist,” Franz notes, “it would require more rate hikes than the market has priced in today — and for a longer period of time — to realign labour supply and demand.” Over the long term, Franz believes the labour crunch will ease, especially if the US economy falls into recession over the next year or two. But that’s a painful way to solve the problem, he concedes. “Unfortunately, it does sometimes take a significant downturn to resolve imbalances in the economy,” Franz says.
Stocks and bonds falling
Among all the major distortions in the economy and markets today, this one strikes at the heart of portfolio diversification. Simply put, when stocks zig, bonds are supposed to zag. Yet that hasn’t happened in 2022. Both major asset classes have been coming under pressure as high inflation and rising interest rates hurt growth-oriented stocks as well as many types of corporate and government bonds. The entire relationship hinges on inflation. If the Fed can get consumer prices under control, the historically negative correlation between stocks and bonds should return, explains Fixed Income Portfolio Manager Pramod Atluri. “That is the trillion-dollar question,” Atluri says. “Are we in a new higher inflation regime or not? I don’t think we are. In my view, we are likely to see inflation come down as the Fed and other central banks continue to raise interest rates and reduce their balance sheets.” This painful experience, however, could have a long-term impact on the markets by affecting the willingness of governments and central banks to intervene during future times of crisis, Atluri adds. “In my view, there will be less monetary and fiscal support over the next decade as policymakers assess what went wrong,” he adds. “That would be a big shift from what we’ve experienced over the past decade, which was largely defined by government intervention. Less intervention will likely result in more volatile markets than investors have been accustomed to.”
Silver-lining distortions
Not all Covid distortions necessarily carry a negative connotation. In the equity markets, post-pandemic opportunities are emerging in a number of areas, says Nick Grace, an Equity Portfolio Manager. Those areas include what Grace likes to call “structural changes” including the transition from traditional energy sources to more sustainable sources, years of underinvestment in commodities, which could lead to a new commodities super cycle, and big industrial shifts, such as the increasing adoption of automation, resulting in greater demand for semiconductors. He is also watching certain badly bruised tech and consumer-tech companies, including some of the darlings of the Covid lockdowns that have since sharply sold off. The remarkable pull-forward in demand that we saw during the lockdowns has proven to be a fleeting moment in time, rather than a new paradigm, and share prices are starting to reflect that reality. “A lot of the price distortions we saw in 2020 and 2021 are being unwound,” Grace says, “which doesn’t mean they can’t fall further. But there’s already been a great deal of price destruction, and I think a lot of the excesses have been wrung out of the market.”
