When the pandemic struck nearly two years ago, the prospect of supercharged economic growth and a sweeping equity rally appeared improbable at best. Then again, the odds of blistering inflation felt even less likely. And a mass preoccupation with the nooks and crannies of global supply chains was beyond the realm of imagination.
But as 2022 gets underway, the interplay among those contrasting forces may determine what comes next. Uninhibited consumer spending has revved up the U.S. economy. But it’s also contributed to rising prices and snags in the supply chain.
To put it all in context, we spoke with Capital Group Private Client Services principal investment officer Will Robbins, global portfolio manager Gerald Du Manoir, Capital Group economist Anne Vandenabeele and Capital Group semiconductor analyst Mihir Mehta.
Will Robbins: To some extent, the rally in stock prices reflects the extremely strong rebound in earnings, particularly in the U.S. Beyond that, there are two notable dynamics. The first is that the U.S. market has been so strong and has again provided leadership around the globe.
The second dynamic is that this has been something of a two-tiered market in which investors have favored technology companies and high-growth companies over other sectors. Cyclicals provided leadership for a brief period after vaccines became broadly available. But for the most part, investors have been drawn to tech and high growth. It’s notable that defensive stocks haven’t provided leadership throughout this period — or, for that matter, throughout the better part of the last decade.
Anne Vandenabeele: Fiscal and monetary policy have underpinned earnings and market returns. The Federal Reserve’s asset purchases have clearly played a role in encouraging investors to go into riskier assets. That has supported equities and especially companies with the potential for superior long-term earnings and returns.
Vandenabeele: I expect continued growth this year of roughly 2.5% to 3%. That is good by any measure, but it’s a little bit below the consensus in the marketplace. There are a few reasons for this. The first is the risk that COVID-19, and Omicron in particular, poses to both growth and inflation.
Disruption from the virus suggests that some supply bottlenecks may persist for a little bit longer. We’re hearing from some logistics and shipping companies that supply bottlenecks — especially at ports, and especially at those in the U.S. — are not new. They’ve existed for years; COVID-19 just brought them to the fore. That’s going to take a while to get resolved.
Upheaval in the supply chain is also contributing to inflation, which may remain persistent in the coming year and eat into consumer purchasing power. Finally, fiscal and monetary stimulus will be fading in the U.S., which will also weigh on growth.
So, all in all, I expect decent growth but some stubborn inflation.
Mihir Mehta: Demand for semiconductors is very strong. In many ways, they’re the new oil, powering the new world economy.
Taking a step back, we see semiconductors powering the cloud. They’re the backbone of the internet and software giants. Semiconductors enable artificial intelligence and machine learning. Chips power 5G networks, electric cars, autonomous vehicles, industrial automation, edge computing and the Internet of Things. Chips are now going into coffee mugs and our sit-stand desks. Everyday items are becoming “smart.”
The chip industry will remain cyclical, and there will be an eventual downturn. But I think the medium- to long-term outlook for semis is very bright.
Robbins: I maintain significant exposure in the semiconductor space. These are the pick-and-shovel providers to the gold rush that is the technology revolution. I worry to some extent about customers overordering, which could lead to order cancellations or reduced demand down the line. But at the moment, there is a tremendous amount of pricing power and a very strong secular tailwind.
Vandenabeele: Inflation is coming from a lot of different places, and that’s part of the issue. For example, about half the items in the Consumer Price Index are seeing big increases. Inflation is essentially everywhere in goods and services, and it’s due to supply and demand — more demand, less supply. That means higher prices and perhaps persistent high inflation.
I think inflation will begin to moderate, in part because there will be a lot less fiscal stimulus. I also think supply issues will get resolved. I expect inflation will calm down over the course of this year. This may not happen by midyear, as many people were hoping, but I believe we’ll start to see lower inflation in the second half and toward the end of the year, which would be good news.
However, this scenario is somewhat dependent on wages. There’s such a shortage of workers that wages could really pick up. If that broadens out to more and more sectors, it could cause inflation to last longer. I’m watching that very, very carefully. The Fed is watching that very, very carefully.
Gerald Du Manoir: A few things have weighed on European growth and equity returns, particularly compared to the U.S. While market concentration has been noticeable in the U.S. — with a relatively small number of companies powering the indices — it’s been even more strident in Europe. There have actually been unbelievable companies in Europe. There just have not been that many.
Another noticeable difference is that the European market is not fully integrated in the way that the U.S. is. If you launch a product in Germany, you can’t roll it out through 26 markets in the way that you could roll it out through 50 states in the U.S. In other words, the ability to reprime the pump of growth is not that easy.
I’d also point out the structure of the market. The European stock market is heavily weighted to cyclicals, which, as we’ve discussed, have been out of favor. There have been some exceptions. The banks have done OK. Some of the industrials and autos have done OK. But relative to the amount of decline that the market endured, it just barely is caught up.
Vandenabeele: Our China economist believes that growth will be weak this year, maybe even weaker than it’s been recently. There’s been a deceleration in industrial activity because of China’s zero-COVID policy. Income and consumer fundamentals have not really picked up. Overall, it’s a very mediocre growth picture for China. And policy support and stimulus are not expected to be as substantial as they have been in the past. By the time the government takes more forceful steps, the economy may have slowed down meaningfully.
Du Manoir: Because of the uncertainty, some of my colleagues prefer to invest in non-Chinese companies that operate in and can benefit from the Chinese economy. I take a slightly different tack. I believe it’s important to try to position yourself on the right side of the government and what it’s trying to achieve policywise. Therefore, I try to find companies that are at the beginning of their cycle in terms of being the favorites. And it’s important to be willing to pull the plug if conditions change.
What are these companies? Our biotech analyst believes there are some fantastic Chinese early-stage biotech companies that are going to be globally competitive. The Chinese government clearly wants some advanced technology companies to be at the table, whether or not they succeed in the long term.
Robbins: We are very aware of the potential for permanent value destruction for shareholders if a company finds itself in the government’s crosshairs. I think we have a good sense for what the Chinese government is trying to accomplish with its policies, such as addressing inequality. But politics introduce unpredictable variables that create investment uncertainty.
We limit emerging market investments in our global service to 10%. And that encompasses all of the emerging markets, of which direct China representation is quite small. In the portfolios I manage, I have similarly low exposure to China, low single-digit in terms of direct investments in China. Having said that, indirect exposure to China through businesses based in other markets, both developed and developing, is much higher than that. We are investing in companies that we believe can benefit from continued Chinese economic growth while mitigating some of the domestic policy risk.
Robbins: There’s a long-term secular attraction to pharma and biotech. It wasn’t necessarily a good year for health care companies, but I think that’s due partly to the market’s attraction to very high-growth businesses. Our analysts see really compelling drug pipelines in some companies. The challenge is to figure out which ones possess pipelines that will ultimately demonstrate commercial success and be rewarded for it.
Also, as I’ve said in the past, the industry is benefiting from the ease of storage, access to and analytics of data.
I think that has accelerated the pace of drug discovery and created opportunities for novel treatments, as has been demonstrated with recent medical advances. I’m very much attracted to areas in which I feel that good science will ultimately be rewarded.
Mehta: Semiconductors and technology are really pervasive in all parts of our lives. I was talking to someone the other day, and I asked, “If you had to pick either your car or your smartphone, which would you keep?” My friend really had to think about it. That demonstrates how all-encompassing technology is in our lives.
We saw this during COVID. Working remotely, learning remotely and home entertainment such as gaming drove significant smartphone, PC and tablet demand. Apple, for example, had the best five quarters in its history for Macs and iPads, and these are 20- and 10-year-old products, respectively.
The internet companies are strong, software is flourishing, payment networks are transforming. Technology will continue to profoundly change the entire world around us, so the outlook for the tech sector remains strong even as the companies have grown.
Mehta: I think there is a bifurcation between companies that can support their valuations and companies that can’t. I believe Apple can. It sells 250 million premium smartphones a year. Apple generates over $100 billion of free cash flow per year. Revenue grew 33% [in the 12 months through September], while earnings were up 70%. Measured by earnings, its valuation is expensive, but on a free cash flow basis, it’s more reasonable. I believe Apple remains one of the most innovative companies on the planet and is only slightly more expensive than the broader market. And all of this is just Apple’s core business.
It sounds incredible to say this, but I think Apple has a ton of runway ahead in both its core markets and new or adjacent markets. Apple has around a 15% market share in smartphones globally. It has a 7% share of the PC market. There’s room for growth in both, as Apple is just starting to sell to the enterprise market. Apple has a nearly $70 billion services business that continues to rapidly grow, with very good margins.
In terms of new markets, there’s a lot of buzz about a possible augmented reality/virtual reality or “metaverse” device and about Apple Glass. Apple is working on an autonomous electric vehicle, though that may be a few years out. In terms of health care, the Apple Watch could over time do things like check blood pressure and do glucose monitoring. Finally, I believe consumers trust Apple in a way that they don’t necessarily trust some other tech giants. That could be an important differentiator moving forward.
Du Manoir: Technology is bringing about a massive change in how we live our lives. We’re just scratching the surface in terms of how our world is evolving. That means we’re now entering a situation where the “incumbents,” as I call them — the dominant names in various sectors — are going to face challengers. For example, the entire financial world —banking, saving, investing — is in the crosshairs of disruption. Transport is obviously being challenged. This extends all the way to the biggest technology companies. I spend a lot of time thinking about who’s going to disrupt leading businesses. It’s a sign of the speed at which technology is causing disruption.