The wall of worry that markets and investors face every year only seems to be getting taller and wider heading into 2022. There are the known challenges: How long will inflation last? Will central banks raise rates? How will a slowing Chinese economy impact global growth?
There also are unknown shocks and surprises that likely await investors in the year ahead. But smart investors can take action to prepare for the unexpected. Here are five keys to staying on course in 2022 amid economic and geopolitical uncertainty:
What a difference a year makes. At the start of 2021, investors cheered the approval of several COVID vaccines and the rollout of massive government stimulus to bolster economies and markets.
Heading into 2022, COVID case counts are soaring, inflation is hitting new highs and the U.S. Federal Reserve has indicated it could raise rates three times in the coming year.
While such developments can be unnerving, it’s important to keep them in perspective. “The pandemic will likely be with us a long time, if not forever, but over time I expect its impact on the economy and markets will diminish,” says Rob Lovelace, vice chair and president of Capital Group and portfolio manager on Capital Group Canadian Focused Equity FundTM (Canada).
Another likely source of volatility over the next 12 months: the upcoming U.S. midterm elections. Political uncertainty often has a noticeable impact on markets, but that impact has tended to be short term. “I don’t think this year will be any different,” says Chris Buchbinder, portfolio manager on Capital Group U.S. Equity FundTM (Canada). “There may be a few bumps in the road — and investors should brace for short-term volatility — but I don’t think the destination will change.”
Indeed, an analysis of more than 90 years of equity returns reveals that stocks tend to have lower average returns and higher volatility for the first several months of midterm election years. As results at the polls become more predictable, this trend often reverses, and markets have tended to return to their normal upward trajectory.
Uncertainty, whether political or economic, generates a lot of noise. Smart investors would be wise to look past the short-term highs and lows and stay the course.
Evidence is mounting that inflation will stick around in 2022. In November, the U.S. Consumer Price Index, a broad measure of inflation, rose at its fastest rate in nearly 40 years.
“Though inflation will likely normalize within a few years, I do expect COVID and related supply chain issues to dominate the inflation outlook over the next 12 months,” says U.S. economist Darrell Spence.
To blunt inflation’s impact, investors can seek companies with pricing power. Pricing power can help protect a company’s profit margins by passing rising costs along to customers.
High and stable margins can be an indication of pricing power. Companies with pricing power potential include consumer businesses with strong brand recognition, like beverage makers Keurig Dr Pepper and Coca-Cola; companies in industries with favourable supply and demand dynamics, like semiconductor and chip equipment makers Taiwan Semiconductor Manufacturing Company and ASML; and businesses that provide essential services, like health care giants Pfizer and UnitedHealth Group.
“I believe lingering inflation may be the biggest risk companies and investors face in 2022,” says equity portfolio manager Diana Wagner. “That’s why I am so focused on uncovering companies with pricing power.”
Sure, U.S. stock markets have outpaced the rest of the world for much of the past decade, partly because many of the leaders of the digital revolution have been U.S. tech giants. But the outlook for international stock markets is brighter than it’s been in a long time, thanks to improving European economic growth and the expansion of the digital revolution beyond U.S. shores.
Indeed, the digital shift has moved far beyond the turf of Amazon, Google and Microsoft. Across nearly all industries, companies are adopting new technology to improve business and transform the way we live.
“I don’t think these opportunities are yet fully understood by the market,” says equity portfolio manager Greg Wendt. “In addition, there’s no question that valuations are lower for many international and emerging markets companies compared to their U.S. counterparts. That makes non-U.S. markets a very attractive hunting ground.”
Global spending on digital transformation is expected to rise from US$1.3 trillion in 2020 to US$2.4 trillion by 2024, according to Statista. Even old economy companies are investing heavily in technology to reinvent and revitalize their businesses through automation, cyber sales and machine learning.
In Europe, companies like food giant Nestlé and cosmetics leader L’Oréal have ramped up their digital adoption, nearly doubling e-commerce-related revenues as a percentage of total revenue in recent years. China is even further ahead in many ways: Companies like appliance maker Midea Group and restaurant firm Yum China have generated significantly stronger growth in e-commerce revenues.
Does the prospect of rising rates bode poorly for core bond portfolios? Not necessarily, says Capital Group head of fixed income Mike Gitlin.
“The Fed’s intent to hike rates is well telegraphed, and with growth slowing, the central bank will likely move at a measured pace,” Gitlin says. “With that in mind, it still makes sense to maintain an allocation to core bonds.”
Indeed, core bonds held up well the last seven hiking periods. The core U.S. bond benchmark, the Bloomberg U.S. Aggregate Bond Index, declined in only two of those periods and averaged a nearly 4% return in USD. Those two periods, with low single-digit losses, were also a far cry from the double-digit corrections stocks often experience.
Core bond funds should provide a critical function in a balanced portfolio. First, they can offer diversification from equities. That is especially important at a time when the stock market is hitting new highs and volatility is rising.
Uncertainties, such as slowing global growth, an unknown COVID trajectory and a weaker Chinese economy, could result in heightened volatility. Active core bond managers can work to identify bonds with maturities that could hold up relatively well should rates drift higher.
Today, with valuations for most types of financial assets far from cheap and volatility rising, investors may be thinking of moving to cash. But they should remember that well-diversified portfolios like the one in the chart below would have held up well amid shifting market conditions.
The chart illustrates a hypothetical scenario representing three types of investors. Each year, a momentum-driven investor buys the top returning asset class from the previous year. A value-seeking investor buys the lowest returning asset class. A third investor sticks to a 60/40 balance between diversified stock and bond portfolios and rebalances at year-end. In nearly every multi-year holding period over the last 20 years, the balanced portfolio would have outpaced the other two, often by a wide margin.
“Looking at the year ahead, the risks are clear: Inflation is rising, central banks will likely raise rates and growth is slowing,” says Lovelace. “But I am optimistic about an environment that is ideally suited to selective investing grounded in bottom-up, fundamental research.”
Bloomberg U.S. Aggregate Bond Index represents the U.S. investment-grade fixed-rate bond market. Bloomberg Global Aggregate Bond Index represents the global investment-grade fixed-rate bond market. Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt. Bloomberg 1–3 Month U.S. Treasury Bill Index is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months. Bloomberg Taxable Municipal Bond Index is a market value-weighted index designed to represent the long-term investment-grade taxable municipal bond market.
FTSE USA REIT Index represents the market for U.S.-based real estate investment trust (REIT) companies.
LBMA Gold Price represents the global benchmark spot prices for unallocated gold delivered in London and is administered independently by ICE Benchmark Administration.
MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization-weighted index designed to measure developed equity market results, excluding the United States and Canada. MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index designed to measure equity market results in the global emerging markets, consisting of more than 20 emerging market country indexes. MSCI World Index is a free float-adjusted market capitalization-weighted index designed to measure equity market results of developed markets.
Russell 2000 Index measures the performance of 2,000 small cap stocks.
Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks.
S&P GSCI is a is a broad-based production-weighted index of the global commodities market.
Source: Morningstar, Inc. © 2022 All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from this information. Past performance is no guarantee of future results.