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  Insights

Market Volatility
A resolute Federal Reserve is determined to knock out inflation

In a year of whipsaw volatility, it can feel like the economy is caught in the middle of a fight between two heavyweights — the Federal Reserve in one corner duking it out with inflation in the other. The central bank certainly has the means to punch out inflation. But it’s unclear how many rounds of interest rate hikes that will require — and how many body blows the economy may absorb in the process.


For all of the hand-wringing, key indicators suggest a recession hasn’t taken hold at this point. Despite losing some altitude, the labor market keeps churning out jobs. Wages and the number of hours worked continue to curl higher. And industrial production and consumer spending remain sturdy — hardly the conditions associated with a downturn. Those kind of numbers raised hope over the summer that policymakers would be able to subdue inflation without smothering growth.


The soft-landing scenario sparked a tantalizing but ultimately undercooked equity rally. From mid-June to mid-August, the MSCI World index recouped half of its early-year losses. But share prices buckled again as inflation burrowed deeper and the Fed responded with a string of aggressive and prolonged rate hikes. Equity prices ended the third quarter at fresh lows as rising interest rates continued to slam the bond market.


Indeed, the drumbeat of rate hikes appears to be mixing with other factors to slow the economy. Higher mortgage rates are tormenting the housing market. Oil and other commodities prices have skidded with waning demand and rising recessionary fears. And overseas economies are waterlogged by a variety of their own issues.


Inflation remains the biggest hazard. It’s been largely impervious to the five rate hikes so far this year, including three supersized moves of 0.75% each. Pricing pressures have migrated from goods to services, and particularly to “sticky” categories such as wages and rent. Given the Fed’s increasingly vocal determination to dispatch inflation at any cost, Capital Group economists believe there is a growing probability of a recession.


The near-term direction of the markets may rest on whether a downturn sets in — and, if it does, how severe it would be. Since World War II, the S&P 500 has fallen more than 15% on 19 occasions, according to Capital Group research. In the declines that did not coincide with a recession, the median drop was 19.8% and lasted for five months. Setbacks that included recessions were longer and more bruising — a nearly 34% slide that lingered for 17 months. Thus, a recession could extend the decline in the S&P 500 beyond its nearly 24% setback through the third quarter.


Today’s economy must be put into perspective.


Though a hawkish central bank has historically taken a bite out of markets, the U.S. economy has gotten past many such episodes to emerge with new vigor and renewed bull runs. Maddening as they can be, selloffs have set the stage for subsequent advances by clearing out excesses and lowering valuations to more attractive levels. It’s important to note that the deep-seated imbalances that provoked past market convulsions — especially the 2008 global financial crisis — are not in place today.


In historical terms, current valuation levels have been a good basis for future returns. Since 1985, whenever the S&P 500 was at its current price/earnings ratio around 16, the index rose an average of 7% to 9% annually over the following decade.


At its current level, the stock market has historically risen an average of 7% to 9% over the following decade

This chart shows average annualized returns in the 10 years after a variety of valuations. Historically, markets starting at current valuations have seen a 7% to 9% annual returns for a decade. When price-to-earnings ratios were less than 12x, subsequent average annualized returns for the next 10 years were 16.8%. When ratios were 12x–14x, returns were 12.8%. When ratios were 14x–16x, returns were 9.4%. When ratios were 16x–18x, returns were 7.5%. When ratios were18x–20x, returns were 5.2%. When ratios were 20x or greater, returns were 0.8%. Current ratios are 16.2x. The chart shows annualized subsequent 10-year S&P 500 Index total return by forward P/E ratio, using monthly data from January 31, 1985, to September 30, 2022. The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. Past performance is no guarantee of future results. As of September 30, 2022. Sources: Standard & Poor’s, Refinitiv.
Sources: Standard & Poor’s, Refinitiv. Chart shows annualized subsequent 10-year S&P 500 Index total return by forward P/E ratio, using monthly data from January 31, 1985, to September 30, 2022. Indices are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. Past performance is no guarantee of future results. As of September 30, 2022.

In light of the recessionary threat, Capital Group Private Client Services portfolio managers have reduced exposure to hard-hit sectors such as technology, consumer discretionary and communication services while emphasizing companies with pricing power, defensive attributes and reliable dividends.


Insurance brokers, for example, sell policies but are not responsible for paying claims, and leading brokers have fortified themselves through a wave of consolidations in recent years. When insurers raise prices, brokers collect a portion of the increased fees. Meanwhile, the appeal of utilities is promising. Though this is traditionally a sleepy sector, utilities are historically recession resilient. More than that, the sector stands to benefit from the global push toward electric vehicles and energy-efficient buildings.


The surging dollar is adding to the woes plaguing economies around the world.


As disorienting as the Fed’s rate hikes have been in the U.S., they are compounding the plight of already troubled overseas economies. Higher rates have drawn capital to the U.S., pushing the dollar to multidecade highs. Among other effects, this has added to inflationary pressures outside the U.S., as oil is priced in dollars.


Europe continues to grapple with the economic repercussions of the war in Ukraine, particularly soaring energy costs. Governments are racing to wean themselves from Russian oil and gas, while rushing out stopgap measures including price caps and plans for potential gas rationing. Despite the risk of further economic damage, the European Central Bank has embarked on a bold rate-raising campaign to dampen inflation, which recently hit a record 10%.


Great Britain is contending with its own inflationary hailstorm, as well as with a self-induced pratfall. The new prime minister uncorked a sweeping tax cut plan that caught investors flat-footed. Among other things, it raised the prospect of fiscal stimulus at loggerheads with the central bank campaign to stamp out inflation. The Bank of England intervened to head off a potential bond market crisis, and the government backtracked slightly a few days later by dropping a provision that would have slashed income tax rates for top earners.


On the bright side, weaker foreign currencies give a lift to overseas manufacturers, such as Japanese robotic businesses, that produce goods in local currencies but sell them globally in dollars. Foreign markets, which have a relative underweight to the hard-hit technology sector, also might benefit in coming years from a potential market rotation to other sectors.


Rising yields increase income potential for bonds

Alt text: Rising yields increase income potential for bonds. The yield of the Bloomberg US Aggregate Bond Index rose from its most recent low of 1.02% on August 4, 2020, to 4.75% on September 30, 2022, a 3.73 point increase. Investment-grade corporates rose from 1.74% on December 31, 2020, to 5.69, a 3.94 point increase. High-yield corporates rose from 3.53 on July 6, 2021, to 9.68%, a 6.15 point increase. Emerging markets debt rose from 4.36% on January 4, 2021, to 8.66%, a 4.3 point increase. Municipal bonds rose from 0.86% on July 27, 2021, to 4.04%, a 3.18 point increase. Investment-grade corporates are represented by Bloomberg US Corporate Investment Grade Index; High-yield corporates by Bloomberg US Corporate High-Yield Index; Emerging markets debt by a 50% JPMorgan EMBI Global Diversified Index/50% JPMorgan GBI-EM Global Diversified Index blend; and Municipal bonds by Bloomberg Municipal Bond Index. Index returns are presented in US$. Indexes are unmanaged and, therefore, do not have expenses. Investors cannot invest directly in an index. Past performance is no guarantee of future results. Period covers January 1, 2020, to September 30, 2022. As of September 30, 2022. Sources: Bloomberg Index Services, Inc., JP Morgan.
Sources: Bloomberg Index Services Ltd., JP Morgan. Investment-grade corporates represented by Bloomberg U.S. Corporate Investment Grade Index; high-yield corporates by Bloomberg U.S. Corporate High-Yield Index; emerging markets debt by a 50% JPMorgan EMBI Global Diversified Index/50% JPMorgan GBI-EM Global Diversified Index blend; and municipal bonds by Bloomberg Municipal Bond Index. Index returns are presented in US$. Indices are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index. Past performance is no guarantee of future results. Period covers January 1, 2020, to September 30, 2022. As of September 30, 2022.

The pain for bonds has continued.


This year’s unexpectedly steep rate increases have menaced the normally staid bond market. The yield on 10-year Treasury notes has nearly tripled, producing what may be the worst year for fixed income since 1926, the modern period for which there is reliable data.


In light of market conditions, our investment team remains extremely cautious, with less interest rate exposure and reduced credit risk. Municipal securities have held up far better than taxable bonds, given the strong finances of state and local governments.


Despite the near-term difficulties, bond yields are more attractive than they’ve been in a number of years, and bonds may be able to generate strong absolute returns moving forward. After a yearslong run of rock-bottom bond yields, fixed income may produce notably more income for patient investors.



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