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United States
U.S. Outlook: Expect solid growth, stubborn inflation
Darrell Spence
Economist
Diana Wagner
Equity Portfolio Manager
Chris Buchbinder
Equity Portfolio Manager
KEY TAKEAWAYS
  • The U.S. economy remains on a solid path, with growth expected in the 2.5% to 3.0% range.
  • With inflation pressures lingering, investors should consider companies with pricing power and proven dividend growth.
  • Prepare for market volatility stemming from COVID variants and the midterm elections.

The American economy is healthy again and appears to be on a path towards solid growth in 2022, which should be encouraging news for U.S. financial markets.


Yet investors can be forgiven for feeling extremely uncertain about the year ahead, according to U.S. economist Darrell Spence.


“We're far enough along with the pandemic that the economy is not in distress,” Spence says, “but COVID and the response to it created a number of distortions — in global supply chains, labour markets, sectors and even politics.”


He expects U.S. economic growth to be solid but slowing in 2022, in the range of 2.5% to 3.0%, as the economy contends with waning stimulus and inflationary headwinds. Although full economic shutdowns may be behind us, emerging COVID variants, including Omicron, and other surprises could further dampen growth.


“Things are returning to normal, but none of us has experienced this before. It’s important to acknowledge there are still things we don’t know,” Spence adds.


Will the US economy overcome inflation pressures?


Perhaps the biggest questions on investors’ minds are about inflation. How high will it go and how long will it last?


Neither investors nor Federal Reserve officials have had to contend with meaningful inflation over the past three decades. That changed last summer.


“When stimulus-induced demand met COVID-restricted supply it created distortions in the economy,” Spence says. “And that fuelled rapidly rising prices wherever there were bottlenecks.”


Fed officials have maintained that high inflation levels in the U.S. are transitory, and prices should retreat once these distortions are corrected. But Spence expects inflation levels will remain elevated throughout 2022.


“I’m not convinced that these shifts are fundamental changes to the productive capacity of the economy, so I expect inflation to moderate. But it may take longer than Fed officials expect for supply and demand to come back into balance.”


Stocks and bonds have done well in inflationary periods


Average annual returns at different inflation rates (1970-2021)


Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor’s. As of 31/10/21. All returns are inflation-adjusted real returns. U.S. equity returns represented by the Standard & Poor’s 500 Composite Index. U.S. fixed income represented by Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index from 1/1/70–31/12/75, and Bloomberg U.S. Aggregate Bond Index from 1/1/76–31/10/21. Inflation rates are defined by the rolling 12-month returns of the Ibbotson Associates SBBI U.S. Inflation Index.


Investors worried about the destructive impact of inflation on their portfolios should consider this: Even during times of higher inflation, stocks and bonds have generally provided solid returns. It’s mostly at the extremes — when inflation is above 6% or negative — that financial assets have tended to struggle.


What’s more, some inflation can be healthy for companies, such as banks and commodity-linked companies that have struggled in a low inflation, low interest rate world.


Stocks aren’t cheap either, so selectivity is key


Consumer goods aren’t the only things that appear to be expensive. Thanks to low interest rates, accommodative central bank policy and the reopening of economies, most classes of stocks and bonds have gotten pricey.


U.S. equity markets have been generally strong in the post-pandemic period, thanks in part to robust corporate earnings. That said, price-to-earnings ratios, a measure of how expensive stocks are, have been elevated relative to historical averages.


That’s why careful security selection and diversification are more important than ever.


“We have seen a range of stocks — from fast-growing digital stocks to old economy stocks tied to the cyclical recovery — become more expensive over the past year,” says equity portfolio manager Chris Buchbinder.


“Given the level of uncertainty we face today, I am looking to strike a balance in my portfolios, seeking exposure to companies with long-term growth potential, like certain giants in e-commerce, streaming and digital payments; companies that can still participate in the cyclical recovery, like airplane engine manufacturers; and those with secular growth and cyclical components, like automaker General Motors — whose Cruise division is a leader in driverless car technology.”


Dividends are staging a comeback


One potential bright spot for investors in 2022 is the universe of dividend-paying stocks.


After record dividend cuts and suspensions during the pandemic, companies are reinstating dividend payments, and some with surplus capital are declaring catch-up dividends.


“Today I am finding no shortage of opportunities to invest in companies restoring and even increasing dividend payments,” Wagner says. “With profit margins recently near peak levels, companies are able to increase dividends despite inflationary pressures.”


Of course, not all dividend payers are created equal. Wagner is focusing not on the highest yielders, but on those companies with strong underlying earnings growth that have demonstrated a capacity and commitment to raise dividends over time. Consider, for example, semiconductor makers like Broadcom, which has increased its annual dividend in each of the last five years. Even during the pandemic, the company raised its dividend more than 11%, supported by record profitability. Such dividend growers historically have tended to generate greater returns than other dividend strategies, while also keeping up relatively well with the broader market.


Companies paying meaningful and growing dividends can be found across a range of sectors. Among these are health care services providers like UnitedHealth Group and telecommunications conglomerates like Comcast.


Midterm elections will likely move the markets


While it might feel like a lifetime away, investors may want to be mindful of the midterm elections in November. Historically, elections have little impact on the long-term direction of markets, but they tend to cause some volatility during election years.


“I don’t think this year will be any different,” Buchbinder says. “I don’t expect the result to be a huge driver of investment outcomes one way or the other. There may be a few bumps in the road, and investors should brace for short-term volatility throughout the year.”


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. But these are just averages, so investors shouldn’t try to time an entry point into the market.


Prepare for stock market volatility this midterm election year


S&P 500 Index average returns since 1931


Sources: Capital Group, RIMES, Standard & Poor’s. The chart shows the average trajectory of equity returns throughout midterm election years compared to non-midterm election years. Each point on the lines represents the average year-to-date return as of that particular month and day and is calculated using daily price returns from 1/1/31–31/10/21.



Darrell R. Spence  is an economist at Capital Group. He has 29 years of investment industry experience, all with Capital Group. He holds a bachelor’s degree with honors in economics from Occidental College graduating cum laude, and is a member of Phi Beta Kappa and Omicron Delta Epsilon. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics. Darrell is based in Los Angeles.

Diana Wagner is an equity portfolio manager with 23 years of investment experience. She holds an MBA from Columbia Business School and a bachelor’s degree in art history from Yale University.

Chris Buchbinder is an equity portfolio manager with 25 years of investment experience. He holds bachelor's degrees in economics and international relations from Brown University.